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 TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended March 31, 2010**

 

**OR**

 

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

 

**For thetransition period from                 to          **

 

**CommissionFile Number  0-20191**

 

**INTRUSIONINC.**

(Exact name of registrantas specified in its charter)

 

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

 

**1101East Arapaho Road, Suite 200, Richardson, Texas 75081**

(Address of principalexecutive offices)

(Zip Code)

 

**(972)234-6400**

(Registrant’s telephonenumber, including area code)

 

**NotApplicable**

(Former name, formeraddress and former fiscal year, if changed since last report)

 

* * * * * * * * * *

 

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x No o

 

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

 

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

 

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

 

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

 

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on April 30, 2010 was 11,736,150.

 

 

 

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**INTRUSIONINC.**

 

INDEX

 
| **PART I —  FINANCIAL INFORMATION**                                                                       |
|---------------------------------------------------------------------------------------------------------------------|
|                                                                                                                |
| Item 1. Financial Statements                                                                                        |
|                                                                                                                |
| Unaudited  Condensed Consolidated Balance Sheets as of March 31, 2010 and  December 31, 2009              |
|                                                                                                                |
| Unaudited  Condensed Consolidated Statements of Operations for the three months ended March 31, 2010 and 2009  |
|                                                                                                                |
| Unaudited  Condensed Consolidated Statements of Cash Flows for the three months ended  March 31, 2010 and 2009 |
|                                                                                                                |
| Notes  to Unaudited Condensed Consolidated Financial Statements                                                     |
|                                                                                                                |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations                 |
|                                                                                                                |
| Item 4T. Controls and Procedures                                                                                    |
|                                                                                                                |
| **PART II  — OTHER INFORMATION**                                                                          |
|                                                                                                                |
| Item  1. Legal Proceedings                                                                                          |
|                                                                                                                |
| Item 1A. Risk Factors                                                                                               |
|                                                                                                                |
| Item 6. Exhibits                                                                                                    |
|                                                                                                                |
| Signature Page                                                                                                      |

 

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**PART I— FINANCIAL INFORMATION**

 

Item 1. FINANCIALSTATEMENTS

 

**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except parvalue amounts)

 
| ** **                                                                                                         | ** ** | **March ****31,********2010** | ** ** | **December ****31,  2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                         |       |                               |       |                            |       |
| Current Assets:                                                                                                    |       |                               |       |                            |       |
| Cash and cash equivalents                                                                                          |       | $                                  | 365        |                            | $          | 519 |   |
| Accounts receivable                                                                                                |       | 437                                |       | 351                             |       |
| Inventories, net                                                                                                   |       | 34                                 |       | 7                               |       |
| Prepaid expenses                                                                                                   |       | 80                                 |       | 68                              |       |
| Total current assets                                                                                               |       | 916                                |       | 945                             |       |
| Property and equipment, net                                                                                        |       | 152                                |       | 146                             |       |
| Other assets                                                                                                       |       | 39                                 |       | 39                              |       |
| TOTAL ASSETS                                                                                                       |       | $                                  | 1,107      |                            | $          | 1,130 |   |
|                                                                                                               |       |                               |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                    |       |                               |       |                            |       |
|                                                                                                               |       |                               |       |                            |       |
| Current Liabilities:                                                                                               |       |                               |       |                            |       |
| Accounts payable and accrued expenses                                                                              |       | $                                  | 731        |                            | $          | 674 |   |
| Dividends payable                                                                                                  |       | 36                                 |       | 360                             |       |
| Deferred revenue                                                                                                   |       | 113                                |       | 93                              |       |
| Loan payable to officer                                                                                            |       | 970                                |       | —                          |       |
|                                                                                                               |       |                               |       |                            |       |
| Total current liabilities                                                                                          |       | 1,850                              |       | 1,127                           |       |
|                                                                                                               |       |                               |       |                            |       |
| Loan payable to officer                                                                                            |       | —                             |       | 970                             |       |
|                                                                                                               |       |                               |       |                            |       |
| Commitments and contingencies                                                                                      |       |                               |       |                            |       |
|                                                                                                               |       |                               |       |                            |       |
| Stockholders’ deficit:                                                                                        |       |                               |       |                            |       |
| Preferred stock, $0.01 par value: Authorized  shares — 5,000                                                  |       |                               |       |                            |       |
| Series 1 shares issued and outstanding — 220  Liquidation preference of $1,127 as of March 31, 2010 |       | 778                                |       | 778                             |       |
| Series 2 shares issued and outstanding — 460  Liquidation preference of $1,155 as of March 31, 2010 |       | 724                                |       | 724                             |       |
| Series 3 shares issued and outstanding — 354  Liquidation preference of $776 as of March 31, 2010   |       | 504                                |       | 504                             |       |
| Common stock, $0.01 par value:                                                                                     |       |                               |       |                            |       |
| Authorized shares — 80,000                                                                                    |       |                               |       |                            |       |
| Issued shares — 11,715 Outstanding shares — 11,705                                                       |       | 117                                |       | 117                             |       |
| Common stock held in treasury, at cost — 10 shares                                                            |       | (362                               | )          | (362                            | )          |
| Additional paid-in capital                                                                                         |       | 55,565                             |       | 55,545                          |       |
| Accumulated deficit                                                                                                |       | (57,890                            | )          | (58,094                         | )          |
| Accumulated other comprehensive loss                                                                               |       | (179                               | )          | (179                            | )          |
| Total stockholders’ deficit                                                                                   |       | (743                               | )          | (967                            | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                   |       | $                                  | 1,107      |                            | $          | 1,130 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITED CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS 

