Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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| **x**                                                 | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|-------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                  |       |                                                                                                    |
| **For the quarterly period ended June 30, 2008** |
|                                                  |       |                                                                                                    |
| **OR**                                                |
|                                                  |       |                                                                                                    |
| **o**                                                 | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the transition period from                 to                 **

 

**Commission File Number 0-20191**

 

**INTRUSIONINC.**

(Exactname of small business issuer as specified in its charter)

 

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

 

**1101 East Arapaho Road, Suite 200, Richardson, Texas75081**

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Issuer’stelephone number, including area code)

 

**Not Applicable**

Formername, if changed since last report)

 

** * * * * * * * *

 

Check whether the Registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities 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 is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| 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 markwhether the Registrant is a shell company (as defined in Rule 12b-2 of theExchange Act:  Yes o No x

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on July 31,2008 was 11,638,405.

 

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

 

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I – FINANCIAL INFORMATION**                                                                              |       |
|---------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                      |       |
| Item 1. Financial Statements                                                                                              |       |
|                                                                                                                      |       |
| Unaudited Condensed  Consolidated Balance Sheets as of June 30, 2008 and December 31,  2007                     |       |
|                                                                                                                      |       |
| Unaudited Condensed  Consolidated Statements of Operations for the three and six months ended June 30, 2008 and 2007 | ** ** |
|                                                                                                                      |       |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the six months ended  June 30, 2008 and 2007          |       |
|                                                                                                                      |       |
| Notes to  Unaudited Condensed Consolidated Financial Statements                                                           |       |
|                                                                                                                      |       |
| Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                      |       |
|                                                                                                                      |       |
| Item 4. Controls  and Procedures                                                                                          |       |
|                                                                                                                      |       |
| **PART II – OTHER  INFORMATION**                                                                                |       |
|                                                                                                                      |       |
| Item 1. Legal Proceedings                                                                                                 |       |
|                                                                                                                      |       |
| Item 1A. Risk Factors                                                                                                     |       |
|                                                                                                                      |       |
| Item 4.  Submission of Matters to a Vote of Security Holders                                                              |       |
|                                                                                                                      |       |
| Item 6. Exhibits                                                                                                          |       |
|                                                                                                                      |       |
| Signature Page                                                                                                            |       |

 

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**PART I – FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                         | ** ** | **June 30,**** ****2008** | ** ** | **December 31,   2007** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| **ASSETS**                                                                         |       |                                |       |                              |       |
| Current Assets:                                                                    |       |                                |       |                              |       |
| Cash and cash equivalents                                                          |       | $                                   | 212        |                              | $          | 362 |   |
| Accounts receivable, less allowance for  doubtful accounts of $40 in 2008 and 2007 |       | 554                                 |       | 110                               |       |
| Inventories, net                                                                   |       | 83                                  |       | 146                               |       |
| Prepaid expenses                                                                   |       | 64                                  |       | 75                                |       |
| Total current  assets                                                              |       | 913                                 |       | 693                               |       |
| Property and equipment, net                                                        |       | 121                                 |       | 144                               |       |
| Other assets                                                                       |       | 39                                  |       | 39                                |       |
| TOTAL ASSETS                                                                       |       | $                                   | 1,073      |                              | $          | 876 |   |
|                                                                               |       |                                |       |                              |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                    |       |                                |       |                              |       |
|                                                                               |       |                                |       |                              |       |
| Current Liabilities:                                                               |       |                                |       |                              |       |
| Accounts payable and accrued expenses                                              |       | $                                   | 736        |                              | $          | 688 |   |
| Line of credit                                                                     |       | —                              |       | 100                               |       |
| Loans payable to officer                                                           |       | 1,180                               |       | —                            |       |
| Deferred revenue                                                                   |       | 266                                 |       | 312                               |       |
| Total current liabilities                                                          |       | 2,182                               |       | 1,100                             |       |
|                                                                               |       |                                |       |                              |       |
| Stockholders’ Deficit:                                                        |       |                                |       |                              |       |
| Preferred stock, $0.01 par value:  Authorized shares – 5,000                  |       |                                |       |                              |       |
| Series 1 shares issued and outstanding  — 260                            |       |                                |       |                              |       |
| Liquidation preference of $1,347 as of  June 30, 2008                         |       | 918                                 |       | 918                               |       |
| Series 2 shares issued and outstanding  — 460                            |       |                                |       |                              |       |
| Liquidation preference of $1,184 as of  June 30, 2008                         |       | 724                                 |       | 724                               |       |
| Series 3 shares issued and outstanding  — 354                            |       |                                |       |                              |       |
| Liquidation preference of $795 as of  June 30, 2008                           |       | 504                                 |       | 504                               |       |
| Common stock, $0.01 par value:                                                     |       |                                |       |                              |       |
| Authorized shares — 80,000                                                    |       |                                |       |                              |       |
| Issued shares — 11,648                                                        |       |                                |       |                              |       |
| Outstanding shares — 11,638                                                   |       | 116                                 |       | 116                               |       |
| Common stock held in treasury, at cost – 10  shares                           |       | (362                                | )          | (362                              | )          |
| Additional paid-in capital                                                         |       | 55,475                              |       | 55,527                            |       |
| Accumulated deficit                                                                |       | (58,305                             | )          | (57,472                           | )          |
| Accumulated other comprehensive loss                                               |       | (179                                | )          | (179                              | )          |
| Total stockholders’ deficit                                                   |       | (1,109                              | )          | (224                              | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                   |       | $                                   | 1,073      |                              | $          | 876 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS 

(Inthousands, except per share amounts)

 
| ** **                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**    | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| Net product revenue                                                        |       | $                                | 1,132      |                           | $          | 829 |   | $ | 1,431 |   | $ | 1,727 |   |
| Net customer support and maintenance  revenue                              |       | 151                              |       | 174                            |       | 315 |   | 368 |   |
| Total revenue                                                              |       | 1,283                            |       | 1,003                          |       | 1,746 |   | 2,095 |   |
| Cost of product revenue                                                    |       | 434                              |       | 371                            |       | 608 |   | 774 |   |
| Cost of customer support and maintenance  revenue                          |       | 6                                |       | 22                             |       | 11 |   | 40 |   |
| Total cost of revenue                                                      |       | 440                              |       | 393                            |       | 620 |   | 814 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Gross profit                                                               |       | 843                              |       | 610                            |       | 1,126 |   | 1,281 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                                        |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                                        |       | 361                              |       | 504                            |       | 732 |   | 1,019 |   |
| Research and development                                                   |       | 195                              |       | 388                            |       | 710 |   | 811 |   |
| General and administrative                                                 |       | 230                              |       | 248                            |       | 496 |   | 475 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Operating income (loss)                                                    |       | 57                               |       | (530                           | )          | (812 | ) | (1,024 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Other income (expense), net                                                |       | —                           |       | 1                              |       | — |   | 1 |   |
| Interest income (expense), net                                             |       | (16                              | )          | (1                             | )          | (22 | ) | 1 |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Income (loss) before income tax provision                                  |       | 41                               |       | (530                           | )          | (834 | ) | (1,022 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Income tax provision                                                       |       | —                           |       | —                         |       | — |   | — |   |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net income (loss)                                                          |       | $                                | 41         |                           | $          | (530 | ) | $ | (834 | ) | $ | (1,022 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Preferred stock dividends accrued                                          |       | (40                              | )          | (43                            | )          | (105 | ) | (86 | ) |
| Net income (loss) attributable to common  stockholders                     |       | $                                | 1          |                           | $          | (573 | ) | $ | (939 | ) | $ | (1,108 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Net loss per share attributable to common  stockholders, basic and diluted |       | $                                | 0.00       |                           | $          | (0.06 | ) | $ | (0.08 | ) | $ | (0.12 | ) |
|                                                                       |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares outstanding,  basic and diluted             |       | 11,638                           |       | 9,271                          |       | 11,638 |   | 8,873 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Inthousands)

