**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM10-QSB**

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| ý                                                                                                                                                                                                                                                                                 | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                   |
| **For  the quarterly period ended June 30, 2007**                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                                                                   |
| **OR**                                                                                                                                                                                                                                                                                 |
|                                                                                                                                                                                                                                                                                   |
| o                                                                                                                                                                                                                                                                                      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                   |
| **For the transition period from                   to                       ** |
|                                                                                                                                                                                                                                                                                   |
| **Commission  File Number  0-20191**                                                                                                                                                                                                                                              |

 

**INTRUSIONINC.**

(Exact name ofsmall business issuer as specified in its charter)

| **Delaware**                                                     |   | **75-1911917**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |

 

| **1101 East Arapaho Road, Suite 200, Richardson, Texas 75081** |
|----------------------------------------------------------------|
| (Address of  principal executive offices)                      |
| (Zip Code)                                                     |
| ** **                                                     |
| **(972)  234-6400**                                            |
| (Issuer’s  telephone number, including area code)         |
| ** **                                                     |
| **Not  Applicable**                                            |
| Former name, if  changed since last report)                    |

 

* * * * * * * * **

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 xNo o

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act: Yes oNo x

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on July 27, 2007 was 10,333,250.

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

 

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**INTRUSIONINC.**

INDEX
| **PART I – FINANCIAL  INFORMATION**                                                                                | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                    |       |
| Item 1. Financial  Statements                                                                                           |       |
|                                                                                                                    |       |
| Unaudited  Condensed Consolidated Balance Sheets as of June 30, 2007 and  December 31, 2006                        |       |
|                                                                                                                    |       |
| Unaudited  Condensed Consolidated Statements of Operations for the three and six months  ended   June 30, 2007 and 2006 |       |
|                                                                                                                    |       |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the six months ended June  30, 2007 and 2006             |       |
|                                                                                                                    |       |
| Notes to  Unaudited Condensed Consolidated Financial Statements                                                         |       |
|                                                                                                                    |       |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                    |       |
|                                                                                                                    |       |
| Item 3. Controls and  Procedures                                                                                        |       |
|                                                                                                                    |       |
| **PART II – OTHER  INFORMATION**                                                                                   | ** ** |
|                                                                                                                    |       |
| Item 1. Legal Proceedings                                                                                               |       |
|                                                                                                                    |       |
| Item 4. Submission  of Matters to a Vote of Security Holders                                                            |       |
|                                                                                                                    |       |
| Item  6. Exhibits                                                                                                       |       |
|                                                                                                                    |       |
| Signature  Page                                                                                                         |       |

 

2

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**PART I – FINANCIAL INFORMATION**

Item 1. FINANCIALSTATEMENTS

**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)
| ** **                                                                                                         | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                         |       |                    |       |                        |       |
| Current Assets:                                                                                                    |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                         |       | $                       | 715        |                        | $          | 933 |   |
| Accounts  receivable, less allowance for doubtful accounts of $76 in 2007 and $90 in  2006                         |       | 747                     |       | 844                         |       |
| Inventories, net                                                                                                   |       | 224                     |       | 209                         |       |
| Prepaid expenses                                                                                                   |       | 127                     |       | 198                         |       |
| Total current assets                                                                                               |       | 1,813                   |       | 2,184                       |       |
| Property and equipment,  net                                                                                       |       | 167                     |       | 162                         |       |
| Other assets                                                                                                       |       | 39                      |       | 41                          |       |
| TOTAL ASSETS                                                                                                       |       | $                       | 2,019      |                        | $          | 2,387 |   |
|                                                                                                               |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                     |       |                    |       |                        |       |
|                                                                                                               |       |                    |       |                        |       |
| Current Liabilities:                                                                                               |       |                    |       |                        |       |
| Accounts payable  and accrued expenses                                                                             |       | $                       | 888        |                        | $          | 1,099 |   |
| Line of credit                                                                                                     |       | 125                     |       | 200                         |       |
| Deferred revenue                                                                                                   |       | 349                     |       | 367                         |       |
| Total current  liabilities                                                                                         |       | 1,362                   |       | 1,666                       |       |
|                                                                                                               |       |                    |       |                        |       |
| Stockholders’ Equity:                                                                                         |       |                    |       |                        |       |
| Preferred stock,  $0.01 par value: Authorized shares – 5,000                                                  |       |                    |       |                        |       |
| Series 1 shares  issued and outstanding — 260  Liquidation preference of $1,331 as of June 30, 2007           |       | 918                     |       | 918                         |       |
| Series 2 shares  issued and outstanding — 460  Liquidation preference of $1,155 as of June 30, 2007           |       | 724                     |       | 724                         |       |
| Series 3 shares  issued and outstanding — 469  Liquidation preference of $1,026 as of June 30, 2007           |       | 667                     |       | 667                         |       |
| Common stock,  $0.01 par value:                                                                                    |       |                    |       |                        |       |
| Authorized  shares — 80,000                                                                                   |       |                    |       |                        |       |
| Issued  shares — 10,343 in 2007 and 8,306 in 2006  Outstanding shares — 10,333 in 2007 and 8,296 in 2006 |       | 103                     |       | 83                          |       |
| Common stock  held in treasury, at cost – 10 shares                                                           |       | (362                    | )          | (362                        | )          |
| Additional  paid-in capital                                                                                        |       | 54,885                  |       | 53,947                      |       |
| Accumulated  deficit                                                                                               |       | (56,099                 | )          | (55,077                     | )          |
| Accumulated  other comprehensive loss                                                                              |       | (179                    | )          | (179                        | )          |
| Total stockholders’  equity                                                                                   |       | 657                     |       | 721                         |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                    |       | $                       | 2,019      |                        | $          | 2,387 |   |

 

See accompanyingnotes.

3

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS 

(In thousands,except per share amounts)
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006**    | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| Net product  revenue                                                       |       | $                                | 829        |                           | $          | 957 |   | $ | 1,727 |   | $ | 1,375 |   |
| Net customer  support and maintenance revenue                              |       | 174                              |       | 247                            |       | 368 |   | 680 |   |
| Total revenue                                                              |       | 1,003                            |       | 1,204                          |       | 2,095 |   | 2,055 |   |
| Cost of product  revenue                                                   |       | 371                              |       | 429                            |       | 774 |   | 686 |   |
| Cost of customer  support and maintenance revenue                          |       | 22                               |       | 30                             |       | 40 |   | 160 |   |
| Total cost of revenue                                                      |       | 393                              |       | 459                            |       | 814 |   | 846 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                               |       | 610                              |       | 745                            |       | 1,281 |   | 1,209 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating  expenses:                                                       |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                                        |       | 504                              |       | 848                            |       | 1,019 |   | 1,665 |   |
| Research and development                                                   |       | 388                              |       | 615                            |       | 811 |   | 1,407 |   |
| General and administrative                                                 |       | 248                              |       | 385                            |       | 475 |   | 733 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating loss                                                             |       | (530                             | )          | (1,103                         | )          | (1,024 | ) | (2,596 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Other income  (expense), net                                               |       | 1                                |       | (53                            | )          | 1 |   | (65 | ) |
| Interest income  (expense), net                                            |       | (1                               | )          | 11                             |       | 1 |   | 41 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Loss before  income tax provision                                          |       | (530                             | )          | (1,145                         | )          | (1,022 | ) | (2,620 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Income tax  provision                                                      |       | —                           |       | —                         |       | — |   | — |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net loss                                                                   |       | $                                | (530       | )                              | $          | (1,145 | ) | $ | (1,022 | ) | $ | (2,620 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Preferred stock  dividends accrued                                         |       | (43                              | )          | (43                            | )          | (86 | ) | (88 | ) |
| Net loss  attributable to common stockholders                              |       | $                                | (573       | )                              | $          | (1,188 | ) | $ | (1,108 | ) | $ | (2,708 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net loss per  share attributable to common stockholders, basic and diluted |       | $                                | (0.06      | )                              | $          | (0.17 | ) | $ | (0.12 | ) | $ | (0.39 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Weighted average common  shares outstanding, basic and diluted             |       | 9,271                            |       | 7,046                          |       | 8,873 |   | 7,014 |   |

 

See accompanyingnotes.