(In thousands, except pershare amounts)

 
| ** **                                                                          | ** ** | **Three Months Ended**  | ** ** |
|-------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                          | ** ** | **March 31, 2010** | ** ** | **March 31, 2009** | ** ** |
| Net product revenue                                                                 |       | $                       | 1,484      |   | $ | 761 |   |
| Net customer support and maintenance revenue                                        |       | 51                      |       | 95 |   |
| Total revenue                                                                       |       | 1,535                   |       | 856 |   |
| Cost of product revenue                                                             |       | 550                     |       | 271 |   |
| Cost of customer support and maintenance revenue                                    |       | 4                       |       | 5 |   |
| Total cost of revenue                                                               |       | 554                     |       | 276 |   |
|                                                                                |       |                    |       |   |   |
| Gross profit                                                                        |       | 981                     |       | 580 |   |
|                                                                                |       |                    |       |   |   |
| Operating expenses:                                                                 |       |                    |       |   |   |
| Sales and marketing                                                                 |       | 203                     |       | 264 |   |
| Research and development                                                            |       | 301                     |       | 366 |   |
| General and administrative                                                          |       | 260                     |       | 260 |   |
|                                                                                |       |                    |       |   |   |
| Operating income (loss)                                                             |       | 217                     |       | (310 | ) |
|                                                                                |       |                    |       |   |   |
| Interest expense, net                                                               |       | (13                     | )          | (12 | ) |
|                                                                                |       |                    |       |   |   |
| Income (loss) before income tax provision                                           |       | 204                     |       | (322 | ) |
|                                                                                |       |                    |       |   |   |
| Income tax provision                                                                |       | —                  |       | — |   |
|                                                                                |       |                    |       |   |   |
| Net income (loss)                                                                   |       | $                       | 204        |   | $ | (322 | ) |
|                                                                                |       |                    |       |   |   |
| Preferred stock dividends accrued                                                   |       | (37                     | )          | (40 | ) |
| Net income (loss) attributable to common  stockholders                              |       | $                       | 167        |   | $ | (362 | ) |
|                                                                                |       |                    |       |   |   |
| Net income (loss) per share attributable to common  stockholders, basic and diluted |       | $                       | 0.01       |   | $ | (0.03 | ) |
|                                                                                |       |                    |       |   |   |
| Weighted average common shares outstanding:                                         |       |                    |       |   |   |
| Basic                                                                               |       | 11,705                  |       | 11,638 |   |
| Diluted                                                                             |       | 13,611                  |       | 11,638 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

