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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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**x****      QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30,2009**

 

**OR**

 

**o****         TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from                 to**

 

**Commission File Number  0-20191**

 

**INTRUSION INC.**

(Exact name of registrant 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**

(Registrant’s telephone number, including area code)

 

**Not Applicable**

(Former name, former address and former fiscal year,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) hasbeen subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the registrant hassubmitted electronically and posted on its corporate Web site, if any, everyInteractive Data File required to be submitted and posted pursuant to Rule 405of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).  Yes o No o

 

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

 

| Large accelerated  filer o                |   | Accelerated filer o          |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                  |   | Smaller reporting  company x |
| (Do not check if a  smaller reporting company) |   |                              |

 

Indicate by check mark whether the Registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act):  Yes o No x

 

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on October 31, 2009 was 11,704,535.

 

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I —  FINANCIAL INFORMATION**                                                                                     |
|-----------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                              |
| Item 1. Financial  Statements                                                                                                     |
|                                                                                                                              |
| Unaudited  Condensed Consolidated Balance Sheets as of September 30, 2009 and  December 31, 2008                        |
|                                                                                                                              |
| Unaudited  Condensed Consolidated Statements of Operations for the three and nine months  ended September 30, 2009  and 2008 |
|                                                                                                                              |
| Unaudited Condensed  Consolidated Statements of Cash Flows for the nine months ended  September 30, 2009 and 2008            |
|                                                                                                                              |
| Notes to  Unaudited Condensed Consolidated Financial Statements                                                                   |
|                                                                                                                              |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                              |
|                                                                                                                              |
| Item 4T. Controls  and Procedures                                                                                                 |
|                                                                                                                              |
| **PART II — OTHER  INFORMATION**                                                                                        |
|                                                                                                                              |
| Item 1. Legal Proceedings                                                                                                         |
|                                                                                                                              |
| Item 1A. Risk Factors                                                                                                             |
|                                                                                                                              |
| Item 3.  Defaults Upon Senior Securities                                                                                          |
|                                                                                                                              |
| Item 6. Exhibits                                                                                                                  |
|                                                                                                                              |
| Signature Page                                                                                                                    |

 

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**PART I— FINANCIAL INFORMATION**

 

Item 1. FINANCIALSTATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except parvalue amounts)

 
| ** **                                                                                                                                     | ** ** | **September ****30,******** 2009** | ** ** | **December ****31,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                     |       |                                         |       |                            |       |
| Current Assets:                                                                                                                                |       |                                         |       |                            |       |
| Cash and cash equivalents                                                                                                                      |       | $                                            | 103        |                            | $          | 554 |   |
| Accounts receivable                                                                                                                            |       | 283                                          |       | 341                             |       |
| Inventories, net                                                                                                                               |       | 17                                           |       | 20                              |       |
| Prepaid expenses                                                                                                                               |       | 69                                           |       | 56                              |       |
| Total current assets                                                                                                                           |       | 472                                          |       | 971                             |       |
| Property and equipment, net                                                                                                                    |       | 129                                          |       | 169                             |       |
| Other assets                                                                                                                                   |       | 39                                           |       | 39                              |       |
| TOTAL ASSETS                                                                                                                                   |       | $                                            | 640        |                            | $          | 1,179 |   |
|                                                                                                                                           |       |                                         |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                |       |                                         |       |                            |       |
|                                                                                                                                           |       |                                         |       |                            |       |
| Current Liabilities:                                                                                                                           |       |                                         |       |                            |       |
| Accounts payable and accrued expenses                                                                                                          |       | $                                            | 598        |                            | $          | 538 |   |
| Loan payable to officer                                                                                                                        |       | 970                                          |       | 480                             |       |
| Dividends payable                                                                                                                              |       | 318                                          |       | 187                             |       |
| Deferred revenue                                                                                                                               |       | 100                                          |       | 1,090                           |       |
| Total current liabilities                                                                                                                      |       | 1,986                                        |       | 2,295                           |       |
|                                                                                                                                           |       |                                         |       |                            |       |
| Commitments and contingencies                                                                                                                  |       |                                         |       |                            |       |
| Stockholders’ deficit:                                                                                                                    |       |                                         |       |                            |       |
| Preferred stock, $0.01 par value: Authorized shares — 5,000                                                                               |       |                                         |       |                            |       |
| Series 1 shares issued and outstanding — 220 in 2009 and 260 in  2008 Liquidation preference of $1,226 as of September 30, 2009 |       | 778                                          |       | 918                             |       |
| Series 2 shares issued and outstanding — 460 Liquidation  preference of $1,256 as of September 30, 2009                         |       | 724                                          |       | 724                             |       |
| Series 3 shares issued and outstanding — 354 Liquidation  preference of $843 as of September 30, 2009                           |       | 504                                          |       | 504                             |       |
| Common stock, $0.01 par value:                                                                                                                 |       |                                         |       |                            |       |
| Authorized shares — 80,000                                                                                                                |       |                                         |       |                            |       |
| Issued shares — 11,715 in 2009 and 11,648 in 2008 Outstanding shares  — 11,705 in 2009 and 11,638 in 2008                            |       | 117                                          |       | 116                             |       |
| Common stock held in treasury, at cost — 10 shares                                                                                        |       | (362                                         | )          | (362                            | )          |
| Additional paid-in capital                                                                                                                     |       | 55,545                                       |       | 55,443                          |       |
| Accumulated deficit                                                                                                                            |       | (58,473                                      | )          | (58,280                         | )          |
| Accumulated other comprehensive loss                                                                                                           |       | (179                                         | )          | (179                            | )          |
| Total stockholders’ deficit                                                                                                               |       | (1,346                                       | )          | (1,116                          | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                                               |       | $                                            | 640        |                            | $          | 1,179 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except pershare amounts)