 
| ** **                                                                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                   | ** ** | **June 30,   2008**  | ** ** | **June 30,   2007** | ** ** |
| Operating Activities:                                                        |       |                           |       |   |   |
| Net loss                                                                     |       | $                              | (834       | ) | $ | (1,022 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                           |       |   |   |
| Depreciation and amortization                                                |       | 23                             |       | 32 |   |
| Provision for doubtful accounts                                              |       | —                         |       | (14 | ) |
| Stock-based compensation                                                     |       | 29                             |       | 44 |   |
| Changes in operating assets and  liabilities:                                |       |                           |       |   |   |
| Accounts receivable                                                          |       | (444                           | )          | 111 |   |
| Inventories                                                                  |       | 64                             |       | (15 | ) |
| Prepaid expenses and other assets                                            |       | 10                             |       | 73 |   |
| Accounts payable and accrued expenses                                        |       | (32                            | )          | (210 | ) |
| Deferred revenue                                                             |       | (46                            | )          | (18 | ) |
| Net cash used in operating activities                                        |       | (1,230                         | )          | (1,019 | ) |
| Investing Activities:                                                        |       |                           |       |   |   |
| Purchases of property and equipment                                          |       | —                         |       | (37 | ) |
| Financing Activities:                                                        |       |                           |       |   |   |
| Net activity under line of credit                                            |       | (100                           | )          | (75 | ) |
| Borrowings from officer                                                      |       | 1,180                          |       | — |   |
| Dividends paid on preferred stock                                            |       | —                         |       | (87 | ) |
| Proceeds from the issuance of common stock                                   |       | —                         |       | 1,000 |   |
| Net cash provided by financing activities                                    |       | 1,080                          |       | 838 |   |
|                                                                         |       |                           |       |   |   |
| Net decrease in cash and cash equivalents                                    |       | (150                           | )          | (218 | ) |
| Cash and cash equivalents at beginning of  period                            |       | 362                            |       | 933 |   |
| Cash and cash equivalents at end of period                                   |       | $                              | 212        |   | $ | 715 |   |
|                                                                         |       |                           |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                   |       |                           |       |   |   |
|                                                                         |       |                           |       |   |   |
| Preferred stock dividends accrued                                            |       | $                              | 106        |   | $ | 86 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Description of Business

 

We develop, market and support a family of entity identification,regulated information compliance, data privacy protection and network intrusionprevention/detection products.  Ourproduct families include:  TraceCopTMfor identity discovery and disclosure, Compliance CommanderTM for regulated information and dataprivacy protection, and Intrusion SecureNetTM for network intrusion prevention and detection.  Our products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

 

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

 

We were organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we announced plans to sell, or otherwisedispose of, our networking divisions, which included our EssentialCommunications division and our local area networking 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 reflect our focus on intrusionprevention and detection solutions, along with information compliance and dataprivacy protection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

Our principal executive offices 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 andTraceCopTM are trademarks of Intrusion Inc.

 

As of June 30, 2008, we had cash, cash equivalents and investmentsof approximately $0.2 million, down from approximately $0.4 million as of December 31,2007.  Although we generated net incomeof $41,000 in the second quarter of 2008, operating cash outflows may continuethrough the third quarter of 2008 and possibly later into the fiscal year2008.  The sufficiency of our cashresources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  As of June 30, 2008, we had cash and cash equivalents of $212,000,$218,000 in funding available under our line of credit at Silicon Valley Bankand $1.0 million funding available from a written commitment to investup to $1.5 million from G. Ward Paxton, the Company’s Chairman, President andChief Executive Officer.  Based onprojections for increased revenues in the remainder of 2008, a commitment fromthe Company’s CEO to advance the Company up to $1.0 million in additionalfunding should it be necessary, $2.5 million line of credit with borrowingsavailable of $218,000 at June 30, 2008, and our Company’s production ofnet income in the second quarter of 2008, we believe that our available creditline and available cash resources will provide sufficient cash resources tofinance our operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operations throughCompany profits, our line of credit, and possibly additional investments ofprivate equity and debt, which, if we are able to obtain, will have the effectof diluting our existing common stockholders, perhaps significantly.  Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case of equityfinancings, may result in dilution to our stockholders. If our operations donot generate positive cash flow in the upcoming quarters, or if we are not ableto obtain additional debt or equity financing on terms and conditionsacceptable to us, if at all, we may be unable to implement our business plan,fund our liquidity needs or even continue our operations.

 

2.     Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Item10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financialstatements.  The December 31, 2007balance sheet was derived from audited financial statements, but does notinclude all the disclosures required by accounting principles generallyaccepted in the United States.  However,we believe that the disclosures are adequate to make the information presentednot misleading.  In our opinion, all theadjustments (consisting of normal recurring adjustments) considered necessaryfor fair presentation have been included. The results of operations for the three and six month periods ending June 30,2008 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 included hereinshould be read in conjunction with the consolidated financial statements andnotes thereto included in our annual report on Form 10-KSB for the yearended December 31, 2007, filed with the commission on March 28, 2008.

 

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3.     Inventories (In thousands)

 
| ** **              | ** ** | **June 30,   2008** | ** ** | **December 31,   2007** | ** ** |
|-------------------------|------------|-------------------------------|------------|-----------------------------------|------------|
|                    |       |                          |       |                              |       |
| Inventories consist of: |       |                          |       |                              |       |
|                    |       |                          |       |                              |       |
| Finished goods          |       | $                             | 72         |                              | $          | 123 |   |
| Work in progress        |       | 8                             |       | 8                                 |       |
| Demonstration systems   |       | 3                             |       | 15                                |       |
| Net inventory           |       | $                             | 83         |                              | $          | 146 |   |

 

4.     Loans Payable to Officer

 

On January 30, 2008, we enteredinto a revolving promissory note to borrow up to $700,000 from G. WardPaxton, the Company’s Chairman, 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 are due on December 31,2008.  On March 20, 2008, wereceived a written commitment from our Chief Executive Officer to investup to an additional $1,500,000 in the Company until March 2009, shouldsuch funding be required by the Company. Amounts the Company borrows under the note and the commitmentaccrue interest at a floating rate per annum equal to the announced prime rateof Silicon Valley Bank (“SVB”) plus 1% and are unsecured.  As of June 30, 2008 we had $1.0 millionavailable to borrow under the commitment.

 

5.     Line of Credit

 

On March 29, 2006,we entered into a Loan and Security Agreement (the “Prior Agreement”) with SVBto establish a $1.0 million line of credit (the “Prior Line of Credit”) withSVB.  On June 30, 2008, we enteredinto an Amended and Restated Loan and Security Agreement (the “Loan Agreement”)with SVB to, among other things, replace the Prior Line of Credit with a new$2.5 million line of credit (the “Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  Borrowings under the Line ofCredit are based on advances (each, an “Advance”) against certain of ouraccounts receivable that are approved by SVB (“Eligible Accounts”).  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 (a) the greater of the prime rate or 5.25%,plus (b) 1.5% or 2.0%, depending on certain qualifying financial factorsspecified in the Loan Agreement.  Financecharges are payable at the same time its related Advance is due.  Each Advance is also subject to a monthlycollateral handling fee of 0.25% or 0.5% of all outstanding Advances, dependingon certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Loan Agreement, or (c) thedate on which any “Adjustment” (as defined in the Loan Agreement) is assertedto the Eligible Account.  The LoanAgreement terminates and all outstanding advances, accrued but unpaid financecharges, outstanding collateral handing fees, and other amounts due under theLoan Agreement and related documents.  Wehave zero outstanding under this credit line as of June 30, 2008 and hadborrowings available of $218,000 based on our borrowing base calculation.

 

6.     Accounting for Stock-Based Compensation

 

The Company recognized$24,000 and $37,000, respectively, stock-based compensation expense for thethree month periods ended June 30, 2008 and 2007.