 
| ** **                                                                            | ** ** | **Three Months Ended**   | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                            | ** ** | **March 31,  2010** | ** ** | **March 31,  2009** | ** ** |
| Operating Activities:                                                                 |       |                     |       |   |   |
| Net income (loss)                                                                     |       | $                        | 204        |   | $ | (322 | ) |
| Adjustments to reconcile net income (loss) to net  cash used in operating activities: |       |                     |       |   |   |
| Depreciation and amortization                                                         |       | 18                       |       | 17 |   |
| Stock-based compensation                                                              |       | 42                       |       | 17 |   |
| Changes in operating assets and liabilities:                                          |       |                     |       |   |   |
| Accounts receivable                                                                   |       | (86                      | )          | 141 |   |
| Inventories                                                                           |       | (27                      | )          | 4 |   |
| Prepaid expenses and other assets                                                     |       | (12                      | )          | (5 | ) |
| Accounts payable and accrued expenses                                                 |       | 45                       |       | (42 | ) |
| Deferred revenue                                                                      |       | 20                       |       | (340 | ) |
| Net cash provided by (used in) operating  activities                                  |       | 204                      |       | (530 | ) |
|                                                                                  |       |                     |       |   |   |
| Investing Activities:                                                                 |       |                     |       |   |   |
| Purchases of property and equipment                                                   |       | (24                      | )          | — |   |
|                                                                                  |       |                     |       |   |   |
| Financing Activities:                                                                 |       |                     |       |   |   |
| Dividends paid on preferred stock                                                     |       | (334                     | )          | — |   |
| Borrowings from officer                                                               |       | —                   |       | 150 |   |
| Net cash provided by (used in) financing  activities                                  |       | (334                     | )          | 150 |   |
|                                                                                  |       |                     |       |   |   |
| Net decrease in cash and cash equivalents                                             |       | (154                     | )          | (380 | ) |
| Cash and cash equivalents at beginning of period                                      |       | 519                      |       | 554 |   |
| Cash and cash equivalents at end of period                                            |       | $                        | 365        |   | $ | 174 |   |
|                                                                                  |       |                     |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING  ACTIVITIES:                            |       |                     |       |   |   |
| Preferred stock dividends accrued                                                     |       | $                        | 37         |   | $ | 40 |   |

 

See accompanying notes.

 

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTES TO UNAUDITEDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Description of Business

 

We develop, market andsupport a family of entity identification, high speed data mining, regulatedinformation compliance, data privacy protection and network intrusionprevention/detection products.  Ourproduct families include:

 

·              TraceCopTM for identity discovery and disclosure,

·              SavantTM for network data mining,

·              Compliance CommanderTM for regulated information anddata privacy protection,

·              SecureNetTM for network intrusion prevention anddetection.

 

We market and distributeour products through a direct sales force to:

 

·              end-users,

·              value-added resellers,

·              system integrators,

·              managed service providers, and

·              distributors.

 

Our end-usercustomers include:

 

·              U.S. federal government entities,

·              foreign government entities,

·              local government entities,

·              banks,

·              credit unions,

·              other financial institutions,

·              hospitals and other healthcare providers, and

·              other customers.

 

Essentially, ourend-users can be defined as ‘any end-user requiring network security solutionsfor protecting their mission critical data’.

 

Wewere organized in Texas in September 1983 and reincorporated in Delawarein October 1995. For more than 15 years, we provided local areanetworking equipment and were known as Optical Data Systems or ODS Networks. OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which included our Essential Communications division andour local area networking assets. On June 1, 2000, we changed our namefrom ODS Networks, Inc. to Intrusion.com, Inc., and our ticker symbolfrom ODSI to INTZ to reflect our focus on intrusion prevention and detectionsolutions, along with information compliance and data privacy protectionproducts. On November 1, 2001, we changed our name from Intrusion.com, Inc.to Intrusion Inc.

 

Ourprincipal 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 and TraceCopTM aretrademarks of Intrusion Inc.

 

Asof March 31, 2010, we had cash and cash equivalents of approximately$365,000, down from approximately $519,000 as of December 31, 2009, and aworking capital deficit totaling $0.9 million. We generated net income of $204,000 in the first quarter of 2010compared to a net loss of $322,000 for the first quarter of 2009.  As of March 31, 2010, in addition tocash and cash equivalents of $365,000, we had $276,000 in funding availableunder our $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our 

 

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stockholders. If ouroperations do not generate positive cash flow in the upcoming year, or if weare not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

 

2.     Basis of Presentation

 

The accompanying unaudited condensed consolidatedfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States for interim financialinformation and with the instructions to Form 10-Q and Item 10-01 ofRegulation S-X.  Accordingly, they do notinclude all of the information and footnotes required by accounting principlesgenerally accepted in the United States for complete financial statements.  The December 31, 2009 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that thedisclosures are adequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three month periods ended March 31, 2010 arenot necessarily indicative of the results that may be achieved for the fullfiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in our annual report on Form 10-K for the yearended December 31, 2009, filed with the U.S. Securities and ExchangeCommission (the “SEC”) on March 29, 2010.

 

The Company calculates the fair value of its assets and liabilitieswhich qualify as financial instruments and includes this additional informationin the notes to consolidated financial statements when the fair value isdifferent than the carrying value of these financial instruments. The estimatedfair value of accounts receivable, accounts payable and accrued expenses, anddividends payable approximate their carrying amounts due to the relativelyshort maturity of these instruments. The carrying value of loans payable toofficer also approximates fair value since these instruments bear market ratesof interest. None of these instruments are held for trading purposes.