 
| ** **                                                       | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                       | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** |
| Net product revenue                                              |       | $                            | 1,194      |                         | $          | 1,078 |   | $ | 3,171 |   | $ | 2,509 |   |
| Net customer support and maintenance revenue                     |       | 59                           |       | 137                          |       | 230 |   | 452 |   |
| Total revenue                                                    |       | 1,253                        |       | 1,215                        |       | 3,401 |   | 2,961 |   |
| Cost of product revenue                                          |       | 432                          |       | 367                          |       | 1,133 |   | 975 |   |
| Cost of customer support and maintenance revenue                 |       | 3                            |       | 6                            |       | 12 |   | 18 |   |
| Total cost of revenue                                            |       | 435                          |       | 373                          |       | 1,145 |   | 993 |   |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Gross profit                                                     |       | 818                          |       | 842                          |       | 2,256 |   | 1,968 |   |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Operating expenses:                                              |       |                         |       |                         |       |   |   |   |   |
| Sales and marketing                                              |       | 198                          |       | 349                          |       | 733 |   | 1,081 |   |
| Research and development                                         |       | 288                          |       | 210                          |       | 904 |   | 920 |   |
| General and administrative                                       |       | 235                          |       | 244                          |       | 768 |   | 739 |   |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Operating income (loss)                                          |       | 97                           |       | 39                           |       | (149 | ) | (772 | ) |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Interest expense, net                                            |       | (18                          | )          | (22                          | )          | (44 | ) | (45 | ) |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Income (loss) before income tax provision                        |       | 79                           |       | 17                           |       | (193 | ) | (817 | ) |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Income tax provision                                             |       | —                       |       | —                       |       | — |   | — |   |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Net income (loss)                                                |       | $                            | 79         |                         | $          | 17 |   | $ | (193 | ) | $ | (817 | ) |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Preferred stock dividends accrued                                |       | (38                          | )          | (41                          | )          | (116 | ) | (121 | ) |
| Net income (loss) attributable to common stockholders            |       | $                            | 41         |                         | $          | (24 | ) | $ | (309 | ) | $ | (938 | ) |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Net income (loss) per share attributable to common stockholders: |       |                         |       |                         |       |   |   |   |   |
| Basic                                                            |       | $                            | 0.00       |                         | $          | 0.00 |   | $ | (0.03 | ) | $ | (0.08 | ) |
| Diluted                                                          |       | $                            | 0.00       |                         | $          | 0.00 |   | $ | (0.03 | ) | $ | (0.08 | ) |
|                                                             |       |                         |       |                         |       |   |   |   |   |
| Weighted average common shares outstanding:                      |       |                         |       |                         |       |   |   |   |   |
| Basic                                                            |       | 11,704                       |       | 11,638                       |       | 11,669 |   | 11,638 |   |
| Diluted                                                          |       | 13,529                       |       | 11,638                       |       | 11,669 |   | 11,638 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 
| ** **                                                                   | ** ** | **Nine Months Ended**        | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                   | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** |
| Operating Activities:                                                        |       |                         |       |   |   |
| Net loss                                                                     |       | $                            | (193       | ) | $ | (817 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities: |       |                         |       |   |   |
| Depreciation and amortization                                                |       | 57                           |       | 33 |   |
| Stock-based compensation                                                     |       | 71                           |       | 55 |   |
| Changes in operating assets and liabilities:                                 |       |                         |       |   |   |
| Accounts receivable                                                          |       | 58                           |       | (651 | ) |
| Inventories                                                                  |       | 3                            |       | 52 |   |
| Prepaid expenses and other assets                                            |       | (13                          | )          | 43 |   |
| Accounts payable and accrued expenses                                        |       | 81                           |       | (61 | ) |
| Deferred revenue                                                             |       | (990                         | )          | (107 | ) |
| Net cash used in operating activities                                        |       | (926                         | )          | (1,453 | ) |
| Investing Activities:                                                        |       |                         |       |   |   |
| Purchases of property and equipment                                          |       | (16                          | )          | (23 | ) |
| Financing Activities:                                                        |       |                         |       |   |   |
| Net activity under line of credit                                            |       | —                       |       | 30 |   |
| Borrowings from officer                                                      |       | 490                          |       | 1,180 |   |
| Proceeds from the issuance of common stock                                   |       | 1                            |       | — |   |
| Net cash provided by financing activities                                    |       | 491                          |       | 1,210 |   |
|                                                                         |       |                         |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (451                         | )          | (266 | ) |
| Cash and cash equivalents at beginning of period                             |       | 554                          |       | 362 |   |
| Cash and cash equivalents at end of period                                   |       | $                            | 103        |   | $ | 96 |   |
|                                                                         |       |                         |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                    |       |                         |       |   |   |
|                                                                         |       |                         |       |   |   |
| Preferred stock dividends accrued                                            |       | $                            | 116        |   | $ | 121 |   |
| Inventory transferred to property and equipment                              |       | $                            | —     |   | $ | 33 |   |
| Series 1 preferred stock converted to common                            |       | $                            | 140        |   | $ | — |   |

 

See accompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Descriptionof Business

 

We develop, market andsupport a family of entity identification, regulated information compliance,data privacy protection, data leak prevention and network intrusionprevention/detection products.  Ourproduct families include:  TraceCopTM for identity discovery anddisclosure, Compliance CommanderTM for regulated information compliance, leakprotection and data privacy protection, and Intrusion SecureNetTM for network intrusionprevention and detection.  Our 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.

 

Our TraceCop productsinclude:  (1) databases containingIP addresses which are continually updated and used in the determination of theorigination of cyber based attacks or other cyber based crimes; (2) analysissoftware used for the location of cyber based attacks and (3) datacollected relative to the location of the crimes.

 

We market and distribute ourproducts through a direct sales force to end-users, distributors and systemintegrators, managed service providers and value-added resellers. Our end-usercustomers include U.S. federal government entities, banks, credit unions, otherfinancial institutions, foreign government entities and local governmententities, hospitals and other healthcare providers, academic institutions andcommercial customers.

 

We were organized in Texasin September 1983 and reincorporated in Delaware in October 1995. Formore than 15 years, we provided local area networking equipment and wereknown as Optical Data Systems or ODS Networks. On April 17, 2000, weannounced plans to sell, or otherwise dispose of, our networking divisions,which included our Essential Communications division and our local areanetworking assets. On June 1, 2000, we changed our name from ODS Networks, Inc.to Intrusion.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. On November 1,2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

 

Our principal executiveoffices are located at 1101 East Arapaho Road, Suite 200, Richardson,Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.  References to “we”, “us”, “our” or“Intrusion Inc.” refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM and TraceCopTM aretrademarks of Intrusion Inc.