4

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,  2007**        | ** ** | **June 30,  2006** | ** ** |
| Operating  Activities:                                                       |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (1,022     | ) | $ | (2,620 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                |       | 32                             |       | 59 |   |
| Provision for doubtful accounts                                              |       | (14                            | )          | (13 | ) |
| Stock-based compensation                                                     |       | 44                             |       | 363 |   |
| Changes in  operating assets and liabilities:                                |       |                           |       |   |   |
| Accounts receivable                                                          |       | 111                            |       | (382 | ) |
| Inventories                                                                  |       | (15                            | )          | 49 |   |
| Prepaid expenses and other assets                                            |       | 73                             |       | 47 |   |
| Accounts payable and accrued expenses                                        |       | (210                           | )          | (176 | ) |
| Deferred revenue                                                             |       | (18                            | )          | (244 | ) |
| Net cash used in  operating activities                                       |       | (1,019                         | )          | (2,917 | ) |
| Investing  Activities:                                                       |       |                           |       |   |   |
| Maturities of short-term investments                                         |       | —                         |       | 500 |   |
| Purchases of property and equipment                                          |       | (37                            | )          | (3 | ) |
| Net cash  provided by (used in) investing activities                         |       | (37                            | )          | 497 |   |
| Financing  Activities:                                                       |       |                           |       |   |   |
| Net activity under line of credit                                            |       | (75                            | )          | — |   |
| Dividends paid on preferred stock                                            |       | (87                            | )          | (106 | ) |
| Proceeds from the issuance of common stock                                   |       | 1,000                          |       | 1 |   |
| Net cash  provided by (used in) financing activities                         |       | 838                            |       | (105 | ) |
|                                                                         |       |                           |       |   |   |
| Net decrease in  cash and cash equivalents                                   |       | (218                           | )          | (2,525 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 933                            |       | 2,844 |   |
| Cash and cash  equivalents at end of period                                  |       | $                              | 715        |   | $ | 319 |   |
|                                                                         |       |                           |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                   |       |                           |       |   |   |
|                                                                         |       |                           |       |   |   |
| Preferred stock  dividends accrued                                           |       | $                              | 86         |   | $ | 88 |   |

 

See accompanyingnotes.

5

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.     Description of Business

Wedevelop, market, and support a family of network intrusion prevention,intrusion detection, regulated information compliance, data privacy protectionand entity identification products.  Ourproduct families include the Compliance CommanderTM for regulated informationand data privacy protection, Intrusion SpySnareTM for real-time inline blockingof spyware and unwanted peer-to-peer (P2P) applications, Intrusion SecureNetfor network intrusion prevention and detection and TraceCopTM for identityidentification.  Intrusion’s productshelp protect critical information assets by quickly detecting, protecting,analyzing and reporting attacks or misuse of classified, private and regulatedinformation for government and enterprise networks.

Wemarket and distribute our products through a direct sales force to end-users,distributors and numerous system integrators, managed service providers andvalue-added resellers. Our end-user customers include banks, credit unions,other financial institutions, U.S. federal government entities, foreigngovernment entities and local government entities, high technology, e-commerceand telecommunication companies, hospital and other healthcare providers andacademic institutions.  Essentially, ourend-users can be defined as ‘any end-user requiring network security solutionsfor protecting their mission critical data’.

Wewere organized in Texas in September 1983 and reincorporated in Delawarein October 1995. For more than 15 years, we provided local areanetworking equipment and were known as Optical Data Systems or ODS Networks. OnJune 1, 2000, we changed our name from ODS Networks, Inc. toIntrusion.com, Inc., and our ticker symbol from ODSI to INTZ to reflectour focus on intrusion prevention and detection solutions, along withinformation compliance and data privacy protection products. OnNovember 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

Our principal executiveoffices are located at 1101 East Arapaho Road, Suite 200, Richardson, Texas75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  Information contained in or linked to ourwebsite is not a part of this report. References to “we,” “us” and “our” in this report refer to IntrusionInc. and its subsidiaries.

As ofJune 30, 2007, we had cash and cash equivalents of approximately $0.7million, down from approximately $0.9 million as of December 31,2006.  We expect our net operating lossesand operating cash outflows to continue through at least the third quarter of2007 and possibly throughout the remainder of fiscal year 2007.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  Of the $0.7 million in cash and cash equivalents at June 30, 2007, $0.5million was derived from a private investment by our Chief Executive and ChiefFinancial Officers which closed on June 28, 2007.   As of June 30, 2007, due to our borrowingbase calculation, we did not have any additional available funding under ourexisting credit lines.  If necessary, weexpect to fund our operations through additional investments of private equity,which, if we are able to obtain, will have the effect of diluting our existingcommon stockholders, perhaps significantly. On March 15, 2007, the Company received a written commitment from ourChief Executive Officer to invest up to $750,000 in the Company through March2008, of which $450,000 was funded on June 28, 2007.  Any additional equity or debt financings, ifavailable at all, may be on terms which are not favorable to us and, in thecase of equity financings, may result in dilution to our stockholders. If ouroperations do not generate positive cash flow in the next few months, or if weare not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement our businessplan, fund our liquidity needs or even continue our operations.

2.     Basis of Presentation

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-QSB andItem 310 of Regulation S-B.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2006balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generally acceptedin the United States.  However, we believethat the disclosures are adequate to make the information presented notmisleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three and six month periods endingJune 30, 2007 are not necessarily indicative of the results that may beachieved for the full fiscal year or for any future period.  The unaudited condensed consolidated financialstatements included herein should be read in conjunction with the consolidatedfinancial statements and notes thereto included in the Company’s annual reporton Form 10-KSB for the year ended December 31, 2006.

6

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3.     Inventories (In thousands)
|                          | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                     |       |                    |       |                        |       |
| Inventories  consist of: |       |                    |       |                        |       |
|                     |       |                    |       |                        |       |
| Finished goods           |       | $                       | 203        |                        | $          | 180 |   |
| Work in progress         |       | 8                       |       | 8                           |       |
| Demonstration  systems   |       | 13                      |       | 21                          |       |
| Net inventory            |       | $                       | 224        |                        | $          | 209 |   |

 

4.     Accounting for Stock-Based Compensation

AtJune 30, 2007, we have three stock-based compensation plans, which aredescribed below. These plans were developed to retain and attract key employeesand directors.

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providedfor the issuance of both non-qualified and incentive stock options to ouremployees, officers, and employee-directors. The 1995 Plan expired by its termson March 21, 2005 and no options were available for future issuance after theexpiration.  At June 30, 2007, 67,365employee options have been exercised and employee options to purchase a totalof 367,406 shares of common stock are outstanding.  A total of 2,290,295 options have beengranted pursuant to the 1995 Plan, of which, 1,855,524 have been cancelled.

In 1995, we adopted the 1995 Non-Employee Director Stock Option Plan(the “1995 Non-Employee Director Plan”). The 1995 Non-Employee Director Plan provided for the issuance ofnon-qualified stock options to non-employee directors. The 1995 Non-Employee DirectorPlan was amended in April 2002 to increase the number of shares available forissuance to 65,000 from 40,000 shares. The 1995 Non-Employee Director Planexpired by its terms on March 21, 2005 and no options were available for futureissuance after the expiration.  Nooptions have been exercised under the 1995 Non-Employee Director Plan.  Non-employee options to purchase a total of32,500 shares of common stock are outstanding at June 30, 2007. A total of62,500 options have been granted to directors pursuant to the 1995Non-Employee Director Plan, of which, 30,000 have been cancelled.

On March 17, 2005,the Board approved the 2005 Stock Incentive Plan (the “2005 Plan”), which wasapproved by the stockholders on June 14, 2005. The 2005 Plan serves as a replacement for the 1995 Non-Employee DirectorPlan and the 1995 Option Plan which expired by their terms on March 21,2005.  The approval of the 2005 Plan hadno effect on the 1995 Plans or any options granted pursuant to eitherplan.  All options will continue withtheir existing terms and will be subject to the 1995 Non-Employee Director Planor the 1995 Plan, as applicable. Further, the Company will not be able to re-issue any option which iscancelled or terminated under the 1995 Non-Employee Director Plan or the 1995Option Plan.  Originally, the 2005 Planprovided for the issuance of up to 750,000 shares of common stock upon exerciseof options granted pursuant to the 2005 Plan. This amount was increased by an additional 750,000 shares as approved bythe Board on January 25, 2007 and the stockholders on May 30, 2007.  The 2005 Plan consists of three (3) separateequity incentive programs: the Discretionary Option Grant Program; the StockIssuance Program; and the Automatic Option Grant Program for non-employee Boardmembers.  Officers and employees,non-employee Board members and independent contractors are eligible toparticipate in the Discretionary Option Grant and Stock Issuance Programs.  Participation in the Automatic Option GrantProgram is limited to non-employee members of the Board.  Each non-employee Board member will receivean option grant for 10,000 shares of Common Stock upon initial election orappointment to the Board, provided that individual has not previously beenemployed by the Company in the preceding six (6) months.  In addition, on the date of each annualstockholders meeting, each Board member will automatically be granted an optionto purchase 5,000 shares of Common Stock, provided he or she has served as anon-employee Board member for at least six (6) months.  At June 30, 2007, no 2005 Plan options havebeen exercised and employee and non-employee Board member options to purchase atotal of 961,500 shares of common stock are outstanding.  A total of 1,071,500 options have beengranted under the 2005 Plan, of which 110,000 have been cancelled and optionsfor 538,500 shares remain available for future grant.  No shares have been issued pursuant to theStock Issuance Program.

TheCompensation Committee of our Board of Directors determines for all employeeoptions, the term of each option, option exercise price within limits set forthin the plans, number of shares for which each option is granted and the rate atwhich each option is exercisable (generally ratably over one, three or fiveyears from grant date).  However, theexercise price of any incentive stock option may not be less than the fairmarket value of the shares on the date granted (or less than 110% of the fairmarket value in the case of optionees holding more than 10% of our voting stockof the Company), and the term cannot exceed ten years (five years for incentivestock options granted to holders of more than 10% of our voting stock).