 

Valuation Assumptions

 

The fair values of option awards were estimated at the date of grantusing a Black-Scholes option-pricing model with the following assumptions:

 
| ** **                             | ** ** | **For Three Months   Ended   June 30, 2008** | ** ** | **For Three Months   Ended   June 30, 2007** | ** ** | **For Six Months   Ended   June 30, 2008** | ** ** | **For Six Months   Ended   June 30, 2007** | ** ** |
|----------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|--------------------------------------------------------------------------|------------|
|                                   |       |                                                                       |       |                                                                       |       |                                                                     |       |                                                                     |       |
| Weighted average grant date fair value |       | $                                                                          | 0.16       |                                                                       | $          | 0.31                                                                     |       | $                                                                        | 0.17       |   | $ | 0.32 |   |
| Weighted average assumptions used:     |       |                                                                       |       |                                                                       |       |                                                                     |       |                                                                     |       |
| Expected dividend yield                |       | 0.0                                                                        | %          | 0.0                                                                        | %          | 0.0                                                                      | %          | 0.0                                                                      | %          |
| Risk-free interest rate                |       | 3.4                                                                        | %          | 4.9                                                                        | %          | 2.6                                                                      | %          | 4.9                                                                      | %          |
| Expected volatility                    |       | 111.0                                                                      | %          | 105.0                                                                      | %          | 107.1                                                                    | %          | 105.1                                                                    | %          |
| Expected life (in years)               |       | 5.0                                                                        |       | 4.9                                                                        |       | 5.0                                                                      |       | 4.9                                                                      |       |
|                                        |            |                                                                            |            |                                                                            |            |                                                                          |            |                                                                          |            |  |  |  |  |

 

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

 

7.     Net Income (Loss) Per Share

 

Basic net income (loss) pershare is computed by dividing net loss attributable to common stockholders forthe period by the weighted average number of common shares outstanding for theperiod.  Diluted net income (loss) pershare is computed by dividing the net income (loss) attributable to commonstockholders by the weighted average number of common shares and dilutivecommon stock equivalents outstanding for the period.  Our common stock equivalents include allcommon stock issuable upon conversion of preferred stock and the exercise ofoutstanding options and warrants.  Theaggregate number of common stock equivalents excluded from the diluted income(loss) per share calculation for the periods ended June 30, 2008 and 2007are 4,227,826 and 4,226,998, respectively. Our common stock equivalents are not included in the diluted income(loss) per share for the three and six month periods ended June 30, 2008and 2007, as they are antidilutive.

 

8.     New Accounting Pronouncements

 

In February 2008, FASB Staff Position (“FSP”) FAS No. 157-2, *Effective Date of FASB Statement No. 157*(“FSP 157-2”),was issued. FSP 157-2 defers the effective date of SFAS 157-2 tofiscal years beginning after December 15, 2008, and interim periods withinthose fiscal years, for all nonfinancial assets and liabilities, except thosethat are recognized or disclosed at fair value in the financial statements on arecurring basis (at least annually). Examples of items within the scope of FSP 157-2are nonfinancial assets and nonfinancial liabilities initially measured at fairvalue in a business combination (but not measured at fair value in subsequentperiods), and long-lived assets, such as property, plant and equipment andintangible assets measured at fair value for an impairment assessment underSFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets*.

 

The partial adoption of SFAS 157-2 on January 1, 2008 withrespect to financial assets and financial liabilities recognized or disclosedat fair value in the financial statements on a recurring basis is not expectedto have a material impact on our consolidated financial statements. We are inthe process of analyzing the potential impact of SFAS 157-2 relating to ourplanned December 31, 2008 adoption of the remainder of the standard.

 

In December 2007, FASB issued SFAS No. 160, *Non-Controlling Interests in Consolidated Financial Statements anamendment of ARB No. 51* (“SFAS 160”). SFAS 160establishes new standards for the accounting for and reporting ofnon-controlling interests (formerly minority interests) and for the loss ofcontrol of partially owned and consolidated subsidiaries. SFAS 160 doesnot change the criteria for consolidating a partially owned entity. SFAS 160is effective for fiscal years beginning after December 15, 2008. We do notexpect the adoption of SFAS 160 will have a material impact on ourconsolidated financial statements.

 

Also in December 2007, FASB issued SFAS No. 141(revised2007) (“SFAS 141R”), a revision of SFAS 141, *BusinessCombinations*.   SFAS 141Restablishes requirements for the recognition and measurement of acquiredassets, liabilities, goodwill, and non-controlling interests. SFAS 141Ralso provides disclosure requirements related to business combinations.SFAS 141R is effective for fiscal years beginning after December 15,2008. SFAS 141R will be applied prospectively to business combinationswith an acquisition date on or after the effective date.

 

9.     Commitments and Contingencies

 

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

 

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

 

Forward LookingStatements

 

This QuarterlyReport on Form 10-Q, including, without limitation, the section entitled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,”contains forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Actof 1934 (The “Exchange Act”). Such forward-looking statements are generallyaccompanied by words such as “estimate,” “expect,” “believe,” “should,” “would,”“could,” “anticipate,” “may” or other words that convey uncertainty of futureevents or outcomes.  These statementsrelate to future events or to our future financial performance, and involveknown and unknown risks, uncertainties and other factors that may cause ouractual results, levels of activity, performance, or achievements to bematerially different from any future results, levels of activity, performanceor achievements expressed or implied by these forward-looking statements.Factors that may cause actual results to differ materially from currentexpectations, which we describe in more detail elsewhere in this QuarterlyReport on Form 10-Q  under theheading “Factors That May Affect Future Results of Operations,” and in our2007 Annual Report on Form 10-KSB in “Item 1 – Description of Business”include, but are not limited to:

 
| · | insufficient  cash to operate our business and inability to meet our liquidity  requirements;                                                                                                                                |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                         |
| · | loss of revenues  due to the failure of our newer products to achieve market acceptance;                                                                                                                                     |
|   |                                                                                                                                                                                                                         |
| · | our need to  generate substantially greater revenues from sales in order to achieve  profitability;                                                                                                                          |
|   |                                                                                                                                                                                                                         |
| · | concentration of  our revenues from U.S. government entities and the possibility of loss of one  of these customers and the unique risks associated with government customers;                                               |
|   |                                                                                                                                                                                                                         |
| · | our dependence  on sales made through indirect channels;                                                                                                                                                                     |
|   |                                                                                                                                                                                                                         |
| · | the challenge of  selling our products internationally;                                                                                                                                                                      |
|   |                                                                                                                                                                                                                         |
| · | our dependence  on equity or debt financing provided primarily by our Chief Executive Officer  in order to meet our cash flow requirements;                                                                                  |
|   |                                                                                                                                                                                                                         |
| · | the effect that  payment of accrued dividends on our preferred stock has on our cash resources  and the substantial dilution upon the conversion or redemption of our  preferred stock and exercise of outstanding warrants; |
|   |                                                                                                                                                                                                                         |
| · | the impact of  conversion of preferred stock or exercise of warrants on the price of our  common stock;                                                                                                                      |
|   |                                                                                                                                                                                                                         |
| · | the ability of  our preferred stockholders and lenders to hinder additional financing; and                                                                                                                                   |
|   |                                                                                                                                                                                                                         |
| · | the influence  that our management and larger stockholders have over actions taken by the  company.                                                                                                                          |

 

If one or more ofthese or other risks or uncertainties materialize, or if our underlyingassumptions prove to be incorrect, actual results may vary significantly fromwhat we projected. These forward-looking statements and other statements madeelsewhere in this report are made in reliance on the Private SecuritiesLitigation Reform Act of 1995.  Anyforward-looking statement you read in this Quarterly Report on Form 10-Qor our Annual Report on Form 10-KSB reflects our current views withrespect to future events and is subject to these and other risks, uncertaintiesand assumptions relating to our operations, results of operations, growthstrategy and liquidity. We assume no obligation to publicly update or revisethese forward-looking statements for any reason, or to update the reasonsactual results 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.