 

As of September 30,2009, we had cash and cash equivalents of approximately $103,000, down fromapproximately $554,000 as of December 31, 2008, and a working capitaldeficit totaling $1.5 million.  We used$152,000 of cash in operations in the third quarter 2009 and operating cashoutflows may continue in 2009 and possibly beyond.  As of September 30, 2009, in addition tocash and cash equivalents of $103,000, we had $96,000 in funding availableunder our $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, ourChairman, President and Chief Executive Officer (the “CEO”).  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

2.     Basis ofPresentation

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Item 10-01 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  The December 31, 2008 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that the disclosuresare adequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three and nine month periods ended September 30,2009 are not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in our 

 

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annual report on Form 10-Kfor the year ended December 31, 2008, filed with the U.S. Securities andExchange Commission (the “SEC”) on March 27, 2009.

 

The Company calculatesthe fair value of its assets and liabilities which qualify as financialinstruments and includes this additional information in the notes toconsolidated financial statements when the fair value is different than thecarrying value of these financial instruments. The estimated fair value ofaccounts receivable, accounts payable and accrued expenses, and dividendspayable approximate their carrying amounts due to the relatively short maturityof these instruments. The carrying value of loans payable to officer alsoapproximates fair value since these instruments bear market rates of interest.None of these instruments are held for trading purposes.

 

3.     Inventories(In thousands)

 
| ** **                     | ** ** | **September 30,  2009** | ** ** | **December 31,  2008** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                           |       |                         |       |                        |       |
| Inventories consist of:        |       |                         |       |                        |       |
|                           |       |                         |       |                        |       |
| Finished goods                 |       | $                            | 68         |                        | $          | 67 |   |
| Demonstration systems          |       | 1                            |       | 5                           |       |
| Reserve for obsolete inventory |       | (52                          | )          | (52                         | )          |
| Net inventory                  |       | $                            | 17         |                        | $          | 20 |   |

 

4.     Loan Payable to Officer

 

On January 30, 2008, weentered into a revolvingpromissory note to borrow up to $700,000 from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.    Under the terms of the note, the Companymay borrow, repay and reborrow on the loan as needed up to an outstandingprincipal amount of $700,000 at any date. All outstanding principal and accrued but unpaid interest was originallydue on December 31, 2008 but was extended on March 19, 2009 to matureon March 31, 2010.  As of September 30,2009, we had borrowings of $700,000 outstanding from the note with accruedinterest payable of $24,000.  On March 20,2008, we received a writtencommitment from our Chief Executive Officer to invest up to an additional $1.5million in the Company until March 2009, should such funding be requiredby the Company.  This commitment tocontinue to advance additional funds as needed was extended on November 7,2008 to mature in March 2010.  As of September 30,2009, we had borrowings of $270,000 outstanding under the commitment withaccrued interest payable of $3,000.  Amounts theCompany borrows under the note and the commitment accrue interest at a floatingrate per annum equal to the announced prime rate of Silicon Valley Bank (“SVB”)plus 1% and are unsecured.

 

5.     Line ofCredit

 

On March 29, 2006,we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”)to establish a $1.0 million line of credit with SVB (the “2006 CreditLine”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to Amended and Restated Loan andSecurity Agreement (the “Loan Agreement”) with SVB to replace the 2008 CreditLine with a $1.25 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  In addition, G. Ward Paxton,the Company’s Chief Executive Officer, has established a Guaranty Agreementwith SVB for all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Creditare based on advances (each an “Advance”) against certain of our accountsreceivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Amended and Restated Loan Agreement, or (c) the date onwhich any “Adjustment” (as defined in the Loan Agreement) is asserted to theEligible Account.  On June 27, 2010,the Loan Agreement terminates and all outstanding Advances, accrued but unpaidfinance charges, outstanding collateral handing fees, and other amounts becomedue under the Amended and Restated Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofSeptember 30, 2009 and had borrowings available of $96,000.

 

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6.     Accountingfor Stock-Based Compensation

 

During the three month period ended September 30,2009 and 2008, the Company granted 0 stock options and 3,000 options to employeesand directors in each period.  TheCompany recognized $21,621 and $26,000, respectively, stock-based compensationexpense for the three month periods ended September 30, 2009 and2008.  During the nine month period endedSeptember 30, 2009 and 2008, the Company granted 491,000 and 445,000,respectively, stock options to employees and directors.  The Company recognized $71,340 and $55,000,respectively, stock-based compensation expense for the nine month period ended September 30,2009 and 2008.

 

During the three month period ended September 30,2009 and 2008, no options were exercised under the 2005 Plan,respectively.   During the nine monthperiod ended September 30, 2009 and 2008, 3,001and 0, respectively,options were exercised under the 2005 Plan.

 

Valuation Assumptions

 

The fair values of optionawards were estimated at the date of grant using a Black-Scholes option-pricingmodel with the following assumptions:

 
| ** **                             | ** ** | **For Nine  Months Ended  September 30, 2009** | ** ** | **For Nine  Months Ended  September 30, 2008** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------|------------|-----------------------------------------------------|------------|
|                                   |       |                                                     |       |                                                |       |
| Weighted average grant date fair value |       | $                                                        | 0.26       |                                                | $          | 0.17 |   |
| Weighted average assumptions used:     |       |                                                     |       |                                                |       |
| Expected dividend yield                |       | 0.00                                                     | %          | 0.00                                                | %          |
| Risk-free interest rate                |       | 1.90                                                     | %          | 2.60                                                | %          |
| Expected volatility                    |       | 163.50                                                   | %          | 107.10                                              | %          |
| Expected life (in years)               |       | 4.89                                                     |       | 5.00                                                |       |
|                                        |            |                                                          |            |                                                     |            |  |  |

 

Expected volatility is basedon historical volatility and in part on implied volatility.  The expected life considers the contractualterm of the option as well as historical exercise and forfeiture behavior.  The risk-free interest rate is based on therates in effect on the grant date for U.S. Treasury instruments with maturitiesmatching the relevant expected term of the award. Options granted tonon-employees are valued using the fair market value on each measurement dateof the option.