 

3.     Inventories (In thousands)

 
| ** **                     | ** ** | **March 31,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                           |       |                     |       |                        |       |
| Inventories consist of:        |       |                     |       |                        |       |
|                           |       |                     |       |                        |       |
| Finished goods                 |       | $                        | 32         |                        | $          | 5 |   |
| Demonstration systems          |       | 2                        |       | 2                           |       |
| Reserve for obsolete inventory |       | —                   |       | —                      |       |
| Net inventory                  |       | $                        | 34         |                        | $          | 7 |   |

 

4.     Loan Payable to Officer

 

On January 30, 2008,and extended on October 24, 2008, March 19, 2009, and February 4,2010, the Company entered into an unsecured revolving promissory note to borrowup to $700,000 from G. Ward Paxton, the Company’s Chairman, President and ChiefExecutive Officer.  Under the terms ofthe note, the Company may borrow, repay and reborrow on the loan as needed upto an outstanding principal balance due of $700,000 at any given time.

 

OnMarch 20, 2008, and extended on November 7, 2008, and February 4,2010, we received a writtencommitment from our Chief Executive Officer to invest up to an additional$1,500,000 in the Company until March 2011, should such funding berequired by the Company, on terms and conditions identical to those describedabove on the $700,000 note.

 

Amounts borrowed fromthis officer accrue interest at a floating rate per annum equal to SVB’s primerate plus 1% (5% at March 31, 2010). All outstanding borrowings and accrued but unpaid interest is due on March 31,2011.  As of March 31, 2010, theborrowings outstanding totaled $970,000 and accrued interest totaled$51,000.  The Company accrued interest of$12,000 in the first quarter of 2010 on the borrowings compared to $6,000 inthe first quarter of 2009.

 

5.     Line of Credit

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SiliconValley Bank (“SVB”) to establish a $1.0 million line of credit with SVB (the “2006Credit Line”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to the Amended and Restated Loan andSecurity Agreement (as amended, the “Loan Agreement”) with SVB to replace the2008 Credit Line with a $1.25 million line of credit (the “Current Line ofCredit”).  Our obligations under the LoanAgreement are secured by substantially all of our assets, including all of ourintellectual 

 

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property.  In addition, G. Ward Paxton, the Company’sChief Executive Officer, has established a Guaranty Agreement with SVB for alloutstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Creditare based on advances (each an “Advance”) against certain of our accountsreceivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Loan Agreement, or (c) the date on which any “Adjustment”(as defined in the Loan Agreement) is asserted to the Eligible Account.  On June 27, 2010, the Loan Agreementterminates and all outstanding Advances, accrued but unpaid finance charges,outstanding collateral handing fees, and other amounts become due under theLoan Agreement and related documents.  Wehave certain non-financial and financial covenants, including a liquiditycoverage ratio and a rolling EBITDA computation, as defined in the LoanAgreement.  We have no borrowingsoutstanding under the Current Line of Credit as of March 31, 2010, and hadborrowings available of $276,000.

 

6.     Accounting for Stock-Based Compensation

 

During the three monthperiods ended March 31, 2010 and 2009, the Company granted 480,000 and476,000, respectively, stock options to employees and directors.  The Company recognized $42,000 and $17,000,respectively, stock-based compensation expense for the three month periodsended March 31, 2010 and 2009.

 

ValuationAssumptions

 

Thefair values of employee and director option awards were estimated at the dateof grant using a Black-Scholes option-pricing model with the followingassumptions:

 
| ** **                             | ** ** | **For Three Months  Ended  March 31, 2010** | ** ** | **For Three Months  Ended  March 31, 2009** | ** ** |
|----------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|
|                                   |       |                                             |       |                                             |       |
| Weighted average grant date fair value |       | $                                                | 0.39       |                                             | $          | 0.26 |   |
| Weighted average assumptions used:     |       |                                             |       |                                             |       |
| Expected dividend yield                |       | 0.0                                              | %          | 0.0                                              | %          |
| Risk-free interest rate                |       | 2.2                                              | %          | 1.9                                              | %          |
| Expected volatility                    |       | 200.0                                            | %          | 163.0                                            | %          |
| Expected life (in years)               |       | 4.9                                              |       | 4.9                                              |       |
|                                        |            |                                                  |            |                                                  |            |  |  |

 

Expectedvolatility is based on historical volatility and in part on impliedvolatility.  The expected term considersthe contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward. Options granted to non-employees are valued using the fair market valueon each measurement date of the option.