7

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The following tablesummarizes stock-based compensation expense under SFAS No. 123(R) for the threemonths and six months ended June 30, 2007 and June 30, 2006 (in thousands,except per share data) which was allocated as follows:
| ** **                                         | ** ** | **For Three Months Ended** | ** ** | **For Six Months Ended** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                         | ** ** | **June 30, 2007**               | ** ** | **June 30, 2006**             | ** ** | **June 30, 2007(1)** | ** ** | **June 30, 2006** | ** ** |
|                                               |       |                                      |       |                                    |       |   |   |   |   |
| Cost of revenue                                    |       | $                                         | 1          |                                    | $          | 22 |   | $ | — |   | $ | 46 |   |
| Research and development                           |       | 12                                        |       | 36                                      |       | 20 |   | 79 |   |
| Sales and marketing                                |       | 13                                        |       | 56                                      |       | 13 |   | 125 |   |
| General and administrative                         |       | 10                                        |       | 51                                      |       | 11 |   | 113 |   |
| Effect on net  loss                                |       | $                                         | 36         |                                    | $          | 165 |   | $ | 44 |   | $ | 363 |   |
| Effect on basic and diluted  loss per common share |       | $                                         | (0.00      | )                                       | $          | (0.02 | ) | $ | (0.00 | ) | $ | (0.05 | ) |

 

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(1) Includes an increase of the estimated forfeiturerate for January 2007 to 20% from 15%. The increase in the forfeiture rate is due to greater than expectedoption terminations due to higher employee turnover than in the past.

ValuationAssumptions

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions:
| ** **                              | ** ** | **For Three Months  Ended  June 30, 2007** | ** ** | **For Three Months  Ended  June 30, 2006** | ** ** | **For Six Months  Ended  June 30, 2007** | ** ** | **For Six Months  Ended  June 30, 2006** | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|--------------------------------------------------------------|------------|---------------------------------------------------------|------------|
|                                    |       |                                                           |       |                                                           |       |                                                         |       |                                                    |       |
| Weighted average  grant date fair value |       | $                                                              | 0.31       |                                                           | $          | 0.50                                                         |       | $                                                       | 0.32       |   | $ | 1.03 |   |
| Weighted average  assumptions used:     |       |                                                           |       |                                                           |       |                                                         |       |                                                    |       |
| Expected dividend yield                 |       | 0.0                                                            | %          | 0.0                                                            | %          | 0.0                                                          | %          | 0.0                                                     | %          |
| Risk-free interest rate                 |       | 4.9                                                            | %          | 5.1                                                            | %          | 4.9                                                          | %          | 4.6                                                     | %          |
| Expected volatility                     |       | 105.0                                                          | %          | 101.0                                                          | %          | 105.1                                                        | %          | 98.6                                                    | %          |
| Expected life  (in years)               |       | 4.9                                                            |       | 5.0                                                            |       | 4.9                                                          |       | 5.0                                                     |       |
|                                         |            |                                                                |            |                                                                |            |                                                              |            |                                                         |            |  |  |  |  |

 

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Because ouremployee stock options have characteristics significantly different from thoseof traded options, and because changes in the subjective input assumptions canmaterially affect the fair value estimate, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of its employee stock options.

Expectedvolatility is based on historical volatility and in part on impliedvolatility.  The expected term considersthe contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward.

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Stock IncentivePlan Activity

Stockoption activity under the Company’s various long-term incentive and directorcompensation plans during the six months ended June 30, 2007, were as follows:
|                                   | ** ** | **Number of  Options  (in thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | ** **                                       | ** ** | ** **                             | ** ** |
| Outstanding at  December 31, 2006 |       | 1,086                                            |       | $                                      | 3.23       |   |
| Granted                           |       | 345                                              |       | 0.42                                   |       |
| Exercised                         |       | —                                           |       | —                                 |       |
| Cancelled                         |       |                                             |       |                                   |       |
| Forfeited                         |       | (45                                              | )          | 1.24                                   |       |
| Expired                           |       | (25                                              | )          | 3.10                                   |       |
|                              |       |                                             |       |                                   |       |
| Outstanding at June 30,  2007     |       | 1,361                                            |       | $                                      | 2.59       |   |

 

Summarizedinformation about outstanding stock options as of June 30, 2007, that are fullyvested and those that are expected to vest in the future as well as stockoptions that are fully vested and currently exercisable, are as follows:
| As of June 30, 2007      | ** ** | **Outstanding Stock   Options (Fully Vested   and Expected to Vest)*** | ** ** | **Options that are  Exercisable** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                                                                                     | ** ** | ** **                                  | ** ** |
| Number of  outstanding options               |       | 1,358                                                                                                          |       | 595                                         |       |
| Weighted average  remaining contractual life |       | 7.63                                                                                                           |       | 6.58                                        |       |
| Weighted average  exercise price per share   |       | $                                                                                                              | 2.59       |                                        | $          | 5.24 |   |
| Intrinsic value (in  thousands)              |       | $                                                                                                              | 25         |                                        | $          | — |   |

 

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* Includes effectsof expected forfeitures

As ofJune 30, 2007, the total unrecognized compensation cost related to non-vestedoptions not yet recognized in the statement of operations totaled approximately$216 thousand (including estimated forfeitures) and the weighted period overwhich these awards are expected to be recognized is 1.56 years.

5.     Net Loss Per Share

Basic net loss per shareis computed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod.  Diluted net loss per share iscomputed by dividing the net loss attributable to common stockholders by theweighted average number of common shares and common stock equivalentsoutstanding for the period.  Our commonstock equivalents include all common stock issuable upon conversion ofpreferred stock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the diluted loss per share calculation for theperiods ended June 30, 2007 and 2006 are 4,226,998 and 3,742,472,respectively.  Our common stockequivalents are not included in the diluted loss per share for the three andsix month periods ended June 30, 2007 and 2006, as they are antidilutive.

6.     New Accounting Pronouncement

In January 2007, we adopted the Financial AccountingStandards Board Interpretation No. 48, “Accounting for Uncertainty inIncome Taxes — An Interpretation of FASB Statement No. 109” (FIN 48). Thisinterpretation clarifies the accounting for uncertainty in income taxesrecognized in a company’s financial statements. FIN 48 requires companies todetermine whether it is “more likely than not” that a tax position will besustained upon examination by the appropriate taxing authorities before anypart of the benefit can be recorded in the financial statements. It alsoprovides guidance on the recognition, measurement and classification of incometax uncertainties, along with any related interest and penalties. We did notrecognize any adjustments to our financial statements as a result of ourimplementation of FIN 48.

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7.     Commitments and Contingencies

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact**.**

8.               Common Stock

On June 28, 2007, wecompleted a private placement to our CEO and CFO of 1,111,111 shares of ourcommon stock for gross proceeds totaling $500,000.  On March 15, 2007, we completed a privateplacement to our CEO and CFO of 925,926 shares of our common stock for grossproceeds totaling $500,000.

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Item 2            MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Forward LookingStatements

This QuarterlyReport on Form 10-QSB, including, without limitation, the section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”contains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.Such forward-looking statements are generally accompanied by words such as “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords that convey uncertainty of future events or outcomes.  These statements relate to future events orto our future financial performance, and involve known and unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance, or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by these forward-looking statements. Factors that may cause actualresults to differ materially from current expectations, which we describe inmore detail elsewhere in this Quarterly Report on Form 10-QSB under the heading“Factors That May Affect Future Results of Operations,” include, but are notlimited to:

·                  insufficientcash to operate our business and inability to meet certain liquidityrequirements;

·                  lossof revenues due to the failure of our newer products to achieve marketacceptance;

·                  ourneed to generate substantially greater revenues from sales in order to achieveprofitability;

·                  concentrationof our revenues from U.S. government entities and the possibility of loss ofone of these customers;

·                  uniquerisks associated with government customers;

·                  ourdependence on sales made through indirect channels;

·                  ourability to sell our products internationally;

·                  theeffect of payment of accrued dividends on our preferred stock on our cashresources;

·                  substantialdilution upon the conversion or redemption of our preferred stock and exerciseof outstanding warrants;

·                  theimpact of conversion of preferred stock or exercise of warrants on the price ofour common stock;

·                  theability of our preferred stockholders and lenders to hinder additionalfinancing; and

·                  theinfluence that our management and larger stockholders have over actions takenby the company.

If one or more ofthese or other risks or uncertainties materialize, or if our underlyingassumptions prove to be incorrect, actual results may vary significantly fromwhat we projected. These forward-looking statements and other statements madeelsewhere in this report are made in reliance on the Private SecuritiesLitigation Reform Act of 1995.  Any forward-lookingstatement you read in this Quarterly Report on Form 10-QSB reflects our currentviews with respect to future events and is subject to these and other risks,uncertainties and assumptions relating to our operations, results ofoperations, growth strategy and liquidity. We assume no obligation to publiclyupdate or revise these forward-looking statements for any reason, or to updatethe reasons actual results could differ materially from those anticipated inthese forward-looking statements, even if new information becomes available inthe future.  The section below entitled “FactorsThat May Affect Future Results of Operations” sets forth and incorporates byreference certain factors that could cause actual future results of the Companyto differ materially from these statements.