 

7.     Net LossPer Share

 

Basic net loss per share is computed by dividing netloss attributable to common stockholders for the period by the weighted averagenumber of common shares outstanding for the period.  Diluted net loss per share is computed bydividing the net loss attributable to common stockholders by the weightedaverage number of common shares and dilutive 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 earnings per share calculation for thethree month periods ending September 30, 2009 and 2008 are 1,069,444 and4,223,951, respectively as they are antidilutive. In addition, for the ninemonth period ending September 30, 2009 and 2008, respectfully, 3,993,130and 4,223,951 common stock equivalents are not included in the diluted loss pershare as they are antidilutive.

 

8.     Concentrations

 

Our operations areconcentrated in one area—security software/entity identification.  Sales to the U.S. Government through directand indirect channels totaled 66.3% of total revenues for the third quarter of2009 compared to 91.2% of total revenues for the third quarter of 2008.  During the third quarter of 2009approximately 66.2% of total revenues are attributable to three governmentcustomers compared to approximately 86.6% of total revenues attributable to twogovernment customers in the third quarter of 2008.  In the third quarter of 2009, we had oneindividual commercial customer exceed 10% of total revenues for thequarter.  There were no individualcommercial customers in the third quarter of 2008 that exceeded 10% of totalrevenues for that quarter.  Our similarproduct and service offerings are not viewed as individual segments, as ourmanagement analyzes the business as a whole and expenses are not allocated toeach product offering.

 

9.     Commitmentsand Contingencies

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact.

 

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10.   DividendsPayable

 

During the quarter ended September 30,2009, we accrued $14,000 in dividends to the holders of our 5% Preferred Stock,$14,000 in dividends to the holders of our Series 2 5% Preferred Stock and$10,000 in dividends to the holders of our Series 3 5% PreferredStock.  As of September 30, 2009, wehave $303,000 in accrued and unpaid dividends included in other currentliabilities.  Delaware law provides thatwe may only pay dividends out of our capital surplus or, if no surplus isavailable, out of our net profits for the fiscal year the dividend is declaredand/or the preceding fiscal year.  Wehave not had net profits for the last two fiscal years and did not 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.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  Total penalties accruedduring the quarter ended September 30, 2009 were approximately$4,000.  Our CEO, CFO and one member ofour Board of Directors, who own preferred stock, have waived the late feepenalty so we have recorded approximately $3,000 as contributed capital duringthe quarter related to these waivers.  Inaddition to this late penalty, the holders of our Series 2 Preferred Stockand Series 3 Preferred Stock could elect to present us with written noticeof our failure to pay dividends as scheduled, in which case we would have 45days to cure such a breach.  In the eventthat we failed to cure the breach, the holders of these shares of preferredstock would then have the right to require us to redeem their shares ofpreferred stock for a cash amount calculated in accordance with theirrespective certificates of designation. If we were required to redeem all shares of Series 2 PreferredStock and Series 3 Preferred Stock as of October 31, 2009, theaggregate redemption price we would owe would be $2.1 million.

 

11.   Fair Value Measurements

 

In April 2009, the FASBissued FASB Staff Position No. FAS 107-1 and APB 28-1, *“Interim Disclosures about Fair Value of Financial Instruments,”*currently within the scope of ASC 825-10. ASC 825-10 requires disclosures aboutthe fair value of financial instruments whenever a public company issuesfinancial information for interim reporting periods. ASC 825-10 is effectivefor interim reporting periods ending after June 15, 2009. We adopted thisstaff position upon its issuance, and it had no material impact on ourfinancial statements because we believe the financial assets and liabilities asreported in the Company’s financial statements approximate their respectivefair values.

 

12.   Recent Accounting Pronouncements

 

In May 2009, the FASB issued SFAS 165, “*Subsequent Events,”*currently within thescope of ASC 855-10. ASC 855-10 establishes general standards of accounting forand disclosure of events that occur after the balance sheet date but beforefinancial statements are issued or are available to be issued. This guidance iseffective for interim or annual financial periods ending after June 15,2009, and the Company adopted this guidance during the three months ended June 30,2009. The Company’s adoption of this guidance did not have a material impact onits financial statements.

 

In June 2009, the FASB issued SFAS 168, *“The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles,”*currentlywithin the scope of ASC 105-10. ASC 105-10 identifies the FASB AccountingStandards Codification (the “Codification”) as the authoritative source ofgenerally accepted accounting principles (“GAAP”) in the United States. The Codification did not change GAAP but reorganizes the literature.  Rules and interpretive releases of theSecurities and Exchange Commission under federal securities laws are alsosources of authoritative GAAP for Securities and Exchange Commissionregistrants. This guidance is**effectivefor financial statements issued for interim and annual periods ending after September 15,2009 and the Company adopted the provisions of this guidance as of September 30,2009.  The Company’s adoption of thisguidance did not have a material impact on its financial statements.

 

13.   SubsequentEvents

 

Management performedan evaluation of the Company’s activities through November 12th, 2009,and has concluded that there are no significant subsequent events requiringdisclosure through the date these financial statements were issued.

 

Item 2.             MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS

 

Forward Looking Statements

 

This Quarterly Report on Form 10-Q,including, without limitation, the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” containsforward-looking statements within the meaning of Section 27A 

 

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of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Suchforward-looking statements are generally accompanied by words such as“estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,”“may” or other words 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-Q under theheading “Factors That May Affect Future Results of Operations,” and in our2008 Annual Report on Form 10-K in “Item 1 — Description of Business”include, but are not limited to:

 

·                  insufficient cash to operate our business andinability to meet our liquidity requirements;

 

·                  loss of revenues due to the failure of our newerproducts to achieve market acceptance;

 

·                  our need to continue or increase current revenuelevels in order to sustain profitability;

 

·                  concentration of our revenues from U.S. governmententities or commercial customers and the possibility of loss of one of thesecustomers and the unique risks associated with government customers;

 

·                  our dependence on sales made through indirectchannels;

 

·                  the challenge of selling our products internationally;

 

·                  our dependence on equity or debt financing providedprimarily by our Chief Executive Officer in order to meet our cash flowrequirements;

 

·                  the effect that payment of accrued dividends on ourpreferred stock has on our cash resources and the substantial dilution upon theconversion or redemption of our preferred stock and exercise of outstandingwarrants;

 

·                  the impact of conversion of preferred stock orexercise of warrants on the price of our common stock;

 

·                  the ability of our preferred stockholders and lendersto hinder additional financing; and

 

·                  the influence that our management and largerstockholders have over actions taken by the Company.