 

7.     Net Earnings (Loss) Per Share

 

Basic net earnings (loss) per share is computed bydividing net earnings (loss) attributable to common stockholders for the periodby the weighted average number of common shares outstanding for theperiod.  Diluted net earnings (loss) pershare is computed by dividing the net earnings (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 earnings(loss) per share calculation for the three month periods ending March 31,2010 and 2009 are 1,382,474 and 4,058,737, respectively as they areantidilutive.

 

8.     Concentrations

 

Ouroperations are concentrated in one area—security software/entityidentification.  Sales to the U.S.Government through direct and indirect channels totaled 86.0% of total revenuesfor the first quarter of 2010 compared to 89.3% of total revenues for the firstquarter of 2009.  During the firstquarter of 2010 approximately 85.5% of total revenues are attributable to twogovernment customers compared to approximately 84.3% of total revenuesattributable to two government customers in the first quarter of 2009.  There were no individual commercial customersin the first quarter of 2010 or 2009 that exceeded 10% of total revenues forthat 

 

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quarter.  Our similar product and service offerings arenot viewed as individual segments, as our management analyzes the business as awhole and expenses are not allocated to each product offering.

 

9.     Commitments and Contingencies

 

We are subject from time to time to various legalproceedings and claims that arise during the ordinary course of ourbusiness.  We do not believe that theoutcome of those “routine” legal matters should have a material adverse affecton our consolidated financial position, operating results or cash flows;however, we can provide no assurances that legal claims that may arise will nothave such a material impact in the future.

 

10.   Dividends Payable

 

Duringthe quarter ended March 31, 2010, we accrued $14,000 in dividends to theholders of our 5% Preferred Stock, $14,000 in dividends to the holders of our Series 25% Preferred Stock and $10,000 in dividends to the holders of our Series 35% Preferred Stock.  As of March 31,2010, we have $36,000 in accrued and unpaid dividends included in currentliabilities.  Delaware law provides thatwe may only pay dividends out of our capital surplus or, if no surplus isavailable, out of our net profits for the fiscal year the dividend is declaredand/or the preceding fiscal year.

 

11.   Recent AccountingPronouncements

 

In October 2009, theFASB issued Topic 605—Revenue Recognition (EITF 08-1,  *Multiple-Deliverable Revenue Arrangements,*(amendments to FASB Topic 605, *RevenueRecognition*)) and Topic 985—Software (EITF 09-3, *Certain Arrangements That Include Software Elements*,(amendments to FASB Topic 985, *Software*)).Topic 605—Revenue Recognition requires entities to allocate revenue in anarrangement using estimated selling prices of the delivered goods and servicesbased on a selling price hierarchy. The amendments eliminate the residualmethod of revenue allocation and require revenue to be allocated using therelative selling price method. Topic 985—Software removes tangible productsfrom the scope of software revenue guidance and provides guidance ondetermining whether software deliverables in an arrangement that includes atangible product are covered by the scope of the software revenue guidance.Topic 605—Revenue Recognition and Topic 985—Software should be applied on aprospective basis for revenue arrangements entered into or materially modifiedin fiscal years beginning on or after June 15, 2010, with early adoptionpermitted. The Company is currently evaluating the impact of Topic 605—RevenueRecognition and Topic 985—Software on its consolidated financial statements.

 

Item2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS

 

Forward LookingStatements

 

This Quarterly Report on Form 10-Q,including, without limitation, the section entitled “Management’s Discussionand Analysis of Financial Condition and Results of Operations,” containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended and Section 21E of the Securities ExchangeAct of 1934, as amended (the “Exchange Act”). Such forward-looking statementsare generally accompanied by words such as “estimate,” “expect,” “believe,” “should,”“would,” “could,” “anticipate,” “may” or other words that convey uncertainty offuture events or outcomes.  Thesestatements relate to future events or to our future financial performance, andinvolve known and unknown risks, uncertainties and other factors that may causeour actual 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 the heading “Factors That May Affect FutureResults of Operations,” and in our 2009 Annual Report on Form 10-K in “Item1 — Description of Business” include, but are not limited to:

 

·      insufficient cash to operate our businessand inability to meet our liquidity requirements;

 

·      loss of revenues due to the failure ofour newer products to achieve market acceptance;

 

·      our need to continue or increase currentrevenue levels in order to sustain profitability;