 

Critical Accounting Policiesand Estimates

 

Management’sdiscussion and analysis of financial condition and results of operations arebased upon our unaudited condensed consolidated financial statements, whichhave been prepared in accordance with accounting principles generally acceptedin the United States.  The preparation ofthese financial statements requires us to make estimates and judgments thataffect the reported amounts of assets, liabilities, revenues and expenses, andrelated disclosure of contingent assets and liabilities.  On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, restructuring, maintenance contracts andcontingencies.  We base our estimates onhistorical experience and on various other assumptions that we believe arereasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from these estimates under differentassumptions or conditions.

 

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

 

*Revenue Recognition*

 

We generally recognize product revenue upon shipment of product. Weaccrue for estimated warranty costs and sales returns at the time of shipmentbased on our experience. Revenue from maintenance contracts is deferred andrecognized over the contractual period the services are performed, generallyone year.  There is a risk that technicalissues on new products could result in unexpected warranty costs andreturns.  However, as we migrate to moreof a software-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followingcriteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectability is probable. Bundled hardware andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a Vendor SpecificObjective Evidence analysis to appropriately determine the amount of revenuederived from each deliverable.  If ourlicense strategy changes and we begin to offer licenses on a subscriptionbasis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical salesinformation on our product offerings.  Wedefer and recognize maintenance and support revenue over the term of thecontract period, which is generally one year.

 

We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.

 

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

 

*Allowance for Doubtful Accounts and Returns*

 

We maintain allowances for doubtful accounts for estimated lossesresulting from the inability of our customers to make required payments. Ourreceivables are uncollaterized and we expect to continue this policy in thefuture.  If the financial condition ofour customers were to deteriorate, resulting in an impairment of their abilityto make payments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

 

*Inventory*

 

We write down our inventory for estimated obsolescence or unmarketableinventory equal to the difference between the cost of inventory and theestimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, additional inventory write-downs may be required.   Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

 

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Results of Operations

 

The following table setsforth, for the periods indicated, certain financial data as a percentage of netrevenues. The period-to-period comparison of financial results is notnecessarily indicative of future results.

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**    | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| Net product revenue                                    |       | 88.2                             | %          | 82.7                           | %          | 82.0 | % | 82.4 | % |
| Net customer support and maintenance  revenue          |       | 11.8                             |       | 17.3                           |       | 18.0 |   | 17.6 |   |
| Total revenue                                          |       | 100.0                            |       | 100.0                          |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                                |       | 33.8                             |       | 37.1                           |       | 34.8 |   | 37.0 |   |
| Cost of customer support and maintenance  revenue      |       | 0.5                              |       | 2.1                            |       | 0.7 |   | 1.9 |   |
| Total cost of revenue                                  |       | 34.3                             |       | 39.2                           |       | 35.5 |   | 38.9 |   |
| Gross profit                                           |       | 65.7                             |       | 60.8                           |       | 64.5 |   | 61.1 |   |
| Operating expenses:                                    |       |                             |       |                           |       |   |   |   |   |
| Sales and marketing                                    |       | 28.2                             |       | 50.2                           |       | 41.9 |   | 48.7 |   |
| Research and development                               |       | 15.2                             |       | 38.7                           |       | 40.7 |   | 38.7 |   |
| General and administrative                             |       | 17.9                             |       | 24.7                           |       | 28.4 |   | 22.6 |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Operating income (loss)                                |       | 4.4                              |       | (52.8                          | )          | (46.5 | ) | (48.9 | ) |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Other income (expense), net                            |       | —                           |       | —                         |       | — |   | (0.1 | ) |
| Interest expense                                       |       | (1.2                             | )          | (0.1                           | )          | (1.3 | ) | — |   |
| Income (loss) before income tax provision              |       | 3.2                              |       | (52.9                          | )          | (47.8 | ) | (48.8 | ) |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Income tax provision                                   |       | —                           |       | —                         |       | — |   | — |   |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net income (loss)                                      |       | 3.2                              | %          | (52.9                          | )%         | (47.8 | )% | (48.8 | )% |
| Preferred stock dividends accrued                      |       | (3.1                             | )          | (4.3                           | )          | (6.2 | ) | (4.1 | ) |
|                                                   |       |                             |       |                           |       |   |   |   |   |
| Net income (loss) attributable to common  stockholders |       | 0.1                              | %          | (57.2                          | )%         | (54.0 | )% | (52.9 | )% |

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **          | ** ** | **June 30, 2008**      | ** ** | **June 30, 2007**    | ** ** | **June 30, 2008** | ** ** | **June 30, 2007** | ** ** |
| Domestic revenues   |       | 96.6                             | %          | 95.9                           | %          | 93.4 | % | 91.8 | % |
| Export revenues to: |       |                             |       |                           |       |   |   |   |   |
| Europe              |       | 3.0                              |       | 3.1                            |       | 5.9 |   | 7.2 |   |
| Canada              |       | 0.1                              |       | 0.1                            |       | 0.1 |   | 0.1 |   |
| Asia                |       | 0.2                              |       | 0.8                            |       | 0.4 |   | 0.8 |   |
| Latin America       |       | 0.1                              |       | 0.1                            |       | 0.2 |   | 0.1 |   |
|                |       |                             |       |                           |       |   |   |   |   |
| Net revenues        |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Net revenues for the quarter and sixmonths ended June 30, 2008 were $1.3 million and $1.7 million,respectively, compared to $1.0 million and $2.1 million for the same periods in2007.  Product revenues increased $0.3million for the quarter ended June 30,2008, and decreased $0.3 million for the six months ended June 30,2008 compared to the same periods in 2007. Customer support and maintenance revenue decreased $22 thousand and $53thousand for the quarter and six months ended June 30, 2008 compared tothe same periods in 2007.  This decreasewas due to the current sales mix with a high concentration of government salesnot requiring a maintenance contract.

 

**Concentrationof Revenues**.  Revenues from sales to various U.S.government entities totaled $1.1 million, or 86.5% of revenues, for the quarterended June 30, 2008 compared to $0.8 million, or 80.3% of revenues, forthe same period in 2007.  Revenues fromsales to various U.S. government entities totaled $1.4 million, or 79.6% ofrevenues, for the six months ended June 30, 2008 compared to $1.6 million,or 75.2% of revenues, for the same period in 2007.    Although we expect our concentration ofrevenues to vary among customers in future periods depending upon the timing ofcertain sales, we anticipate that sales to government customers will continueto account for a significant portion of our revenues in future periods.  Sales to the government present risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including, without limitation, potential disruptionto appropriation and spending patterns and the government’s reservation of theright to cancel contracts and purchase orders 

 

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for its convenience.  Although we do not believe that any of ourrevenues with government customers are subject to renegotiation, a large numberof cancelled or renegotiated government orders could have a material adverseeffect on our financial results. Currently, we are not aware of any proposed cancellation orrenegotiation of any of our existing arrangements with government entities and,historically, government entities have not cancelled or renegotiated orderswhich had a material adverse effect on our business.

 

**GrossProfit**.  Gross profit was $0.8 million or 65.7%of net revenues for the quarter ended June 30, 2008, compared to $0.6million or 60.8% of net revenues for the quarter ended June 30, 2007.  Gross profit was $1.1 million or 64.5% of netrevenues for the six months ended June 30, 2008 compared to $1.3 millionor 61.1% of net revenues for the six months ended June 30, 2007.   Gross profit on product revenues for thequarter and six months ended June 30, trended from 55.2% and 55.2%,respectively, in 2007 to 61.6% and 57.5%, respectively, in 2008 mainly due toan increase in net revenues and/or decreases in fixed costs.  Gross profit on customer support andmaintenance revenues for the quarter and six months ended June 30, trendedfrom 87.6% and 89.1%, respectively, in 2007 to 96.1% and 96.4%, respectively,in 2008.  Gross profit as a percentage of net revenues is impacted by severalfactors, including shifts in product mix, changes in channels of distribution,revenue volume, pricing strategies, and fluctuations in revenues of integratedthird-party products.