 

If one or more of theseor other risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary significantly from what weprojected. These forward-looking statements and other statements made elsewherein this report are made in reliance on the Private Securities Litigation ReformAct of 1995.  Any forward-lookingstatement you read in this Quarterly Report on Form 10-Q or our AnnualReport on Form 10-K reflects our current views with respect to futureevents and is subject to these and other risks, uncertainties and assumptionsrelating to our operations, results of operations, growth strategy andliquidity. We assume no obligation to publicly update or revise theseforward-looking statements for any reason, or to update the reasons actualresults could differ materially from those anticipated in these forward-lookingstatements, even if new information becomes available in the future.  The section below entitled “Factors That May AffectFuture Results of Operations” sets forth and incorporates by reference certainfactors that could cause actual future results of the Company to differmaterially from these statements.

 

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Results ofOperations

 

The following table sets forth, for the periodsindicated, certain financial data as a percentage of net revenues. Theperiod-to-period comparison of financial results is not necessarily indicativeof future results.

 
| ** **                                            | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|-------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                            | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** |
| Net product revenue                                   |       | 95.3                         | %          | 88.7                         | %          | 93.2 | % | 84.7 | % |
| Net customer support and maintenance revenue          |       | 4.7                          |       | 11.3                         |       | 6.8 |   | 15.3 |   |
| Total revenue                                         |       | 100.0                        |       | 100.0                        |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                               |       | 34.5                         |       | 30.2                         |       | 33.4 |   | 32.9 |   |
| Cost of customer support and maintenance revenue      |       | 0.2                          |       | 0.5                          |       | 0.3 |   | 0.6 |   |
| Total cost of revenue                                 |       | 34.7                         |       | 30.7                         |       | 33.7 |   | 33.5 |   |
| Gross profit                                          |       | 65.3                         |       | 69.3                         |       | 66.3 |   | 66.5 |   |
| Operating expenses:                                   |       |                         |       |                         |       |   |   |   |   |
| Sales and marketing                                   |       | 15.8                         |       | 28.7                         |       | 21.5 |   | 36.5 |   |
| Research and development                              |       | 22.9                         |       | 17.3                         |       | 26.6 |   | 31.1 |   |
| General and administrative                            |       | 18.8                         |       | 20.0                         |       | 22.6 |   | 25.0 |   |
|                                                  |       |                         |       |                         |       |   |   |   |   |
| Operating income (loss)                               |       | 7.7                          |       | 3.2                          |       | (4.4 | ) | (26.1 | ) |
|                                                  |       |                         |       |                         |       |   |   |   |   |
| Interest expense                                      |       | (1.4                         | )          | (1.9                         | )          | (1.3 | ) | (1.5 | ) |
| Income (loss) before income tax provision             |       | 6.3                          |       | 1.4                          |       | (5.7 | ) | (27.6 | ) |
|                                                  |       |                         |       |                         |       |   |   |   |   |
| Income tax provision                                  |       | —                       |       | —                       |       | — |   | — |   |
|                                                  |       |                         |       |                         |       |   |   |   |   |
| Net income (loss)                                     |       | 6.3                          | %          | 1.4                          | %          | (5.7 | )% | (27.6 | )% |
| Preferred stock dividends accrued                     |       | (3.0                         | )          | (3.7                         | )          | (3.4 | ) | (4.2 | ) |
|                                                  |       |                         |       |                         |       |   |   |   |   |
| Net income (loss) attributable to common stockholders |       | 3.3                          | %          | (2.3                         | )%         | (9.1 | )% | (31.8 | )% |

 
| ** **          | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|---------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **          | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** | **September 30,  2009** | ** ** | **September 30,  2008** | ** ** |
| Domestic revenues   |       | 99.8                         | %          | 97.1                         | %          | 98.9 | % | 96.1 | % |
| Export revenues to: |       |                         |       |                         |       |   |   |   |   |
| Europe              |       | 0.1                          |       | 2.6                          |       | 1.0 |   | 3.4 |   |
| Asia                |       | —                       |       | 0.2                          |       | — |   | 0.3 |   |
| Latin America       |       | 0.1                          |       | 0.1                          |       | 0.1 |   | 0.2 |   |
|                |       |                         |       |                         |       |   |   |   |   |
| Net revenues        |       | 100.0                        | %          | 100.0                        | %          | 100.0 | % | 100.0 | % |

 

**Net Revenues**.  Net revenuesfor the quarter and nine months ended September 30, 2009 were $1.3 millionand $3.4 million, respectively, compared to $1.2 million and $3.0 million forthe same periods in 2008.  Productrevenues increased $116 thousand for the quarter ended September 30, 2009, andincreased $0.7 million for the nine months ended September 30, 2009compared to the same periods in 2008. Customer support and maintenance revenue decreased $78 thousand and $222thousand for the quarter and nine months ended September 30, 2009,respectively, compared to the same periods in 2008.  This decrease was due to the current salesmix with a high concentration of government sales not requiring a maintenancecontract.

 

**Concentration of Revenues**. Revenues from sales to various U.S. government entities totaled $0.8million, or 66.3% of revenues, for the quarter ended September 30, 2009compared to $1.1 million, or 91.2% of revenues, for the same period in2008.  Revenues from sales to variousU.S. government entities totaled $2.8 million, or 82.7% of revenues, for thenine months ended September 30, 2009 compared to $2.5 million, or 84.0% ofrevenues, for the same period in 2008.   Although we expect our concentration of revenues to vary among customersin future periods depending upon the timing of certain sales, we anticipatethat sales to government customers will continue to account for a significantportion of our revenues in future periods. Sales to the government present risks in addition to those involved insales to commercial customers which could adversely affect our revenues, 

 

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including, withoutlimitation, potential disruption to appropriation and spending patterns and thegovernment’s reservation of the right to cancel contracts and purchase ordersfor its convenience.  Although we do notbelieve that a material portion of our revenues with government customers issubject to renegotiation, a large number of cancelled or renegotiatedgovernment orders could have a material adverse effect on our financialresults.  Currently, we are not aware ofany proposed cancellation or renegotiation of any of our existing arrangementswith government entities and, historically, government entities have notcancelled or renegotiated orders which had a material adverse effect on ourbusiness.