 

·      concentration of our revenues from U.S.government entities or commercial customers and the possibility of loss of oneof these customers and the unique risks associated with government customers;

 

·      our dependence on sales made throughindirect channels;

 

·      our dependence on equity or debtfinancing provided primarily by our Chief Executive Officer in order to meetour cash flow requirements;

 

·      the effect that payment of accrueddividends on our preferred stock has on our cash resources and the substantialdilution upon the conversion or redemption of our preferred stock and exerciseof outstanding warrants;

 

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·      the impact of conversion of preferredstock or exercise of warrants on the price of our common stock;

 

·      the ability of our preferred stockholdersand lenders to hinder additional financing; and

 

·      the influence that our management andlarger stockholders have over actions taken by the Company.

 

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

 

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Resultsof Operations

 

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

 
| ** **                                             | ** ** | **Three Months Ended**  | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|
| ** **                                             | ** ** | **March 31, 2010** | ** ** | **March 31, 2009** | ** ** |
| Net product revenue                                    |       | 96.7                    | %          | 88.9 | % |
| Net customer support and maintenance revenue           |       | 3.3                     |       | 11.1 |   |
| Total revenue                                          |       | 100.0                   |       | 100.0 |   |
| Cost of product revenue                                |       | 35.8                    |       | 31.7 |   |
| Cost of customer support and maintenance revenue       |       | 0.3                     |       | 0.6 |   |
| Total cost of revenue                                  |       | 36.1                    |       | 32.3 |   |
| Gross profit                                           |       | 63.9                    |       | 67.7 |   |
| Operating expenses:                                    |       |                    |       |   |   |
| Sales and marketing                                    |       | 13.2                    |       | 30.9 |   |
| Research and development                               |       | 19.6                    |       | 42.8 |   |
| General and administrative                             |       | 16.9                    |       | 30.3 |   |
|                                                   |       |                    |       |   |   |
| Operating income (loss)                                |       | 14.1                    |       | (36.3 | ) |
|                                                   |       |                    |       |   |   |
| Interest expense, net                                  |       | (0.8                    | )          | (1.3 | ) |
| Income (loss) before income tax provision              |       | 13.3                    |       | (37.6 | ) |
|                                                   |       |                    |       |   |   |
| Income tax provision                                   |       | —                  |       | — |   |
|                                                   |       |                    |       |   |   |
| Net income (loss)                                      |       | 13.3                    | %          | (37.6 | )% |
| Preferred stock dividends accrued                      |       | (2.4                    | )          | (4.6 | ) |
|                                                   |       |                    |       |   |   |
| Net income (loss) attributable to common  stockholders |       | 10.9                    | %          | (42.2 | )% |

 
| ** **          | ** ** | **Three Months Ended**  | ** ** |
|---------------------|------------|-------------------------|------------|
| ** **          | ** ** | **March 31, 2010** | ** ** | **March 31, 2009** | ** ** |
| Domestic revenues   |       | 99.8                    | %          | 96.9 | % |
| Export revenues to: |       |                    |       |   |   |
| Europe              |       | 0.1                     |       | 2.8 |   |
| Canada              |       | 0.0                     |       | 0.0 |   |
| Asia                |       | 0.0                     |       | 0.1 |   |
| Latin America       |       | 0.1                     |       | 0.2 |   |
|                |       |                    |       |   |   |
| Net revenues        |       | 100.0                   | %          | 100.0 | % |

 

**Net Revenues**.  Net revenuesfor the quarter ended March 31, 2010, were $1.5 million, compared to $0.9million for the same period in 2009. Product revenues increased $0.7 million for the quarter ended March 31, 2010, compared to thesame period in 2009.  Increased productrevenues are due to an increase in sales of our TraceCop product line.  TraceCop revenues were $1.5 million for thequarter ended March 31, 2010, compared to $0.8 million for the samequarter in 2009.  Substantially all ofour revenue for the quarters ended March 31, 2010 and 2009, were derivedfrom TraceCop sales.  Customer supportand maintenance revenue decreased $44 thousand for the quarter ended March 31,2010, compared to the same period in 2009. This decrease was due to the current sales mix with a high concentrationof government sales not requiring a maintenance contract.