Critical Accounting Policies and Estimates

Management’s discussionand analysis of financial condition and results of operations are based uponour unaudited condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States.  The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

We believe the followingcritical accounting policies affect our more significant judgments andestimates used in the preparation of our unaudited condensed consolidatedfinancial statements.

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*RevenueRecognition*

Wegenerally recognize product revenue upon shipment of product. We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience. Revenue from maintenance contracts is deferred and recognized overthe contractual period the services are performed, generally one year.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No.104, “Revenue Recognition” whereby revenue from the licensing of our productsis not recognized until all four of the following criteria have been met:i) execution of a written agreement; ii) delivery of the product hasoccurred; iii) the fee is fixed and determinable; andiv) collectibility is probable. Bundled hardware and perpetual softwareproduct sales are recognized at time of delivery, as our licenses are not soldon a subscription basis.  In the case ofmultiple product and service sales, we perform a Vendor Specific ObjectiveEvidence analysis to appropriately determine the amount of revenue derived fromeach deliverable.  If our licensestrategy changes and we begin to offer licenses on a subscription basis, we wouldperform this analysis in a similar manner. Under these circumstances, the revenue related to the license would berecognized ratably over the subscription period.  Market values are easily obtained for all ofour product offerings, as we have historical sales information on our productofferings.  We defer and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accounts receivableand reduce inventory related to the sale at the time of shipment to thedistributor. Revenue, offset by deferred cost of sales, is included in deferredrevenue in the accompanying financial statements.  Since the net balance in deferred revenuerepresents the sales price less the cost of the product maintained by thedistributors, the deferred costs of these products are included in ourobsolescence and slow-moving analysis and are written down according to theirestimated current value.  This transactioneffectively recognizes expense for the write-down, if any, and increases thenet liability in the deferred revenue account.

Wegenerally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation, are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.

*Allowancefor Doubtful Accounts and Returns*

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Our receivables areuncollaterized and we expect to continue this policy in the future.  If the financial condition of our customerswere to deteriorate, resulting in an impairment of their ability to makepayments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

*Inventory*

Wewrite down our inventory for estimated obsolescence or unmarketable inventoryequal to the difference between the cost of inventory and the estimated marketvalue based upon assumptions about future demand and market conditions. Ifactual market conditions are less favorable than those projected by management,additional inventory write-downs may be required.   Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

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Results of Operations

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006**    | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| Net product  revenue                              |       | 82.7                             | %          | 79.5                           | %          | 82.4 | % | 66.9 | % |
| Net customer  support and maintenance revenue     |       | 17.3                             |       | 20.5                           |       | 17.6 |   | 33.1 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0                          |       | 100.0 |   | 100.0 |   |
| Cost of product  revenue                          |       | 37.1                             |       | 35.6                           |       | 37.0 |   | 33.4 |   |
| Cost of customer  support and maintenance revenue |       | 2.1                              |       | 2.5                            |       | 1.9 |   | 7.8 |   |
| Total cost of  revenue                            |       | 39.2                             |       | 38.1                           |       | 38.9 |   | 41.2 |   |
| Gross profit                                      |       | 60.8                             |       | 61.9                           |       | 61.1 |   | 58.8 |   |
| Operating  expenses:                              |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                               |       | 50.2                             |       | 70.4                           |       | 48.7 |   | 81.0 |   |
| Research and development                          |       | 38.7                             |       | 51.1                           |       | 38.7 |   | 68.5 |   |
| General and administrative                        |       | 24.7                             |       | 32.0                           |       | 22.6 |   | 35.7 |   |
| Severance and related costs                       |       | —                           |       | —                         |       | — |   | — |   |
| Operating loss                                    |       | (52.8                            | )          | (91.6                          | )          | (48.9 | ) | (126.4 | ) |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Other income  (expense), net                      |       | —                           |       | (4.4                           | )          | 0.1 |   | (3.2 | ) |
| Interest  income(expense), net                    |       | (0.1                             | )          | 0.9                            |       | — |   | 2.0 |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Loss before  income tax provision                 |       | (52.9                            | )          | (95.10                         | )          | (48.8 | ) | (127.6 | ) |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Income tax  provision                             |       | —                           |       | —                         |       | — |   | — |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Net loss                                          |       | (52.9                            | )%         | (95.1                          | )%         | (48.8 | )% | (127.6 | )% |
| Preferred stock  dividends accrued                |       | (4.3                             | )          | (3.6                           | )          | (4.1 | ) | (4.3 | ) |
| Beneficial  conversion feature on preferred stock |       | —                           |       | —                         |       | — |   | — |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Net loss attributable  to common stockholders     |       | (57.2                            | )%         | (98.7                          | )%         | (52.9 | )% | (131.9 | )% |

 
| ** **           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **           | ** ** | **June 30, 2007**      | ** ** | **June 30, 2006**    | ** ** | **June 30, 2007** | ** ** | **June 30, 2006** | ** ** |
| Domestic  revenues   |       | 95.9                             | %          | 86.6                           | %          | 91.8 | % | 86.3 | % |
| Export revenues  to: |       |                             |       |                           |       |   |   |   |   |
| Europe               |       | 3.1                              |       | 12.6                           |       | 7.2 |   | 10.6 |   |
| Canada               |       | 0.1                              |       | 0.3                            |       | 0.1 |   | 1.6 |   |
| Asia                 |       | 0.8                              |       | 0.4                            |       | 0.8 |   | 1.3 |   |
| Latin America        |       | 0.1                              |       | 0.1                            |       | 0.1 |   | 0.2 |   |
|                 |       |                             |       |                           |       |   |   |   |   |
| Net revenues         |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Net revenuesfor the quarter and six months ended June 30, 2007 were $1.0 million and $2.1million, respectively, compared to $1.2 million and $2.1 million for the sameperiods in 2006.  Product revenuesdecreased $0.1 million for the quarter ended June 30, 2007 compared to the sameperiod in 2006.  Customer support andmaintenance revenue decreased $0.1 and $0.3 million for the quarter and sixmonths ended June 30, 2007 compared to the same periods in 2006.  This decrease was due to the current salesmix with a high concentration of government sales not requiring a maintenancecontract.

**Concentrationof Revenues**.  Revenuesfrom sales to various U.S. government entities totaled $0.8 million, or 80.3%of revenues, for the quarter ended June 30, 2007 compared to $0.9 million, or72.4% of revenues, for the same period in 2006. Revenues from sales to various U.S. government entities totaled $1.6million, or 75.2% of revenues, for the six months ended June 30, 2007 comparedto $1.4 million, or 70.0% of revenues, for the same period in 2006.    Although we expect our concentration ofrevenues to vary among customers in future quarters depending upon the timingof certain sales, we anticipate that sales to government customers willcontinue to account for a significant portion of our revenues in futurequarters.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including potential disruption toappropriation and spending patterns and the government’s reservation of theright to cancel contracts and purchase orders for its

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convenience. Although we do not believe that that any of our revenues with governmentcustomers are subject to renegotiation, a large number of cancelled orrenegotiated government orders could have a material adverse effect on ourfinancial results.  Currently, we are notaware of any proposed cancellation or renegotiation of any of our existingarrangement with government entities and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

**GrossProfit**.  Gross profitwas $0.6 million or 60.8% of net revenues for the quarter ended June 30, 2007,compared to $0.7 million or 61.9% of net revenues for the quarter ended June30, 2006.  Gross profit was $1.3 millionor 61.1% of net revenues for the six months ended June 30, 2007, compared to$1.2 million or 58.8% of net revenues for the six months ended June 30,2006.    Gross profit on product revenuesfor the quarter and six months ended June 30, trended from 55.2% and 50.1%,respectively, in 2006 to 55.2% and 55.2%, respectively, in 2007 due to thetransition to our more profitable software-based products.  Gross profit on customer support andmaintenance revenues for the quarter and six months ended June 30, trended from87.9% and 76.4%, respectively, in 2006 to 87.6% and 89.1%, respectively, in2007.  Gross profit as a percentage ofnet revenues is impacted by several factors, including shifts in product mix,changes in channels of distribution, revenue volume, pricing strategies, andfluctuations in revenues of integrated third-party products.

**Salesand Marketing**.  Salesand marketing expenses decreased to $0.5 million for the quarter ended June 30,2007, compared to $0.8 million for the quarter ended June 30, 2006. Sales andmarketing expenses decreased to $1.0 million for the six months ended June 30,2007, compared to $1.7 million for the six months ended June 30, 2006 primarilydue to a planned reduction in sales related expenses.  Sales and marketing expenses may vary in thefuture.  However, we believe that thesecosts will remain relatively constant through the end of 2007.