 

**Gross Profit**.  Gross profitwas $0.8 million or 65.3% of net revenues for the quarter ended September 30,2009, compared to $0.8 million or 69.3% of net revenues for the quarter ended September 30,2008.  Gross profit was $2.3 million or66.3% of net revenues for the nine months ended September 30, 2009 comparedto $2.0 million or 66.5% of net revenues for the nine months ended September 30,2008.   Gross profit on product revenuesfor the quarter and nine months ended September 30, trended from 66.0% and61.2%, respectively, in 2008 to 63.8% and 64.3%, respectively, in 2009 mainlydue to an increase in net revenues and/or decreases in fixed costs.  Gross profit on customer support andmaintenance revenues for the quarter and nine months ended September 30,trended from 95.5% and 96.1%, respectively, in 2008 to 95.5% and 94.8%,respectively, in 2009.  Gross profit as a percentage of netrevenues 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.

 

**Sales and Marketing**.  Sales andmarketing expenses decreased to $0.2 million for the quarter ended September 30,2009, compared to $0.3 million for the quarter ended September 30, 2008.Sales and marketing expenses decreased to $0.7 million for the nine monthsended September 30, 2009, compared to $1.1 million for the nine monthsended September 30, 2008 primarily due to a planned reduction in sales andmarketing related expenses.  Sales andmarketing expenses may vary in the future. However, we believe that these costs will remain relatively constantthrough the end of 2009, although expenses may be increased relative toincreases in revenue.

 

**Research and Development**.  Research anddevelopment expenses increased to $0.3 million for the quarter ended September 30,2009 compared to $0.2 million for the quarter ended September 30, 2008.Research and development expenses remained constant at $0.9 million for thenine months ended September 30, 2009 and 2008.  Research and developmentcosts are expensed in the period incurred. Research and development expenses fluctuated in the three months ended September 30,2009, compared to the same period in 2008 primarily due to shifts from researchand development expenses to cost of sales in relation to engineering contractjobs.  Research and development expensesmay vary in the future; however, we believe that these costs will remainrelatively constant through the end of 2009, although expenses may be increasedrelative to increases in revenue.

 

**General and Administrative**.  General andadministrative expenses remained constant at $0.2 million for the quarter endedSeptember 30, 2009 and 2008. General and administrative expenses increased slightly to $0.8 millionfor the nine months ended September 30, 2009, compared to $0.7 million forthe nine months ended September 30, 2008.  It is expectedthat general and administrative expenses will remain relatively constantthroughout the remainder of 2009, although expenses may be increased relativeto increases in revenue.

 

**Interest**.  Interestexpense decreased to $18 thousand for the quarter ended September 30, 2009compared to $22 thousand for the same period in 2008.  Interest expense decreased to $44 thousandfor the nine months ended September 30, 2009 compared to $45 thousand forthe same period in 2008.  Interestexpense may vary in the future based on borrowing levels on our line of creditand other debtfinancings.

 

Liquidity andCapital Resources

 

Our principal source of liquidity at September 30,2009 is approximately $103 thousand of cash and cash equivalents.  At September 30, 2009, we had a workingcapital deficiency of $1.5 million compared to a $1.3 million deficiency at September 30,2008.

 

Cash used in operations forthe nine months ended September 30, 2009 was $0.9 million, primarily dueto a net loss of $0.2 million, decreases in deferred revenue of $1.0 millionand an increase in prepaid expenses and other assets of $13 thousand.  This cash decrease was partially offset bydepreciation expense of $57 thousand, stock-based compensation expense of $71thousand, a decrease in accounts receivable of $58 thousand, a decrease ininventories of $3 thousand, and an increase in accounts payable and accruedexpenses of $81 thousand.  Cash used inoperations for the nine months ended September 30, 2008 was $1.5 million,primarily due to a net loss of $817 thousand, an increase in accountsreceivable of $651 thousand, a decrease in accounts payable and accruedexpenses of $61 thousand, and decreases in deferred revenue of $107thousand.  This cash decrease waspartially offset by depreciation expense of $33 thousand, stock-basedcompensation expense of $55 thousand, a decrease in inventories of $52thousand, and a decrease in prepaid expenses and other assets of $43thousand.   Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including, but not limited to, quarterly sales, ourstrategy in building inventory in advance of receiving orders from customers,and the accuracy of our forecasts of product demand and component requirements.

 

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There was $16 thousand ofcash used in investing activities in the nine months ended September 30,2009 compared to $23 thousand of cash used in investing activities in the ninemonths ended September 30, 2008 for net purchases of property and equipment.

 

Cash provided by financing activities in the ninemonths ended September 30, 2009 was $0.5 million, primarily consisting ofthe proceeds from a promissory note and commitment by our CEO, G. Ward Paxton,for $1.5 million, compared to cash provided by financing activities in the ninemonths ended September 30, 2008 of $1.2 million, primarily consisting ofthe proceeds from a promissory note and commitment by our Chief ExecutiveOfficer, G. Ward Paxton,  for $1.2million, with a net increase in the line of credit of $30 thousand.

 

At September 30,2009, the Company did not have any material commitments for capitalexpenditures.

 

During the nine monthsended September 30, 2009, the Company funded its operations through theuse of cash and cash equivalents, and borrowings from our CEO, G. Ward Paxton.