 

**Concentration of Revenues**. Revenues from sales to various U.S. government entities totaled $1.3million, or 86.0% of revenues, for the quarter ended March 31, 2010,compared to $0.8 million, or 89.3% of revenues, for the same period in2009.  Although we expect ourconcentration of revenues to vary among customers in future periods dependingupon the timing of certain sales, we anticipate that sales to governmentcustomers will continue to account for a significant portion of our revenues infuture periods.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including, without limitation,potential disruption to appropriation and spending patterns and the government’sreservation of the right to cancel contracts and purchase orders for itsconvenience.  Although we do notanticipate that any of our 

 

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revenues with government customers will berenegotiated, a large number of cancelled or renegotiated government orderscould have a material adverse effect on our financial results.  Currently, we are not aware of any proposedcancellation or renegotiation of any of our existing arrangements withgovernment entities and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

 

**Gross Profit**.  Gross profitwas $1.0 million or 63.9% of net revenues for the quarter ended March 31,2010, compared to $0.6 million or 67.7% of net revenues for the quarter ended March 31,2009.  Gross profit on product revenuesfor the quarter ended March 31, 2010, trended to 62.9% from 64.4% for thequarter ended March 31, 2009, mainly due to a change in product mix.  Gross profit on customer support andmaintenance revenues for the quarter ended March 31, 2010, trended to93.1% from 94.5% for the quarter ended March 31, 2009.  Gross profit as a percentage of net revenues isimpacted by several factors, including shifts in product mix, changes inchannels of distribution, revenue volume, pricing strategies, and fluctuationsin revenues of integrated third-party products.

 

**Sales and Marketing**.  Sales and marketingexpenses decreased to $0.2 million for the quarter ended March 31, 2010,compared to $0.3 million for the quarter ended March 31, 2009, primarilydue to a planned reduction in sales and marketing related expenses.  Sales and marketing expenses may vary in thefuture.  We believe that these costs willincrease through the end of 2010, with increases in revenue.

 

**Research and Development**.  Research anddevelopment expenses decreased to $0.3 million for the quarter ended March 31,2010, compared to $0.4 million for the quarter ended March 31, 2009.  Research and development costs are expensedin the period incurred.  Research anddevelopment expenses decreased in the three months ended March 31, 2010,compared to the same periods in 2009 primarily due to shifts from research anddevelopment expenses to cost of sales in relation to engineeringcontracts.  Research and developmentexpenses may vary in the future; however, we believe that these costs willremain relatively constant through the end of 2010, although expenses may beincreased with increases in revenue.

 

**General and Administrative**.  General andadministrative expenses remained constant at $0.3 million for the quarter endedMarch 31, 2010, compared to $0.3 million for the quarter ended March 31,2009.  It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of 2010, although expenses may be increased with increases inrevenue.

 

**Interest**.  Net interestexpense increased to $13 thousand for the quarter ended March 31, 2010compared to $12 thousand interest expense for the same period in 2009.  The increase in interest expense wasprimarily due to an increase in interest expenses related to borrowings from aloan payable to an officer.  Net interestexpense may vary in the future based on our level of borrowing, which will beaffected by our cash flow, operating income and capital expenditures.

 

Liquidity and Capital Resources

 

Our principal source of liquidity at March 31,2010, is approximately $365 thousand of cash and cash equivalents.  At March 31, 2010, we had a workingcapital deficiency of $0.9 million compared to a $1.7 million deficiency at March 31,2009.

 

Net cash provided by operations for the three monthsended March 31, 2010, was $204 thousand primarily due to net income of $204thousand and the following sources of cash and non-cash items: a $45 thousandincrease in accounts payable and accrued expenses, a $20 thousand increase indeferred revenue, $42 thousand in stock-based compensation, and $18 thousand indepreciation expense.  This was partiallyoffset by the following uses of cash: an $86 thousand increase in accountsreceivable, a $27 thousand increase in inventories, and a $12 thousand increasein prepaid expenses and other assets. Net cash used in operationsfor the three months ended March 31, 2009, was $0.5 million, primarily dueto a net loss of $322 thousand, a $340 thousand decrease in deferred revenue, a$4 thousand decrease in accounts payable and accrued expenses, and a $5thousand increase in prepaid expenses and other assets.  This was partially offset by the followingsources of cash and non-cash items: a $141 thousand decrease in accountsreceivable, $17 thousand in stock-based compensation, $17 thousand in depreciationexpense, and a $4 thousand decrease in inventories. Future fluctuations ininventory balances, accounts receivable and accounts payable will be dependentupon several factors, including, but not limited to, quarterly sales, ourstrategy in building inventory in advance of receiving orders from customers,and the accuracy of our forecasts of product demand and component requirements.