**Researchand Development**. Research and development expenses decreased to $0.4 million for thequarter ended June 30, 2007 compared to $0.6 million for the quarter ended June30, 2006. Research and development expenses decreased to $0.8 million for thesix months ended June 30, 2007, compared to $1.4 million for the six monthsended June 30, 2006.  Research anddevelopment costs are expensed in the period incurred.  Research and development expenses decreasedin the three and six months ended June 30, 2007, compared to the same periodsin 2006 primarily due to shifts from R&D expenses to cost of sales inrelation to engineering contract jobs. Research and development expenses may vary in the future; however, webelieve that these costs will remain relatively constant through the end of2007.

**Generaland Administrative**. General and administrative expenses decreased to $0.2 million for thequarter ended June 30, 2007 compared to $0.4 million for the quarter ended June30, 2006.  General and administrativeexpenses decreased to $0.5 million for the six months ended June 30, 2007,compared to $0.7 million for the six months ended June 30, 2006.  It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of 2007, as no further cost reductions are anticipated.

**Interest**.  Net interest income decreased to $0.6thousand interest expense for the quarter ended June 30, 2007 compared to $11thousand interest income for the same period in 2006.  Net interest income increased to $0.4thousand for the six months ended June 30, 2007 compared to $41 thousand forthe same period in 2006.  The decrease ininterest income was primarily due to a decrease of cash and short-terminvestment balances when compared to the prior year and an increase in interestexpense related to the line of credit. Net interest income may vary in the future based on our cash flow andrate of return on investments.

Liquidity and Capital Resources

Our principal source ofliquidity at June 30, 2007 is approximately $0.7 million of cash and cashequivalents.  At June 30, 2007 workingcapital was $0.5 million compared to $0.4 million at June 30, 2006.

Cash used in operationsfor the six months ended June 30, 2007 was $1.0 million, primarily due to a netloss of $1.0 million, a decrease in accounts payable and accrued expenses of$210 thousand, a decrease in accounts receivable of  $111 thousand, a decrease in prepaid expensesand other assets of $73 thousand, a reduction in deferred revenue of $18thousand, and a reduction in the provision for doubtful accounts of $14thousand, stock-based compensation of $44 thousand, depreciation expense of $32thousand, and an increase in inventories of $15 thousand.  Cash used in operations for the six monthsended June 30, 2006 was $2.9 million, primarily due to a net loss of $2.6million, a decrease in accounts payable and accrued expenses of $0.2 million, areduction in deferred revenue of $0.2 million, an increase in accountsreceivable of $0.4 million and a reduction in the provision for doubtfulaccounts of $13 thousand.  This cashdecrease was partially offset by stock-based compensation of $0.4 million, depreciationexpense of $59 thousand, a decrease in inventories of $49 thousand and adecrease in prepaid expenses and other assets of $47 thousand.   Future fluctuations in inventory balances,accounts receivable and accounts payable will be dependent upon severalfactors, including, but not limited to, quarterly sales, our strategy inbuilding inventory in advance of receiving orders from customers, and theaccuracy of our forecasts of product demand and component requirements.

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There was $37 thousand ofcash used in investing activities in the six months ended June 30, 2007 for netpurchases of property and equipment, compared to $497 thousand provided byinvesting activities in the six months ended June 30, 2006 primarily related tothe maturities of short-term investments.

Cash provided by financingactivities in the six months ended June 30, 2007 was $0.8 million, primarilyconsisting of the proceeds from the issuance of common stock of $1.0 million,payment of dividends on preferred stock of $87 thousand and net reduction inthe line of credit of $75 thousand, compared to cash used in financingactivities in the six months ended June 30, 2006 was $105 thousand, primarilyconsisting of the payment of dividends on preferred stock.

At June 30, 2007, the Company did not have any material commitments forcapital expenditures.

During the three months ended June 30, 2007, the Company funded itsoperations through the use of cash and cash equivalents.

OnJune 28, 2007, we completed a private placement of 1,111,111 shares of ourCommon Stock for gross proceeds of $500,000.

OnMarch 29, 2006, we established a $1,000,000 line of credit with Silicon ValleyBank.  Under the terms of this agreement,we may borrow an amount equal up to 80% of eligible accounts receivablebalances.  In addition, we may obtain inventoryadvances equal to 35% of finished good inventory, capped at the lesser of theinventory availability, $300,000 or 35% of our total borrowing base.  If our credit line increases to $2,000,000,inventory advances will be capped at the lesser of the inventory availability,$600,000 or 35% of our borrowing base. Amounts we borrow under the credit line accrue interest at an annualrate of prime plus 1% and are secured by a lien on all of our assets.  Accrued interest on all outstanding amountsis payable monthly in arrears and all outstanding principal and accrued butunpaid interest on the amounts we borrow are due on March 28, 2008.  Our ability to receive advances under thiscredit line will increase if we generate additional receivables and inventoryfrom the sale of our products.  We have acurrent balance due under this credit line of $125,000 at June 30, 2007.  Also, assuming receivables and inventoryequal to the $747,000 of net accounts receivable and the $203,000 of finishedgoods inventory we had at June 30, 2007, we did not have any additional fundsavailable under our credit line at June 30, 2007 due to our borrowing basecalculation. The line of credit was renewed on March 29, 2007, accrued intereston all outstanding amounts is payable monthly in arrears and all outstandingprincipal and accrued but unpaid interest on the amounts we borrow are due onMarch 28, 2008.

Weexpect our net operating losses and operating cash outflows to continue throughat least the third quarter of 2007 and possibly throughout the remainder offiscal year 2007.  The sufficiency of ourcash resources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  Of the $0.7 million in cash and cash equivalents at June 30, 2007, $0.5million was derived from a private investment by our Chief Executive and ChiefFinancial Officers which closed on June 28, 2007.   As of June 30, 2007 we did not have anyadditional funds available under our existing credit line due to our borrowingbase calculation.  Based on projectionsfor increased revenues for the next twelve months, the closing of the $0.5million private placement on June 28, 2007 and a commitment from the Company’sCEO to advance the Company up to an additional $0.3 million in funding shouldit be necessary, we believe that our available cash resources will providesufficient cash resources to finance our operations and expected capitalexpenditures over the twelve month period. If we do not achieve our projections for increased revenues, it ispossible that we may need to fund our operations through additional investmentsof private equity, which, if we are able to obtain, will have the effect ofdiluting our existing stockholders, perhaps significantly.  Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case ofequity financings, most likely will result in dilution to our stockholders. Ifour operations do not generate positive cash flow in the next few months, or ifwe are not able to obtain additional debt or equity financing on terms and conditionsacceptable to us, if at all, we may be unable to implement our business plan,fund our liquidity needs or even continue our operations.

We may explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritize additional securitytechnologies, which we may wish to develop, either internally or through thelicensing, or acquisition of products from third parties.  While we may engage from time to time indiscussions with respect to potential acquisitions, there can be no assurancesthat any such acquisitions will be made or that we will be able to successfullyintegrate any acquired business.  Inorder to finance such acquisitions and working capital it may be necessary forus to raise additional funds through public or private financings.  Any equity or debt financings, if availableat all, may be on terms, which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders.

Off-Balance Sheet Arrangements.

As of June 30, 2007, wedid not have any significant off-balance sheet arrangements, as defined by Item303(c)(2) of Regulation S-B.

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Factors That May Affect Future Results of Operations 

Numerous factors mayaffect our business and future results of operations.  These factors include current economic andmarket conditions, the effect of military actions on government and corporatespending on information security products, spending patterns of, and appropriationsto, U.S. government departments, technological changes, competition and marketacceptance, acquisitions, product transitions, timing of orders, manufacturingand suppliers, reliance on outsourcing vendors and other partners, intellectualproperty and licenses, third-party products, dependence on governmentcustomers, international operations, intellectual property issues, liquidityand cash resources and effects of restructuring plans and cost reductions.  The discussion below addresses some of theseand other factors.  For a more thoroughdiscussion of these and other factors that may affect our business and futureresults, see the discussion under the caption “Factors That May Affect FutureResults of Operations” in our Annual Report on Form 10-KSB for the year endedDecember 31, 2006.

***Ourcash and cash equivalents decreased from $0.9 million at December 31, 2006to $0.7 million at June 30, 2007.  As aresult of our expected continuing net cash outflows, we may not have sufficientcash to operate our business and may not be able to maintain certain liquidityrequirements.***

As of June 30,2007, we had cash and cash equivalents of approximately $0.7 million, down fromapproximately $0.9 million as of December 31, 2006.  We expect our net operating losses andoperating cash outflows to continue through at least the third quarter of 2007and possibly throughout the remainder of fiscal year 2007.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  Of the $0.7 million in cash and cash equivalents at June 30, 2007, $0.5million was derived from a private investment by our Chief Executive and ChiefFinancial Officers which closed on June 28, 2007.   As ofJune 30, 2007 we did not have any available funding under our existing creditlines due to our borrowing base calculation. If necessary, we expect to fund our operations through additionalinvestments of private equity, which, if we are able to obtain, will have theeffect of diluting our existing stockholders, perhaps significantly.  On March 15, 2007, the Company received awritten commitment from our Chief Executive Officer to invest up to anadditional $750,000 in the Company through March 2008, of which $450,000 wasfunded on June 28, 2007.    Any equity ordebt financings, if available at all, may be on terms which are not favorableto us and, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in the nextfew months, or if we are not able to obtain additional debt or equity financingon terms and conditions acceptable to us, if at all, we may be unable toimplement our business plan, fund our liquidity needs or even continue ouroperations.