 

**Sales andMarketing**.  Sales and marketing expenses decreasedto $0.4 million for the quarter ended June 30, 2008, compared to $0.5million for the quarter ended June 30, 2007. Sales and marketing expensesdecreased to $0.7 million for the six months ended June 30, 2008, comparedto $1.0 million for the six months ended June 30, 2007 primarily due to aplanned reduction in sales and marketing related expenses.  Sales and marketing expenses may vary in thefuture.  However, we believe that thesecosts will remain relatively constant through the end of 2008, althoughexpenses may be increased relative to increases in revenue.

 

**Researchand Development**.  Research and development expensesdecreased to $0.2 million for the quarter ended June 30, 2008 compared to$0.4 million for the quarter ended June 30, 2007. Research and developmentexpenses decreased to $0.7 million for the six months ended June 30, 2008,compared to $0.8 million for the six months ended June 30, 2007.  Researchand development costs are expensed in the period incurred.  Research and development expenses decreasedin the three and six months ended June 30, 2008, compared to the sameperiods in 2007 primarily due to shifts from research and development expensesto cost of sales in relation to engineering contract jobs.  Research and development expenses may vary inthe future; however, we believe that these costs will remain relativelyconstant through the end of 2008, although expenses may be increased relativeto increases in revenue.

 

**General andAdministrative**.  General and administrative expensesremained at $0.2 million for the quarter ended June 30, 2008 compared to$0.2 million for the quarter ended June 30, 2007.  General and administrative expenses remainedat $0.5 million for the six months ended June 30, 2008, compared to $0.5million for the six months ended June 30, 2007.  It is expected thatgeneral and administrative expenses will remain relatively constant throughoutthe remainder of 2008, although expenses may be increased relative to increasesin revenue.

 

**Interest**.  Netinterest expense increased to $16 thousand interest expense for the quarterended June 30, 2008 compared to $0.6 thousand interest expense for thesame period in 2007.  Net interestexpense increased to $22 thousand for the six months ended June 30, 2008compared to $0.4 thousand of interest income for the same period in 2007.  The decrease in interest income was primarilydue to a decrease of cash and short-term investment balances when compared tothe prior year and an increase in interest expense related to the line ofcredit.  Net interest income may vary inthe future based on our cash flow and rate of return on investments.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at June 30, 2008 is approximately $0.2 million of cash and cashequivalents.  At June 30, 2008 therewas a working capital deficiency of $1.3 million compared to a surplus of $0.5million at June 30, 2007.

 

Cash used inoperations for the six months ended June 30, 2008 was $1.2 million,primarily due to a net loss of $0.8 million, an increase in accounts receivableof $444 thousand and decreases in deferred revenue of $46 thousand and accountspayable and accrued expense of $32 thousand. This cash decrease was partially offset by depreciation expense of $23thousand, stock-based compensation expense of $29 thousand, a decrease ininventories of $64 thousand, and a decrease in prepaid expenses and otherassets of $10 thousand.  Cash used inoperations for the six months ended June 30, 2007 was $1.0 million,primarily due to a net loss of $1.0 million, a decrease in accounts payable andaccrued expenses of $210 thousand, a reduction in deferred revenue of $18thousand, an increase in inventories of $15 thousand, and a reduction in theprovision for doubtful accounts of $14 thousand.  This cash decrease was partially offset bydepreciation expense of $32 thousand, stock-based compensation expense of $44thousand, a decrease in accounts receivable of $111 thousand, and a decrease inprepaid expenses and other assets of $73 thousand.  Future fluctuations in inventory balances,accounts receivable and accounts payable will be dependent upon severalfactors, including, but not limited to, quarterly sales, our strategy inbuilding inventory in advance of receiving orders from customers, and theaccuracy of our forecasts of product demand and component requirements.

 

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There was nocash used in investing activities in the six months ended June 30, 2008compared to $37 thousand of cash used in investing activities in the six monthsended June 30, 2007 for net purchases of property and equipment.

 

Cash provided by financingactivities in the six months ended June 30, 2008 was $1.1 million,primarily consisting of the proceeds from a promissory note and commitment byour Chief Executive Officer, G. Ward Paxton, for $1.2 million which was offset by repayments to the line of credit of$100 thousand compared to cash provided by financing activities in the sixmonths ended June 30, 2007 of $0.8 million, primarily consisting ofproceeds from the issuance of common stock of $1.0 million which was offset bypayment of dividends on preferred stock of $87 thousand and a net reduction inthe line of credit of $75 thousand.

 

At June 30, 2008,the Company did not have any material commitments for capital expenditures.

 

During the six monthsended June 30, 2008, the Company funded its operations through the use ofcash and cash equivalents and borrowings of $1.2 million from our CEO, G. WardPaxton.

 

On March 29, 2006,we entered into a Loan and Security Agreement (the “Prior Agreement”) with SVBto establish a $1.0 million line of credit (the “Prior Line of Credit”) withSVB.  On June 30, 2008, we enteredinto an Amended and Restated Loan and Security Agreement (the “Loan Agreement”)with SVB to, among other things, replace the Prior Line of Credit with a new$2.5 million line of credit (the “Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  Borrowings under the Line ofCredit are based on advances (each, an “Advance”) against certain of ouraccounts receivable that are approved by SVB (“Eligible Accounts”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB may determinein its sole discretion.  Each Advance issubject to a finance charge calculated as a daily rate that is based on a360-day annual rate of (a) the greater of the prime rate or 5.25%, plus (b) 1.5%or 2.0%, depending on certain qualifying financial factors specified in theLoan Agreement.  Finance charges arepayable at the same time its related Advance is due.  Each Advance is also subject to a monthlycollateral handling fee of 0.25% or 0.5% of all outstanding Advances, dependingon certain qualifying financial factors specified in the Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Loan Agreement, or (c) thedate on which any “Adjustment” (as defined in the Loan Agreement) is assertedto the Eligible Account.  The LoanAgreement terminates and all outstanding advances, accrued but unpaid financecharges, outstanding collateral handing fees, and other amounts due under theLoan Agreement and related documents.  Wehave zero outstanding under this credit line as of June 30, 2008 and hadborrowings available of $218,000 based on our borrowing base calculation.

 

Although we generated net income of $41,000 in the second quarter of2008, operating cash outflows may continue through the third quarter of 2008and possibly later into the fiscal year 2008. The sufficiency of our cash resources may depend to a certain extent ongeneral economic, financial, competitive or other factors beyond ourcontrol.  In addition, we are obligatedto make payments of accrued dividends on all our outstanding shares ofpreferred stock that will reduce our available cash resources.   As of June 30, 2008 we had cash andcash equivalents of $212,000, $218,000 funding available under our line ofcredit at Silicon Valley Bank and $1.0 million funding available from a writtencommitment to invest up to $1.5 million from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.  Based on projections for increasedrevenues in the remainder of 2008, a commitment from the Company’s CEO toadvance the Company up to $1.0 million in additional funding should it benecessary, $2.5 million line of credit with borrowings available of $218,000 atJune 30, 2008, and our Company’s production of net income in the secondquarter of 2008, we believe that our available credit line and available cashresources will provide sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months.  Weexpect to fund our operations through Company profits, our line of credit, 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 quarters, or if we are not able to obtain additional debt orequity financing on terms and conditions acceptable to us, if at all, we may beunable to implement our business plan, fund our liquidity needs or evencontinue our operations.

 

We may explore the possibleacquisitions of businesses, products and technologies that are complementary toour existing business.  We are continuingto identify and prioritize additional security technologies, which we may wishto develop, either internally or through the licensing, or acquisition ofproducts from third parties.  While wemay engage from time to time in discussions with respect to potentialacquisitions, there can be no assurances that any such acquisitions will bemade or that we will be able to successfully integrate any acquiredbusiness.  In order to finance suchacquisitions and working capital it may be necessary for us to raise additionalfunds through public or private financings. Any equity or debt financings, if available at all, may be on terms,which are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders.