 

On March 29, 2006,we entered into a Loan and Security Agreement with Silicon Valley Bank (“SVB”)to establish a $1.0 million line of credit with SVB (the “2006 CreditLine”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to Amended and Restated Loan andSecurity Agreement (the “Loan Agreement”) with SVB to replace the 2008 CreditLine with a $1.25 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  In addition, G. Ward Paxton,the Company’s Chief Executive Officer, has established a Guaranty Agreementwith SVB for all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Creditare based on advances (each an “Advance”) against certain of our accountsreceivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus 2.0%.  Finance charges are payable at the same timeits related Advance is due.  Each Advanceis also subject to a monthly collateral handling fee of 0.5% of all outstandingAdvances, depending on certain qualifying financial factors specified in theLoan Agreement.  The collateral handlingfee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliestof (a) the date that the Eligible Account related to the Advance is paid, (b) thedate the Eligible Account is no longer eligible under the Amended and RestatedLoan Agreement, or (c) the date on which any “Adjustment” (as defined inthe Loan Agreement) is asserted to the Eligible Account.  On June 27, 2010, the Loan Agreementterminates and all outstanding Advances, accrued but unpaid finance charges,outstanding collateral handing fees, and other amounts become due under theAmended and Restated Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofSeptember 30, 2009 and had borrowings available of $96,000.

 

Asof September 30, 2009, we had cash and cash equivalents of approximately$103,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.5 million. We used $926,000 of cash in operations in 2009 and operating cashoutflows may continue in 2009 and possibly beyond.  As of September 30, 2009, in addition tocash and cash equivalents of $103,000, we had $96,000 in funding availableunder our $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, ourChairman, President and Chief Executive Officer (the “CEO”).  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

We may explore the possible acquisitions ofbusinesses, products and technologies that are complementary to our existingbusiness.  We are continuing to identifyand prioritize additional security technologies, which we may wish to develop,either internally or through the licensing, or acquisition of products fromthird parties.  While we may engage fromtime to time in discussions with respect to potential acquisitions, there canbe no assurances that any such acquisitions will be made or that we will beable to successfully integrate any acquired business.  In order to finance such acquisitions andworking capital it may be necessary for us to raise additional funds throughpublic or private financings.  Any equityor debt financings, if available at all, may be on terms, which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders.

 

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Item 4T.                        CONTROLS AND PROCEDURES

 

We maintain “disclosurecontrols and procedures,” as defined in Rule 13a-15(e) under theExchange Act, that are designed to ensure that information required to bedisclosed by us in reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms, and that such information is accumulated andcommunicated to our management, including our principal executive officer andprincipal financial officer, as appropriate, to allow timely decisionsregarding required disclosure.  In designingand evaluating our disclosure controls and procedures, management recognizedthat disclosure controls and procedures, no matter how well conceived andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and we necessarily are required to apply our judgment inevaluating the cost-benefit relationship of possible disclosure controls andprocedures.

 

Our management, includingour principal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of September 30, 2009 and concluded that the disclosurecontrols and procedures were effective.

 

There have not been anychanges in our internal control over financial reporting that occurred duringthe quarter ended September 30, 2009 that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II— OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that the outcome of those matters will have a materialadverse affect on our consolidated financial position, operating results orcash flows.  However, there can be noassurance such legal proceedings will not have a material impact.

 

Item 1A.                 RISKFACTORS

 

**Factors That May Affect Future Results of Operations**

 

Weare providing the following information regarding changes that have occurred topreviously disclosed risk factors from our Annual Report on Form 10-K forthe year ended December 31, 2008. In addition to the other information set forth below and elsewhere inthis report, you should consider the factors discussed under the heading“Factors That May Affect Future Results of Operations” in our Form 10-Kfor the year ended December 31, 2008. The risks described in our Quarterly Reports on Form 10-Q are notthe only risks facing our Company. Additional risks and uncertainties not currently known to us or that wecurrently deem to be immaterial also may materially adversely affect ourbusiness, financial condition and/or operating results.

 

***Our cash, cash equivalents, andinvestments decreased from $554 thousand at December 31, 2008 to $103thousand at September 30, 2009.  Ifnet cash outflows continue, we may not have sufficient cash to operate ourbusiness and may not be able to maintain certain liquidity requirements.  Additional debt and equity offerings to fundfuture operations may not be available and, if available, may significantlydilute the value of our currently outstanding common stock.***

 

Asof September 30, 2009, we had cash and cash equivalents of approximately$103,000, down from approximately $554,000 as of December 31, 2008 and aworking capital deficit totaling $1.50 million. We used $152,000 of cash in operations in the third quarter 2009 andoperating cash outflows may continue in 2009 and possibly beyond.  As of September 30, 2009, in addition tocash and cash equivalents of $103,000, we had $96,000 in funding availableunder our $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, ourCEO.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

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***We had a net income of $0.1million for the quarter ended September 30, 2009, a net loss of $0.2million for the nine months ended September 30, 2009 and have anaccumulated deficit of $58.5 million as of September 30, 2009.  To continue profitability, we must continueto generate current or increased revenue levels.***

 

For the quarter ended September 30,2009, we generated a net income of $0.1 million and had an accumulated deficitof approximately $58.5 million as of September 30, 2009, compared to amodest operating income for the quarter ended September 30, 2008 and anaccumulated deficit of approximately $58.3 million as of September 30,2008. ** **Weneed to sustain current or greater revenue levels from the sales of ourproducts if we are to sustain profitability. If we are unable to achieve these revenue levels, losses could happenfor the near term and possibly longer, and we may not sustain profitability orgenerate positive cash flow from operations.

 

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

 

A large percentage of ourrevenues result from sales to U.S. government entities and one commercialcustomer.  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 September 30,2009, sales to U.S. government entities collectively accounted for 66.3% of ourrevenues, compared to 91.2% of our revenues as of September 30,2008.  The loss of any of these key relationshipsmay send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering. We cannot assure you that U.S. government entities will be customersof ours in future periods or that we will be able to diversify our customerportfolio to adequately mitigate the risk of loss of any of these customers.

 

***We are highly dependent on salesmade through indirect channels, the loss of which would materially adverselyaffect our operations.***

 

We derived 62.8% ofrevenue in the third quarter of 2009 through indirect channels of mainlygovernment resellers, compared to 35.2% of our revenues in the quarter ended September 30,2008.   We must expand our sales through theseindirect 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.