***Ourrevenues declined from $6.0 million in 2005 to $5.2 million in 2006 inconnection with a shift in focus from SecureNet products to ComplianceCommander and TraceCop products.   If ournewer products do not achieve market acceptance, our revenues will continue tosuffer.***

We havetransitioned our sales strategy focus from SecureNet to Compliance Commanderand TraceCop.  During this transition,sales of our newer products have not offset the losses in sales associated withour older products.  As a result, our netrevenues declined from $6.0 million in 2005 to $5.2 million in 2006 andremained relatively constant for the first half of 2007 compared to 2006.  We can provide no assurances that sales ofour newer products will ever offset the losses in sales of older products orgenerate sufficient revenues to sustain our business.

Our new networksecurity products, regulated information compliance systems and entityidentification products have only been in the market place for a limited periodof time and may have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  If we are unable to recognize revenues due tolonger sales cycles or other problems, our results of operations will beadversely affected, perhaps materially.

We have not yetreceived broad market acceptance for our newer products.  We cannot assure you that our present orfuture products will achieve market acceptance on a sustained basis.  In order to achieve market acceptance andachieve future revenue growth, we must introduce complementary securityproducts, incorporate new technologies into our existing product lines anddesign, develop and successfully commercialize higher performance products in atimely manner.  We cannot assure you thatwe will be able to offer new or complementary products that gain marketacceptance quickly enough to avoid decreased revenues during current or futureproduct introductions or transitions.

***Wehad a net loss of $0.5 million for the quarter ended June 30, 2007 and anaccumulated deficit of $56.1 million at June 30, 2007.  As a result, we must generate substantiallygreater revenues from sales in order to achieve profitability.***

We incurredsignificant operating losses for the quarter ended June 30, 2007 and haveincurred operating losses in previous quarters. For the year ended December 31, 2006, we incurred a net loss of$3.0 million and had an accumulated deficit of approximately $55.1 million atDecember 31, 2006. ** **We need to generate and sustainsubstantially greater revenues from the sales of our products if we are

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to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue for the near term andpossibly longer, and we may never achieve or sustain profitability or generatepositive cash flow from operations.

***A large percentage of our revenues are received from U.S.government entities, and the loss of one of these customers could reduce ourrevenues and materially harm our business and prospects.***

A large percentageof our revenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended June 30, 2007, salesto U.S. government entities collectively accounted for 80.3% of our total netrevenues.  For the years ended December31, 2004, 2005****and 2006, sales toU.S. government entities collectively accounted for 53.6%, 70.7% and 73.6% ofour total net revenues, respectively. The loss of any of these keyrelationships may send a negative message to other U.S. governmententities or non-governmental customers concerning our product offering.  We cannot assure you that U.S.government entities will be customers of ours in future periods or that we will be able todiversify our customer portfolio to adequately mitigate the risk of loss of anyof these customers.

***Government customers involve unique risks, which couldadversely impact our revenues.***

We expect tocontinue to derive a substantial portion of our revenues from U.S. governmentcustomers in the future.  Sales to thegovernment present risks in addition to those involved in sales to commercialcustomers, including potential disruption due to appropriation and spendingpatterns, delays in approving a federal budget and the government’s right tocancel contracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetary constraints,political agendas, extensive specification development and price negotiationsand milestone requirements.  Eachgovernment entity also maintains its own rules and regulations with which wemust comply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

***Weare highly dependent on sales made through indirect channels, the loss of whichwould materially adversely affect our operations.***

For the yearsended December 31, 2004, 2005 and 2006, we derived 36.9%, 36.2% and 17.3%of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We derived 22.3% of our revenues in the second quarter of 2007 from suchsales channels.  We must expand our salesthrough these indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

***International sales comprise a material portion of ouroverall revenues.  Our ability to sellour products internationally is subject to certain risks, which could harm ourbusiness.***

Revenues fromforeign customers for the fiscal years ended December 31, 2004, 2005 and 2006accounted for approximately 19.2%, 10.7% and 9.4%, respectively, of ourrevenues.  Foreign revenues in the secondquarter 2007 were 4.1% of revenues.  Weexpect sales to foreign customers to continue to represent a significantportion of our revenues in the future. Our international operations are subject to many inherent risks that mayadversely affect our business, financial condition and operating results,including:

·                  political,social and economic instability;

·                  traderestrictions;

·                  increasesin duty rates and other potentially adverse tax consequences;

·                  exposureto different legal standards, particularly with respect to the protection ofintellectual property;

·                  burdensof complying with a variety of foreign laws;

·                  unexpectedchanges in regulatory requirements;

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·                  importand export license requirements and restrictions of the United States and eachother country where we operate;

·                  fluctuationsin currency exchange rates; and

·                  changesin local purchasing practices, including seasonal fluctuations in demand.

Any interruptionsor declines in our international sales would result in a significant adverseimpact on our results of operations and business.

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

On March 25, 2004,we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1 PreferredStock”) and warrants to acquire 556,619 shares of our common stock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  We also issued our placementagent a warrant for 64,408 shares of our common stock at an exercise price of$3.144 per share.  As of April 30, 2007,there were 259,696 shares of the Series 1 Preferred Stock outstanding, representingapproximately 413,003 shares of common stock upon conversion, and warrants topurchase 621,027 shares of common stock outstanding.

On March 28, 2005,we completed a $2,663,000 private placement pursuant to which we issued1,065,200 shares of our Series 2 5% Convertible Preferred Stock (the “Series 2Preferred Stock”) and warrants to acquire 532,600 shares of our commonstock.  We also issued two affiliates ofour placement agent warrants to purchase an aggregate of 60,390 shares ofcommon stock.  The conversion price forthe Series 2 Preferred Stock is $2.50 per share and the exercise price of thewarrants is $2.77 per share.  As of April30, 2007, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion, andwarrants to purchase 592,990 shares of common stock outstanding.

On December 2,2005, we completed a $1,230,843 private placement pursuant to which we issued564,607 shares of our Series 3 5% preferred stock  (the “Series 3 Preferred Stock”) and warrantsto acquire 282,306 shares of our common stock. We also issued two affiliates of our placement agent warrants topurchase an aggregate of 27,531 shares of common stock.  The conversion price of the Series 3Preferred Stock is $2.18 per share and the exercise price of the warrants is$2.58 per share.  As of April 30, 2007,there were 468,735 shares of Series 3 Preferred Stock outstanding, representing468,735 shares of common stock upon conversion, and warrants to purchase 309,837shares of common stock outstanding.

During the fiscalyear ended December 31, 2006, we paid $66,000 in dividends to the holders ofour 5% Preferred Stock, $74,000 in dividends to the holders of our Series 2 5%Preferred Stock and $53,000 in dividends to the holders of our Series 3 5%Preferred Stock.  At June 30, 2007, wehave dividends accrued of $16,187 related to our 5% Preferred Stock, $4,726related to our Series 2 5% Preferred Stock and $4,199 related to ourSeries 3 5% Preferred Stock.

Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years ended as ofDecember 31, 2006.  However, we did havesufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  We cannotassure you that our net assets will continue to exceed our stated capital orthat we will have net profits in order to pay these dividends in thefuture.  These dividends continue toaccrue on all our outstanding shares of preferred stock, regardless of whetherwe are legally able to pay them.  Theaccrual of these dividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business.

If weare unable to pay dividends on our preferred stock, we could be required toredeem the outstanding shares of Series 2 Preferred Stock and Series 3Preferred Stock for shares of our common stock issued at a price equal to 75%of the average of the volume weighted average price of our common stock for theten days ending on the day immediately preceding an election to redeem,subject, in the case of the Series 3 Preferred Stock, to a floor of $0.87.  As a result, the issuance or potential issuanceof these additional shares of common stock could cause our stock price todecline.  Furthermore, our inability topay dividends could adversely affect our ability to raise equity financing inthe future if required.

***Youwill experience substantial dilution upon the conversion or redemption of theshares of preferred stock and the exercise of warrants that we issued in ourrecent private placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible orexercisable into shares of common stock.***

On July 27, 2007,we had 10,333,250 shares of common stock outstanding.  Upon conversion of all outstanding shares ofour preferred stock and exercise of the warrants, we would have 13,198,842shares of common stock outstanding, an increase of approximately 27.7% in thenumber of shares of our common stock outstanding.