 

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Item 4T.                        CONTROLS AND PROCEDURES

 

Wemaintain “disclosure controls and procedures,” as defined in Rule 13a-15(e) and15d-15(e) under the Exchange Act, that are designed to ensure thatinformation required to be disclosed by us in reports we file or submit underthe Exchange Act is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to our management, including ourprincipal executive officer and principal financial officer, as appropriate, toallow timely decisions regarding required disclosure.  In designing and evaluating our disclosurecontrols and procedures, management recognized that disclosure controls andprocedures, no matter how well conceived and operated, can provide onlyreasonable assurance of achieving the desired control objectives, and wenecessarily are required to apply our judgment in evaluating the cost-benefitrelationship of possible disclosure controls and procedures.

 

Ourmanagement, including our principal executive officer and principal financialofficer, evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures as of June 30, 2008 and concluded thatthe disclosure controls and procedures were effective.

 

Therehave not been any changes in our internal control over financial reporting thatoccurred during the quarter ended June 30, 2008 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II – OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

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

 

Item1A.                 RISK FACTORS

 

**Factors That May Affect Future Resultsof Operations**

 

We are providing the following information regarding changes that haveoccurred to previously disclosed risk factors from our Annual Report on Form 10-KSBfor the year ended December 31, 2007. In addition to the other information set forth below and elsewhere inthis report, you should consider the factors discussed under the heading “FactorsThat May Affect Future Results of Operations” in our Form 10-KSB forthe year ended December 31, 2007. 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.

 

***Ourcash, cash equivalents, and investments decreased from $0.4 million at December 31,2007 to $0.2 million at June 30, 2008. If net cash outflows continue, we may not have sufficient cash tooperate our business and may not be able to maintain certain liquidityrequirements.  Additional debt and equityofferings to fund future operations may not be available and, if available, maysignificantly dilute the value of our currently outstanding common stock.***

 

As of June 30, 2008, we had cash, cash equivalents and investmentsof approximately $0.2 million, down from approximately $0.4 million as of December 31,2007.  Although we generated net incomeof $41,000 in the second quarter of 2008, operating cash outflows may continuethrough the third quarter of 2008 and possibly later into the fiscal year2008.  The sufficiency of our cash resourcesmay depend to a certain extent on general economic, financial, competitive orother factors beyond our control.  Inaddition, we are obligated to make payments of accrued dividends on all ouroutstanding shares of preferred stock that will reduce our available cash resources.   As of June 30, 2008 we had cash andcash equivalents of $212,000, $218,000 funding available under our line ofcredit at Silicon Valley Bank and $1.0 million funding available from a writtencommitment to invest up to $1.5 million from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.  Based on projections for increasedrevenues in the remainder of 2008, a commitment from the Company’s CEO toadvance the Company up to $1.0 million in additional funding should it be necessary,$2.5 million line of credit with borrowings available of $218,000 at June 30,2008, and our Company’s production of net income in the second quarter of 2008,we believe that our available credit line and available cash resources willprovide sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  We expect to fund ouroperations through Company profits, our line of credit, and possibly additionalinvestments of private equity and debt, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to us and,in the case of equity financings, may result in dilution to our stockholders.If our operations do not generate positive cash flow in the upcoming quarters,or if we are not able to obtain additional debt or equity financing on termsand conditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

 

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***Our revenues increased from $1.0million in the second quarter 2007 to $1.3 million in the second quarter 2008as a continuing effect from an increase in TraceCop product sales.   If our newer products do not achieve marketacceptance, our revenues may decline.***

 

We have transitioned oursales strategy focus from SecureNet to TraceCop and Compliance Commander.  During this transition, sales of our newerproducts have only recently offset the losses in sales associated with ourolder products.  As a result, our netrevenue increased from $1.0 million in the second quarter 2007 to $1.3 millionin the second quarter 2008.  We canprovide no assurances that sales of our newer products will continue to offsetthe losses in sales of older products or generate sufficient revenues tosustain our business.

 

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

 

We have not yet receivedbroad market acceptance for our newer products. We cannot assure you that our present or future products will achievemarket acceptance on a sustained basis. In order to achieve market acceptance and increase sales of our newerproducts, we must introduce complementary security products, incorporate newtechnologies into our existing product lines and design, develop andsuccessfully commercialize higher performance products in a timely manner.  We cannot assure you that we will be able tooffer new or complementary products that gain market acceptance quickly enoughto avoid decreased revenues during current or future product introductions ortransitions.

 

***Although we had a net profit of$41 thousand for the quarter ended June 30, 2008, we have historicallyincurred losses and have an accumulated deficit of $58.3 million as of June 30,2008.  To achieve continued profitability,we must generate substantially greater revenues.***

 

We incurred modestoperating income for the quarter ended June 30, 2008, but have incurredoperating losses in previous years.  Forthe year ended December 31, 2007, we incurred a net loss of $2.4 millionand had an accumulated deficit of approximately $57.5 million as of December 31,2007. ** **Weneed to generate and sustain substantially greater revenues from the sales ofour products if we are to achieve continued profitability.  If we are unable to achieve these greaterrevenues, losses may continue for the near term and possibly longer.  To the extent that revenues decline or do notgrow at anticipated rates, increases in operating expenses precede or are not subsequentlyfollowed by commensurate increases in revenues or we are unable to adjustoperating expense levels accordingly, your investment could be jeopardized.

 

***A large percentageof our revenues are received from U.S. government entities, and the loss of oneof these customers could reduce our revenues and materially harm our businessand prospects.***

 

A large percentage of ourrevenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended June 30,2008, sales to U.S. government entities collectively accounted for 86.5% of ourrevenues.  For the years ended December 31,2005, 2006****and 2007, sales to U.S.government entities collectively accounted for 70.7%, 73.6% and 73.2% of ourtotal net revenues, respectively. 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.

 

***Governmentcustomers involve unique risks, which could adversely impact our revenues.***

 

We expect to continue toderive a substantial portion of our revenues from U.S. government customers inthe future.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customers,including potential disruption due to appropriation and spending patterns, delaysin approving a federal budget and the government’s right to cancel contractsand purchase orders for its convenience. General political and economic conditions, which we cannot accuratelypredict, directly and indirectly may affect the quantity and allocation ofexpenditures by federal departments.  Inaddition, obtaining government contracts may involve long purchase and paymentcycles, competitive bidding, qualification requirements, delays or changes infunding, budgetary constraints, political agendas, extensive specificationdevelopment and price negotiations and milestone requirements.  Each government entity also maintains its ownrules and regulations with which we must comply and which can varysignificantly among departments.  As aresult, cutbacks or re-allocations in the federal budget or losses ofgovernment sales due to other factors could have a material adverse effect onour revenues and operating results.

 

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

 

We derived 36.3% ofrevenue in the second quarter of 2008 through indirect channels of mainlygovernment resellers.  For the yearsended December 31, 2005, 2006 and 2007, we derived 36.2%, 17.3% and 19.2%of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We must expand our sales through these indirect channels in order toincrease our revenues.  We cannot assureyou that our products will gain market acceptance in these indirect saleschannels or that sales through these indirect sales channels will increase ourrevenues.  Further, many of ourcompetitors are also trying to sell their products through these indirect saleschannels, which could result in lower prices and reduced profit margins forsales of our products.

 

***International salescomprise a portion of our overall revenues. Our ability to sell our products internationally is subject to certainrisks, which could harm our business.***

 

Foreign sales in thesecond quarter of 2008 were 3.4% of revenue. Revenues from foreign customers for the fiscal years ended December 31,2005, 2006 and 2007 accounted for approximately 10.7%, 9.4% and 9.2%,respectively, of our revenue.  We expectsales to foreign customers to continue to represent a significant portion ofour revenues in the future.  Ourinternational operations are subject to many inherent risks that may adverselyaffect our business, financial condition and operating results, including:

 
| · |   | political, social and economic instability;                                                                            |
|--------|--------|------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                   |
| · |   | trade restrictions;                                                                                                    |
|   |   |                                                                                                                   |
| · |   | increases in duty rates and other potentially  adverse tax consequences;                                               |
|   |   |                                                                                                                   |
| · |   | exposure to different legal standards, particularly  with respect to the protection of intellectual property;          |
|   |   |                                                                                                                   |
| · |   | burdens of complying with a variety of foreign laws;                                                                   |
|   |   |                                                                                                                   |
| · |   | unexpected changes in regulatory requirements;                                                                         |
|   |   |                                                                                                                   |
| · |   | import and export license requirements and  restrictions of the United States and each other country where we operate; |
|   |   |                                                                                                                   |
| · |   | fluctuatins in currency exchange rates; and                                                                            |
|   |   |                                                                                                                   |
| · |   | changes in local purchasing practices, including  seasonal fluctuations in demand.                                     |

 

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

 

***The payment ofaccrued dividends on our preferred stock may strain our cash resources.***

 

On March 25, 2004,we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1Preferred Stock”) and warrants to acquire 556,619 shares of our commonstock.  The conversion price for the Series 1Preferred Stock and the exercise price of the warrants is $3.144 pershare.  As of July 31, 2008, therewere 259,696 shares of the Series 1 Preferred Stock outstanding,representing approximately 413,003 shares of common stock upon conversion.