 

***We have been unable to payscheduled dividends on shares of our preferred stock, and the continued failureto make such payments has resulted in late penalty payments and couldpotentially result in additional consequences, some of them material.***

 

During the quarter ended September 30,2009, we accrued $14,000 in dividends to the holders of our 5% Preferred Stock,$14,000 in dividends to the holders of our Series 2 5% Preferred Stock and$10,000 in dividends to the holders of our Series 3 5% PreferredStock.  At September 30, 2009, wehave dividends accrued of $126,000 related to our 5% Preferred Stock, $106,000related to our Series 2 5% Preferred Stock and $71,000 related to our Series 35% Preferred Stock.  Delaware law providesthat we may only pay dividends out of our capital surplus or, if no surplus isavailable, out of our net profits for the fiscal year the dividend is declaredand/or the preceding fiscal year.  Wehave not had net profits for the last two fiscal years and as of the quarterended September 30, 2009, did not have sufficient capital surplus, definedas the amount by which our net assets exceed our stated capital, based on parvalue of our outstanding shares as provided by Delaware law.  We cannot assure you that our net assets willexceed our stated capital or that we will have net profits in order to paythese dividends in the future.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  Our CEO, CFO and outsideboard member that are invested in Series 2 and Series 3 PreferredStock have waived the late fee penalty. In addition to this late penalty, the holders of our Series 2Preferred Stock and Series 3 Preferred Stock could elect to present uswith written notice of our failure to pay dividends as scheduled, in which casewe would have 45 days to cure such a breach. In the event that we failed to cure the breach, the holders of theseshares of preferred stock would then have the right to require us to redeemtheir shares of preferred stock for a cash amount calculated in accordance withtheir respective certificates of designation. If we were required to redeem all shares of Series 2 PreferredStock and Series 3 Preferred Stock as of October 31, 2009, the aggregateredemption price we would owe would be $2.1 million.

 

***You will experience substantialdilution upon the conversion or redemption of the shares of preferred stock andthe exercise of warrants that we issued in our recent private placements or inthe event we raise additional funds through the issuance of new shares of ourcommon stock or securities convertible or exercisable into shares of commonstock.***

 

On October 31, 2009,we had 11,704,535 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have13,771,291 shares of common stock outstanding, approximately 

 

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a 17.7% increase in the number of shares of our commonstock outstanding.

 

Further, the occurrenceof certain events could entitle holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for acertain number of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amountsto the holders, (ii) incurred accrued but unpaid dividends on October 31,2009 of $170,000, (iii) a volume weighted average price of $0.47, whichwas the ten-day volume weighted average closing price of our common stock on October 31,2009, and (iv) our 11,704,535 shares of common stock outstanding on October 31,2009, upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 7,534,819 shares of our common stock.  This would represent an increase ofapproximately 64% in the number of shares of our common stock as of October 31,2009.

 

In addition, managementmay issue additional shares of common stock or securities exercisable orconvertible into shares of common stock in order to finance our continuingoperations.  Any future issuances of suchsecurities would have additional dilutive effects on the existing holders ofour Common Stock.

 

***The conversion of preferred stockor exercise of warrants we issued in the private placements may cause the priceof our common stock to decline.***

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto Rule 144 of the Securities and Exchange Commission.  As of October 31, 2009, 780,000 sharesof our 5% Preferred Stock had converted into 1,240,456 shares of common stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may freely convert their sharesof preferred stock and exercise their warrants and sell the underlying sharesof common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of October 31, 2009,605,200 shares of Series 2 Preferred Stock had converted into 605,200shares of common stock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may freely convert their sharesof Series 3 Preferred Stock and exercise their warrants and sell theunderlying shares of common stock pursuant to Rule 144 of the Securitiesand Exchange Commission.  As of October 31,2009, 210,551 shares of Series 3 Preferred Stock had converted into210,551 shares of common stock.

 

For the four weeks endedon October 31, 2009, the average daily trading volume of our common stockon The OTCBB was 363 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity 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.

 

***Our management andlarger stockholders exercise significant control over our company and have theability to approve or take actions that may be adverse to your interests.***

 

As of October 31,2009, our executive officers, directors and preferred stockholders beneficiallyown approximately 30% 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, we may contemplate the possibleissuance of shares of our Common Stock or of securities exercisable orconvertible into shares of our Common Stock in the future to our ChiefExecutive Officer.  Any such issuancewill increase the percentage of stock our Chief Executive Officer and ourmanagement group beneficially holds.

 

Item 3.                                Defaults Upon Senior Securities

 

During the quarter ended September 30,2009, we accrued $14,000 in dividends to the holders of our 5% Preferred Stock,$14,000 in dividends to the holders of our Series 2 5% Preferred Stock and$10,000 in dividends to the holders of our Series 3 5% PreferredStock.  At September 30, 2009, wehave dividends accrued of $126,000 related to our 5% Preferred Stock, $106,000related to our Series 2 5% Preferred Stock and $71,000 related to our Series 35% 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 and as of thequarter ended September 30, 2009, did not have sufficient capital surplus,defined as the amount by which our net assets exceed our stated capital, basedon par value of our outstanding shares as provided by Delaware law.  We cannot assure you that our net assets willexceed our stated capital or that we will have net profits in order to paythese dividends in the future.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour 

 

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preferred stock, we began accruing an additional latefee penalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock.  Our CEO, CFO and outside board member thatare invested in Series 2 and Series 3 Preferred Stock have waived thelate fee penalty.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of October 31, 2009, the aggregate redemption price we would owewould be $2.1 million.

 

Item 6.                                Exhibits

 

The following Exhibits are filed with this report form10-Q:

 
| 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  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 NA T U R E S**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.

 

 
| ** **                    | **INTRUSION  INC.**                                                      |
|-------------------------------|--------------------------------------------------------------------------|
|                          |                                                                     |
| Date:  November 12, 2009 | /s/ G. Ward  Paxton                                                      |
|                          | G. Ward Paxton                                                           |
|                          | Chairman, President &  Chief Executive Officer                  |
|                          | (Principal  Executive Officer)                                           |
|                          |                                                                     |
|                          |                                                                     |
| Date:  November 12, 2009 | /s/ Michael L.  Paxton                                                   |
|                          | Michael L.  Paxton                                                       |
|                          | Vice President,  Chief Financial Officer, Treasurer & Secretary |
|                          | (Principal  Financial & Accounting Officer)                     |

 

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