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Further, theoccurrence of certain events entitles holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for a certainnumber of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amounts tothe holders, (ii) incurred accrued but unpaid dividends on July 31, 2007 of$17,600, (iii) a volume weighted average price of $0.48, which was the ten-dayvolume weighted average closing price of our common stock on July 31, 2007, and(iv) our 10,333,250 shares of common stock outstanding on July 31, 2007, uponexercise of their redemption right by the holders of the Series 3 PreferredStock and the Series 2 Preferred Stock, we would be obligated to issueapproximately 8,919,053 shares of our common stock.  This would represent an increase ofapproximately 86.3% in the number of shares of our common stock as of July 31,2007.

In addition,management may issue additional shares of common stock or securitiesexercisable or convertible into shares of common stock in order to finance theCompany’s continuing operations.  Anyfuture issuances of such securities would have additional dilutive effects onthe existing holders of our Common Stock.

***Theconversion of preferred stock or exercise of warrants we issued in the privateplacements may cause the price of our common stock to decline.***

The holders of theshares of our 5% Preferred Stock and warrants we issued in connection with thesale of our 5% Preferred Stock may convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock.  As of July 31, 2007, 740,304 shares of our 5%Preferred Stock had converted into 1,177,327 shares of common stock.

The holders of theshares of Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may convert their shares of preferredstock and exercise their warrants and sell the underlying shares of commonstock.  As of July 31, 2007, 605,200shares of Series 2 Preferred Stock had converted into 605,200 shares of commonstock.

The holders of theshares of Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may convert their shares of Series 3Preferred Stock and exercise their warrants and sell the underlying shares ofcommon stock pursuant to an effective registration statement we filed with theCommission on April 26, 2007.  As of July31, 2007, 95,872 shares of Series 3 Preferred Stock had converted into 95,872shares of common stock.

For the four weeksended on July 27, 2007, the average daily trading volume of our common stock onThe OTCBB was 7,153 shares.  Consequently,if holders of preferred stock or warrants elect to convert their remainingshares or exercise their warrants and sell a material amount of theirunderlying shares of common stock on the open market, the increase in sellingactivity could cause a decline in the market price of our common stock.  Furthermore, these sales, or the potentialfor these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

Under the terms ofour preferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of at leasta majority of the holders of our 5% Preferred Stock, all of the holders of ourSeries 2 5% Preferred Stock, and holders of at least 75% of our Series 3 5%Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of our PreferredStock.  Furthermore, the terms of oursecured credit line with Silicon Valley Bank include covenants which restrictour ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

***Our failure to realize the expected benefits of our recentrestructuring efforts could adversely affect our operating results.***

Since we beganrestructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. We have alsoimplemented other strategic initiatives, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

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***Weresemble a developmental stage company and our business strategy may not besuccessful.***

From our foundingin 1983 until 2000, we derived substantially all of our revenue from thedesign, manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenuesgenerated from the sale of our network security products, which have receivedlimited market acceptance.  We have alsointroduced our regulated information compliance systems, entity identificationproducts and spyware products, and the market for these products has only begunto emerge.  We can provide no assurancesthat our newly introduced products will ever achieve widespread marketacceptance or that an adequate market for these products will ever emerge.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

·                  theneed for our network security products, regulated information compliancesystems, entity identification products and spyware products to achieve marketacceptance and produce a sustainable revenue stream;

·                  ourability to manage costs and expenses;

·                  ourdependence on key personnel;

·                  ourability to obtain financing on acceptable terms; and

·                  ourability to offer greater value than our competitors.

Our businessstrategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products, regulated informationcompliance systems, entity identification products and spyware products, ourbusiness, financial condition and operating results would be materiallyadversely affected.

***Our management and larger stockholders exercise significantcontrol over our company and have the ability to approve or take actions thatmay be adverse to your interests.***

As of July 31, 2007,our executive officers, directors and preferred stockholders beneficially ownapproximately 42.6% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, the Company contemplates thepossible issuance of shares of our Common Stock or of securities exercisable orconvertible into shares of our Common Stock in connection with a futureinvestment by our Chief Executive Officer, pursuant to his written commitmentto fund an amount up to $750,000, of which $450,000 was funded on June 28,2007.  Any such issuance will increasethe percentage of stock our Chief Executive Officer and our management groupbeneficially holds.

***We face intense competition from both start-up andestablished companies that may have significant advantages over us and ourproducts.***

The market fornetwork security solutions is intensely competitive. There are numerouscompanies competing with us in various segments of the data security markets,and their products may have advantages over our products in areas such asconformity to existing and emerging industry standards, interoperability withnetworking and other security products, management and security capabilities,performance, price, ease of use, scalability, reliability, flexibility, productfeatures and technical support.

Ourprincipal competitors in the network intrusion prevention and detection marketinclude Internet Security Systems, Inc. (IBM), Cisco Systems, Inc.,Symantec, Inc., Juniper Networks, Inc., McAfee Inc., Tipping PointTechnologies, a division of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu, Port Authority (Websense), Vericept, Reconnex,Tablus and a small number of start-up companies that entered the space withinthe last two years. Regarding the spyware prevention market, we currentlydirectly and indirectly compete with a number of host-based spyware detectionsystems, such as Ad-Aware, Spybot S&D and Spy Sweeper and some inline proxysolutions such as Blue Coat Systems, Inc. Our current and potential competitors may have one or more of thefollowing significant advantages over us:

·                  greaterfinancial, technical and marketing resources;

·                  bettername recognition;

·                  morecomprehensive security solutions;

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·                  betteror more extensive cooperative relationships; and

·                  largercustomer base.

We cannot assureyou that we will be able to compete successfully with our existing or new competitors.  Some of our competitors may have, in relationto us, one or more of the following: longer operating histories,longer-standing relationships with OEM and end-user customers and greatercustomer service, public relations and other resources. As a result, thesecompetitors may be able to more quickly develop or adapt to new or emergingtechnologies and changes in customer requirements, or devote greater resourcesto the development, promotion and sale of their products. Additionally, it islikely that new competitors or alliances among existing competitors couldemerge and rapidly acquire significant market share.

***If we fail to respond to rapid technological changes in thenetwork security industry, we may lose customers or our products may become obsolete.***

The networksecurity industry is characterized by frequent product introductions, rapidlychanging technology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

***Ourproducts are highly technical and if they contain undetected errors, ourbusiness could be adversely affected and we might have to defend lawsuits orpay damages in connection with any alleged or actual failure of our productsand services.***

Our products arehighly technical and complex, are critical to the operation of many networksand, in the case of our security products, provide and monitor network securityand may protect valuable information. Our products have contained and maycontain one or more undetected errors, defects or security vulnerabilities.Some errors in our products may only be discovered after a product has beeninstalled and used by end customers. Any errors or security vulnerabilitiesdiscovered in our products after commercial release could result in loss ofrevenues or delay in revenue recognition, loss of customers and increasedservice and warranty cost, any of which could adversely affect our business andresults of operations. In addition, we could face claims for product liability,tort or breach of warranty. Defending a lawsuit, regardless of its merit, iscostly and may divert management’s attention. In addition, if our businessliability insurance coverage is inadequate or future coverage is unavailable onacceptable terms or at all, our financial condition could be harmed.

***Abreach of network security could harm public perception of our securityproducts, which could cause us to lose revenues.***

If an actual orperceived breach of network security occurs in the network of a customer of oursecurity products, regardless of whether the breach is attributable to ourproducts, the market perception of the effectiveness of our products could beharmed. This could cause us to lose current and potential end customers orcause us to lose current and potential value-added resellers and distributors.Because the techniques used by computer hackers to access or sabotage networkschange frequently and generally are not recognized until launched against atarget, we may be unable to anticipate these techniques.

***Ifour products do not interoperate with our customers’ networks, installationswill be delayed or cancelled and could harm our business.***

Our products aredesigned to interface with our customers’ existing networks, each of which havedifferent specifications and utilize multiple protocol standards and productsfrom other vendors. Many of our customers’ networks contain multiplegenerations of products that have been added over time as these networks havegrown and evolved. Our products will be required to interoperate with many orall of the products within these networks as well as future products in orderto meet our customers’ requirements. If we find errors in the existing softwareor defects in the hardware used in our customers’ networks, we may have tomodify our software or hardware to fix or overcome these errors so that ourproducts will interoperate and scale with the existing software and hardware,which could be costly and negatively impact our operating results. In addition,if our products do not interoperate with those of our customers’ networks,demand for our products could be adversely affected, orders for our productscould be cancelled or our products could be returned. This could hurt ouroperating results, damage our reputation and seriously harm our business andprospects.

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***Whilewe believe that we currently have adequate internal control over financialreporting, we are exposed to risks from recent legislation requiring companiesto evaluate those internal controls.***

Section 404 of theSarbanes-Oxley Act of 2002 requires our management to report on the effectivenessof our internal control over financial reporting. We have an ongoing program toperform the system and process evaluation and testing necessary to comply withthese requirements. We have and will continue to incur significant expenses anddevote management resources to Section 404 compliance on an ongoing basis. Inthe event that our chief executive officer, chief financial officer orindependent registered public accounting firm determine in the future that ourinternal controls over financial reporting are not effective as defined underSection 404, investor perceptions may be adversely affected and could cause adecline in the market price of our stock.