 

On March 28, 2005,we completed a $2,663,000 private placement pursuant to which we issued1,065,200 shares of our Series 2 5% Convertible Preferred Stock (the “Series 2Preferred Stock”) and warrants to acquire 532,600 shares of our commonstock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of July 31,2008, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

On December 2, 2005, we completed a $1,230,843 private placementpursuant to which we issued 564,607 shares of our Series 3 5% preferredstock  (the “Series 3 PreferredStock”) and warrants to acquire 282,306 shares of our common stock. .Thepreferred shares may be converted into 564,607 shares of common stock at aninitial conversion price of $2.18 per share, and the warrants may be exercisedat a price of $0.40 per share during the five-year period commencing on June 2,2006.  As of July 31, 2008, therewere 354,056 shares of Series 3 Preferred Stock outstanding, representing354,056 shares of common stock upon conversion.

 

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During the quarter ended June 30,2008, we accrued $16,000 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% 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 six monthsended June 30, 2008, did not have sufficient capital surplus, defined asthe 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.  The accrual of these dividends may adverselyaffect our operating results.  Moreover,the payment of these dividends could strain our available cash resources, whichcould adversely affect our ability to operate or grow our business.  If we are unable to pay dividends on ourpreferred stock, we will accrue an additional late fee penalty of 18% per annumon the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock, and we could be required to redeem the outstanding shares of Series 2Preferred Stock and Series 3 Preferred Stock for shares of our commonstock issued at a price equal to 75% of the average of the volume weightedaverage price of our common stock for the ten days ending on the dayimmediately preceding an election to redeem, subject, in the case of the Series 3Preferred Stock, to a floor of $0.87.  Asa result, the issuance or potential issuance of these additional shares ofcommon stock could cause our stock price to decline.  Furthermore, our inability to pay dividendscould adversely affect our ability to raise equity financing in the future ifrequired.

 

***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 July 31, 2008, wehad 11,638,405 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have14,389,318 shares of common stock outstanding, approximately a 25.0% increasein the number of shares of our common stock outstanding.

 

Further, theoccurrence of certain events could entitle holders of our Series 2Preferred Stock and Series 3 Preferred Stock to require us to redeem theirshares for a certain number of shares of our common stock.  Assuming (i) we have paid all liquidateddamages and other amounts to the holders, (ii) incurred accrued but unpaiddividends on July 31, 2008 of $119,000, (iii) a volume weightedaverage price of $0.20, which was the ten-day volume weighted average closingprice of our common stock on July 31, 2008, and (iv) our 11,638,405shares of common stock outstanding on July 31, 2008, upon exercise oftheir redemption right by the holders of the Series 3 Preferred Stock andthe Series 2 Preferred Stock, we would be obligated to issue approximately17,449,298 shares of our common stock. This would represent an increase of approximately 149.9% in the numberof shares of our common stock as of July 31, 2008.

 

In addition,management may issue additional shares of common stock or securitiesexercisable or convertible into shares of common stock in order to finance ourcontinuing operations.  Any futureissuances of such securities would have additional dilutive effects on theexisting holders of our 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 July 31, 2008, 740,304 shares ofour 5% Preferred Stock had converted into 1,177,327 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 July 31, 2008,605,200 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 July 31,2008, 210,551 shares of Series 3 Preferred Stock had converted into210,551 shares of common stock.

 

For the four weeks endedon August 1, 2008, the average daily trading volume of our common stock onThe OTCBB was 1,678 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants 

 

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and sell a material amount of their underlying sharesof common stock on the open market, the increase in selling activity couldcause 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.

 

***Certain rights of the holders ofour preferred stock and the terms of our secured credit line may hinder ourability to raise additional financing.***

 

Under the terms of ourpreferred stock instruments, we cannot issue shares of capital stock withrights senior to those of our existing 5% Preferred Stock, Series 2 5%Preferred Stock or Series 3 5% Preferred Stock without the approval of atleast a majority of the holders of our 5% Preferred Stock, all of the holdersof our Series 2 5% Preferred Stock, and holders of at least 75% of our Series 35% Preferred Stock voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of each class of ourPreferred Stock.  Furthermore, the termsof our secured credit line with Silicon Valley Bank include covenants whichrestrict our ability to incur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

***Our failure torealize the expected benefits of our recent restructuring efforts couldadversely affect our operating results.***

 

Since we began restructuringin 2002, we have incurred approximately $1.1 million in restructuring charges,severance, and related expenses. We have also implemented other strategicinitiatives, such as reductions in our work force and facilities and aligningour organization around our business objectives.  Any further work force reductions couldresult in temporary reduced productivity of our remaining employees.  Additionally, our customers and prospects maydelay or forgo purchasing our products due to a perceived uncertainty caused byour restructuring and other changes. Failure to achieve the desired results of our initiatives couldseriously harm our business, results of operations and financial condition.

 

***We resemble a developmental stagecompany and our business strategy may not be successful.***

 

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

 
| · |   | the need for our network security products,  regulated information compliance systems and entity identification products  to achieve market acceptance and produce a sustainable revenue stream; |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                             |
| · |   | our ability to manage costs and expenses;                                                                                                                                                        |
|   |   |                                                                                                                                                                                             |
| · |   | our dependence on key personnel;                                                                                                                                                                 |
|   |   |                                                                                                                                                                                             |
| · |   | our ability to obtain financing on acceptable terms;  and                                                                                                                                        |
|   |   |                                                                                                                                                                                             |
| · |   | our ability to offer greater value than our  competitors.                                                                                                                                        |

 

Our business strategy maynot successfully address these risks.  Ifwe fail to recognize significant revenues from the sales of our networksecurity products, regulated information compliance systems and entityidentification products, our business, financial condition and operatingresults would be materially adversely affected.

 

***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 July 31, 2008,our executive officers, directors and preferred stockholders beneficially ownapproximately 38.7% 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 contemplate the possible issuanceof shares of our Common Stock or of securities exercisable or convertible intoshares of our Common Stock in the future by our Chief Executive Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management groupbeneficially holds.

 

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***We face intensecompetition from both start-up and established companies that may havesignificant advantages over us and our products.***

 

The market for networksecurity solutions is intensely competitive. There are numerous companiescompeting with us in various segments of the data security markets, and theirproducts may have advantages over our products in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

Our principalcompetitors in the network intrusion prevention and detection market includeInternet Security Systems, Inc. (IBM), Cisco Systems, Inc., Symantec, Inc.,Juniper Networks, Inc., McAfee Inc., Tipping Point Technologies, a divisionof 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu (Symantec), Port Authority (Websense),Vericept, Reconnex, Tablus and a small number of start-up companies thatentered the space within the last two years. Our current and potentialcompetitors may have one or more of the following significant advantages overus:

 

·                  greaterfinancial, technical and marketing resources;

 

·                  better namerecognition;

 

·                  morecomprehensive security solutions;

 

·                  better or moreextensive cooperative relationships; and

 

·                  larger customerbase.

 

We cannot assure you thatwe will be able to compete successfully with our existing or newcompetitors.  Some of our competitors mayhave, in relation to us, one or more of the following: longer operatinghistories, longer-standing relationships with OEM and end-user customers andgreater customer service, public relations and other resources. As a result,these competitors may be able to more quickly develop or adapt to new oremerging technologies and changes in customer requirements, or devote greaterresources to the development, promotion and sale of their products.Additionally, it is likely that new competitors or alliances among existingcompetitors could emerge and rapidly acquire significant market share.

 

***If we fail torespond to rapid technological changes in the network security industry, we maylose customers or our products may become obsolete.***

 

The network securityindustry is characterized by frequent product introductions, rapidly changingtechnology and continued evolution of new industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personal computerarchitectures and computer and network operating systems offered by variousvendors, including our competitors.  As aresult, our success depends upon our ability to develop and introduce in atimely manner new products and enhancements to our existing products that meetchanging customer requirements and evolving industry standards. The developmentof technologically advanced network security products is a complex anduncertain process requiring high levels of innovation, rapid response andaccurate anticipation of technological and market trends.  We cannot assure you that we will be able toidentify, develop, manufacture, market or support new or enhanced productssuccessfully in a timely manner. Further, we or our competitors may introduce new products or productenhancements that shorten the life cycle of our existing products or cause ourexisting products to become obsolete.

 

***Our products are highly technical and if they contain undetectederrors, our business could be adversely affected and we might have to defendlawsuits or pay damages in connection with any alleged or actual failure of ourproducts and services.***

 

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

 

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***A breach of network securitycould harm public perception of our security products, which could cause us tolose revenues.***

 

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

 

***If our products do notinteroperate with our customers’ networks, installations will be delayed orcancelled and could harm our business.***

 

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

 

***While we believe that wecurrently have adequate internal control over financial reporting, we areexposed to risks from recent legislation requiring companies to evaluate thoseinternal controls.***

 

Section 404of the Sarbanes-Oxley Act of 2002 requires our management to report on theeffectiveness of our internal control over financial reporting. We have anongoing program to perform the system and process evaluation and testingnecessary to comply with these requirements. We have and will continue to incursignificant expenses and devote management resources to Section 404compliance on an ongoing basis. In the event that our chief executive officer,chief financial officer or independent registered public accounting firmdetermine in the future that our internal controls over financial reporting arenot effective as defined under Section 404, investor perceptions may beadversely affected and could cause a decline in the market price of our stock.

 

***Our products canhave long sales and implementation cycles, which may result in us incurringsubstantial expenses before realizing any associated revenues.***

 

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

 

***Consolidation inthe network security industry may limit market acceptance of our products.***

 

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

 

***We must adequatelyprotect our intellectual property in order to prevent loss of valuableproprietary information.***

 

We rely primarily on acombination of copyright, trademark and trade secret laws, confidentialityprocedures and non-disclosure agreements to protect our proprietarytechnology.  However, unauthorizedparties may attempt to copy or reverse-engineer aspects of our products or toobtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves

 

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to be inadequate or unenforceable, others may be ableto use our proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incursubstantial expenses defending ourselves against claims of infringement.***

 

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

 

***Fluctuations in ourquarterly revenues may cause the price of our common stock to decline.***

 

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

 

***The price of our common stock hasbeen volatile in the past and may continue to be volatile in the future due tofactors outside of our control.***

 

The market price of ourcommon stock has been highly volatile in the past and may continue to bevolatile in the future.  For example, infiscal year 2007, the market price of our common stock on The OTCBB Marketfluctuated between $0.17 and $0.75 per share. The market price of our common stock may fluctuate significantly inresponse to a number of factors, many of which are outside our control,including:

 
| · |   | variations in our quarterly operating results;                                                                                                                 |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                           |
| · |   | changes in estimates of our financial performance by  securities analysts;                                                                                     |
|   |   |                                                                                                                                                           |
| · |   | changes in market valuations of our competitors;                                                                                                               |
|   |   |                                                                                                                                                           |
| · |   | announcements by us or our competitors of new  products, significant contracts, acquisitions, strategic relationships, joint  ventures or capital commitments; |
|   |   |                                                                                                                                                           |
| · |   | product or design flaws, product recalls or similar  occurrences;                                                                                              |
|   |   |                                                                                                                                                           |
| · |   | additions or departures of key personnel;                                                                                                                      |
|   |   |                                                                                                                                                           |
| · |   | sales of common stock in the future; and                                                                                                                       |
|   |   |                                                                                                                                                           |
| · |   | fluctuations in stock market prices and volume,  which can be particularly common among network security and other high  technology companies.                 |

 

***Our past reductionsin our work force may make it more difficult for us to attract and retain thepersonnel necessary to successfully operate our business.***

 

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

 

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***Our acquisition of complementaryproducts or businesses may adversely affect our financial condition.***

 

We have made acquisitionsin the past and, in the future we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels.  Negotiationof potential acquisitions and integration of acquired products, technologies orbusinesses could divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

 

***Compliance with exportregulations may hinder our sales to foreign customers.***

 

Certain of our datasecurity products incorporate encryption and other technology that may requireclearance and export licenses from the U.S. Department of Commerce under UnitedStates export regulations.  Any inabilityto obtain these clearances or licenses or any foreign regulatory approvals, ifrequired, on a timely basis could delay sales and have a material adverseeffect on our operating results.

 

***Provisions of our charterdocuments and Delaware law may have anti-takeover effects.***

 

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

 

***Military actions may disrupt ourbusiness by reducing spending on our products, increasing our costs andaffecting our international operations.***

 

United States military actionsor other events occurring in response to or in connection with them, includingfuture terrorist attacks, actual conflicts involving the United States or itsallies or military or trade disruptions could impact our operations by:

 

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

 

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

 

·                  affecting ourability to conduct business internationally.

 

Should these eventsoccur, our business, operating results and financial condition could bematerially and adversely affected.

 

Item 4.           SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

 

The Annual Meeting ofStockholders was held on May 30, 2008, at the Radisson Hotel, Dallas Northin Richardson, Texas.  The following is abrief description of each matter voted upon by stockholders, including a numberof votes cast for, against, or withheld with regard to each matter of nominee.

 
| (1) |   | Election of five (5) directors to serve until  the next Annual Meeting of Stockholders and until their respective successors  are duly elected and qualified. |
|-----|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 
| ** **             | ** ** | **FOR**    | ** ** | **WITHHELD** | ** ** |
|------------------------|------------|------------|------------|--------------|------------|
| G. Ward Paxton         |       | 11,230,118 |       | 308,207      |       |
| T. Joe Head            |       | 11,228,448 |       | 309,877      |       |
| James F. Gero          |       | 11,231,247 |       | 307,078      |       |
| J. Fred Bucy, Jr. |       | 11,232,722 |       | 305,603      |       |
| Donald M. Johnston     |       | 11,232,897 |       | 305,428      |       |

 

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(2)                                  Ratificationand approval for the amendment of the 2005 Stock Incentive Plan.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 8,218,813 |       | 248,425     |       | 7,997       |       |

 

(3)                                  Ratificationand approval of selection by the Board of Directors of KBA Group LLP asindependent auditors of the Registrant for the fiscal year ending December 31,2008.

 
| **FOR**    | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 11,488,013 |       | 21,954      |       | 28,359      |       |

 

Item6.                                EXHIBITS

 

The following Exhibits arefiled with this report form 10-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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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the Registrant has duly caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
| ** **                 | **INTRUSION  INC.**                                                        |
|----------------------------|----------------------------------------------------------------------------|
|                       |                                                                       |
| Date: August 13, 2008 | /s/ G. Ward Paxton                                                         |
|                       | G. Ward Paxton                                                             |
|                       | Chairman,  President & Chief Executive Officer                    |
|                       | (Principal Executive  Officer)                                             |
|                       |                                                                       |
|                       |                                                                       |
| Date: August 13, 2008 | /s/ Michael L. Paxton                                                      |
|                       | Michael L. Paxton                                                          |
|                       | Vice President, Chief  Financial Officer,   Treasurer & Secretary |
|                       | (Principal  Financial & Accounting Officer)                       |

 

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