***Our products can have long sales and implementation cycles,which may result in us incurring substantial expenses before realizing anyassociated revenues.***

The sale andimplementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a customer orpotential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

***Consolidation in the network security industry may limitmarket acceptance of our products.***

Several of ourcompetitors have acquired security companies with complementary technologies inthe past.  We expect consolidation in thenetwork security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit our accessto commercially significant technologies. Further, business combinations in the network security industry arecreating companies with larger market shares, customer bases, sales forces,product offerings and technology and marketing expertise, which may make itmore difficult for us to compete.

***We must adequately protect our intellectual property inorder to prevent loss of valuable proprietary information.***

We rely on acombination of patent, copyright, trademark and trade secret laws,confidentiality procedures and non-disclosure agreements to protect ourproprietary technology.  However,unauthorized parties may attempt to copy or reverse-engineer aspects of ourproducts or to obtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

***We may incur substantial expenses defending ourselvesagainst claims of infringement.***

There are numerouspatents held by many companies relating to the design and manufacture ofnetwork security systems.  Third partiesmay claim that our products infringe on their intellectual propertyrights.  Any claim, with or withoutmerit, could consume our management’s time, result in costly litigation, causedelays in sales or implementations of our products or require us to enter intoroyalty or licensing agreements. Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

***Fluctuations in our quarterly revenues may cause the priceof our common stock to decline.***

Our operatingresults have varied significantly from quarter to quarter in the past, and weexpect our operating results to vary from quarter to quarter in the future dueto a variety of factors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond tounexpected decreases in revenues. Therefore, if revenues are below our expectations, this shortfall islikely to adversely and disproportionately affect our operating results.  Accordingly, we may not attain positiveoperating margins in future quarters. Any of these factors could cause our operating results to be below theexpectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

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***Theprice of our common stock has been volatile in the past and may continue to bevolatile in the future due to factors outside of our control.***

The market priceof our common stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, infiscal year 2006, the market price of our common stock on The OTCBB and TheNasdaq Capital Market fluctuated between $0.22 and $2.87 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

·                  variationsin our quarterly operating results;

·                  changesin estimates of our financial performance by securities analysts;

·                  changesin market valuations of our competitors;

·                  announcementsby us or our competitors of new products, significant contracts, acquisitions,strategic relationships, joint ventures or capital commitments;

·                  productor design flaws, product recalls or similar occurrences;

·                  additionsor departures of key personnel;

·                  salesof common stock in the future; and

·                  fluctuationsin stock market prices and volume, which can be particularly common amongnetwork security and other high technology companies.

***Our past reductions in our work force may make it moredifficult for us to attract and retain the personnel necessary to successfullyoperate our business.***

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel.  Our futuresuccess depends on retaining our key employees and our continuing ability toattract, train and retain other highly qualified technical, sales andmanagerial personnel.  We do not haveemployment agreements with our key technical, sales and senior managementpersonnel.  As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilate or retain other highlyqualified technical, sales and managerial personnel in the future.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

***Ouracquisition of complementary products or businesses may adversely affect ourfinancial condition.***

We have madeacquisitions in the past and, in the future we may acquire or invest inadditional companies, business units, product lines or technologies toaccelerate the development of products and sales channels complementary to ourexisting products and sales channels. Negotiation of potential acquisitions and integration of acquiredproducts, technologies or businesses could divert our management’s time andresources.  Future acquisitions couldcause us to issue equity securities that would dilute your ownership of us,incur debt or contingent liabilities, amortize intangible assets or write offin-process research and development, goodwill and other acquisition-relatedexpenses that could seriously harm our financial condition and operatingresults.  Further, if we are not able toproperly integrate acquired products, technologies or businesses with ourexisting products and operations, train, retain and motivate personnel from theacquired business or combine potentially different corporate cultures, we maynot receive the intended benefits of our acquisitions, which could adverselyaffect our business, operating results and financial condition.

***Compliance with export regulations may hinder our sales toforeign customers.***

Certain of ourdata security products incorporate encryption and other technology that mayrequire clearance and export licenses from the U.S. Department of Commerceunder United States export regulations. Any inability to obtain these clearances or licenses or any foreignregulatory approvals, if required, on a timely basis could delay sales and havea material adverse effect on our operating results.

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***Provisionsof our charter documents and Delaware law may have anti-takeover effects.***

Certain provisionsof our certificate of incorporation and bylaws, such as our ability to offer “blankcheck” preferred stock and the inability of our stockholders to act by writtenconsent, could make it more difficult for a third party to acquire us, even ifdoing so would be beneficial to our stockholders.  We are also subject to the provisions ofSection 203 of the Delaware General Corporation Law, which restrictscertain business combinations with interested stockholders and could inhibit anon-negotiated merger or other business combination.

***Militaryactions may disrupt our business by reducing spending on our products,increasing our costs and affecting our international operations.***

United Statesmilitary actions or other events occurring in response to or in connection withthem, including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

•                    reducing ordelaying government, military or corporate spending on network securityproducts;

•                    increasing thecost and difficulty in obtaining materials or shipping products; and

•                    affecting ourability to conduct business internationally.

Shouldthese events occur, our business, operating results and financial conditioncould be materially and adversely affected.

Item 3.                                CONTROLSAND PROCEDURES

We maintain “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as amended (the “Exchange Act”),that are designed to ensure that information required to be disclosed by us inreports we file or submit under the Exchange Act is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms, and that such information is accumulated and communicated to ourmanagement, including our principal executive officer and principal financialofficer, as appropriate, to allow timely decisions regarding requireddisclosure. In designing and evaluating our disclosure controls and procedures,management recognized that disclosure controls and procedures, no matter howwell conceived and operated, can provide only reasonable assurance of achievingthe desired control objectives, and we necessarily are required to apply ourjudgment in evaluating the cost-benefit relationship of possible disclosure controlsand procedures.

Our management, includingour principal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of June 30, 2007 and concluded that the disclosure controls andprocedures were effective.

There were no changes inour internal control over financial reporting that occurred during the quarterended June 30, 2007 that have materially affected, or are reasonable likely tomaterially affect, our internal control over financial reporting.

At the end of 2007,Section 404 of the Sarbanes-Oxley Act will require our management toprovide an assessment of the effectiveness of our internal control overfinancial reporting, and at the end of 2008, our independent registered publicaccountants will be required to audit management’s assessment. We are in theprocess of performing the system and process documentation, evaluation andtesting required for management to make this assessment and for its independentregistered public accountants to provide their attestation report in 2008. Wehave not completed this process or its assessment, and this process willrequire significant amounts of management time and resources. In the course ofevaluation and testing, management may identify deficiencies that will need tobe addressed and remediated.

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**PART II – OTHER INFORMATION**

Item 1.                                LEGALPROCEEDINGS

We are subject to legalproceedings and claims that arise in the ordinary course of business.  We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact.

Item 4.             SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS

The Annual Meeting of Stockholders was held on May 30, 2007, at theRadisson Hotel, Dallas North in Richardson, Texas.  The following is a brief description of eachmatter voted upon by stockholders, including a number of votes cast for,against, or withheld with regard to each matter of nominee.

(1)                                  Electionof five (5) directors to serve until the next Annual Meeting of Stockholdersand until their respective successors are duly elected and qualified.
|                    | ** ** | **FOR**   | ** ** | **WITHHELD** | ** ** |
|--------------------|------------|-----------|------------|--------------|------------|
| G. Ward Paxton     |       | 8,743,877 |       | 169,093      |       |
| T. Joe Head        |       | 8,755,999 |       | 156,971      |       |
| James F. Gero      |       | 8,761,635 |       | 151,335      |       |
| J. Fred Bucy,  Jr. |       | 8,773,932 |       | 139,038      |       |
| Donald M. Johnston |       | 8,773,832 |       | 139,138      |       |

 

(2)                                  Ratificationand approval for the amendment of the 2005 Stock Incentive Plan.
| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 4,870,287 |       | 248,436     |       | 15,838      |       |

 

(3)                                  Ratificationand approval of selection by the Board of Directors of KBA Group LLP asindependent auditors of the Registrant for the fiscal year ending December 31,2007.
| FOR       | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 8,876,038 |       | 23,695      |       | 13,238      |       |

 

Item 6.                                EXHIBITS

The following Exhibits are filed with this report form10-QSB:
| 31.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                                             |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act.                                                                                                             |
| 32.1 |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**S I G N A T U R E S**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                            | **INTRUSION  INC.**                                |
|----------------------------|----------------------------------------------------|
|                       |                                               |
| Date: August 10,  2007     | /s/ G. Ward  Paxton                                |   |
|                       | G. Ward Paxton                                     |
|                       | Chairman,  President & Chief Executive Officer |
|                       | (Principal  Executive Officer)                     |
|                       |                                               |
|                       |                                               |
| Date: August 10,  2007     | /s/ Michael L.  Paxton                             |   |
|                       | Michael L.  Paxton                                 |
|                       | Vice President,  Chief Financial Officer,          |
| Treasurer &  Secretary |
|                       | (Principal  Financial & Accounting Officer)    |
|                            |                                                    |  |  |

 

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