 

Net cash used in investingactivities for the three months ended March 31, 2010, was $24 thousand fornet purchases of property and equipment compared to no cash used in investingactivities in the three months ended March 31, 2009.

 

Net cash used in financing activities for the threemonths ended March 31, 2010, was $334 thousand for payments of accrueddividends on preferred stock.  Thiscompared to cash provided by financing activities in the three months ended March 31,2009 of $150 thousand, primarily consisting of the proceeds from a promissorynote from our Chief Executive Officer, G. Ward Paxton.

 

At March 31, 2010,the Company did not have any material commitments for capital expenditures.

 

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During the three monthsended March 31, 2010, the Company funded its operations through the use ofcash and cash equivalents.

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SiliconValley Bank (“SVB”) to establish a $1.0 million line of credit with SVB (the “2006Credit Line”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to the Amended and Restated Loan andSecurity Agreement (as amended, the “Loan Agreement”) with SVB to replace the2008 Credit Line with a $1.25 million line of credit (the “Current Line ofCredit”).  Our obligations under the LoanAgreement are secured by substantially all of our assets, including all of ourintellectual property.  In addition, G.Ward Paxton, the Company’s Chief Executive Officer, has established a GuarantyAgreement with SVB for all outstanding balances under the Current Line ofCredit.  Borrowings under the CurrentLine of Credit are based on advances (each an “Advance”) against certain of ouraccounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Loan Agreement, or (c) the date on which any “Adjustment”(as defined in the Loan Agreement) is asserted to the Eligible Account.  On June 27, 2010, the Loan Agreementterminates and all outstanding Advances, accrued but unpaid finance charges,outstanding collateral handing fees, and other amounts become due under theLoan Agreement and related documents.  Wehave certain non-financial and financial covenants, including a liquiditycoverage ratio and a rolling EBITDA computation, as defined in the LoanAgreement.  We have no borrowingsoutstanding under the Current Line of Credit as of March 31, 2010, and hadborrowings available of $276,000.

 

Asof March 31, 2010, we had cash and cash equivalents of approximately$365,000, down from approximately $519,000 as of December 31, 2009, and aworking capital deficit totaling $0.9 million. We generated net income of $204,000 in the first quarter of 2010compared to a net loss of $322,000 for the first quarter of 2009.  As of March 31, 2010, in addition tocash and cash equivalents of $365,000, we had $276,000 in funding availableunder our $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have sufficient cash resourcesto finance our operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

We may explore the possible acquisitions ofbusinesses, products and technologies that are complementary to our existingbusiness.  We are continuing to identifyand prioritize additional security technologies, which we may wish to develop,either internally or through the licensing, or acquisition of products fromthird parties.  While we may engage fromtime to time in discussions with respect to potential acquisitions, there canbe no assurances that any such acquisitions will be made or that we will beable to successfully integrate any acquired business.  In order to finance such acquisitions and workingcapital it may be necessary for us to raise additional funds through public orprivate financings.  Any equity or debtfinancings, if available at all, may be on terms, which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders.

 

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Item 4T.                        CONTROLS AND PROCEDURES

 

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

 

Our management, includingour principal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of March 31, 2010, and concluded that the disclosurecontrols and procedures were effective.

 

Our management, with theparticipation of our principal executive officer and principal financialofficer, evaluated our “internal control over financial reporting” (as definedin Rule 13a-15(f) under the Exchange Act) as of March 31, 2010,and concluded that there have not been any changes in our internal control overfinancial reporting that occurred during the quarter ended March 31, 2010,that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

**PART II— OTHER INFORMATION**

 

Item 1.                                LEGAL PROCEEDINGS

 

We are subject from time to time to various legalproceedings and claims that arise during the ordinary course of ourbusiness.  We do not believe that theoutcome of those “routine” legal matters should have a material adverse affecton our consolidated financial position, operating results or cash flows;however, we can provide no assurances that legal claims that may arise will nothave such a material impact in the future.

 

Item 1A.                 RISK FACTORS

 

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

 

Weare providing the following information regarding changes that have occurred topreviously disclosed risk factors from our Annual Report on Form 10-K forthe year ended December 31, 2009. 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-K forthe year ended December 31, 2009. 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 to $365,000 at March 31,2010, compared to $519,000 at December 31, 2009.  We may not have sufficient cash to operateour business and may not be able to maintain certain liquidity requirementsunder our existing debt instruments. Additional debt and equity offerings to fund future operations may notbe available and, if available, may significantly dilute the value of ourcurrently outstanding common stock.***

 

Asof March 31, 2010, we had cash and cash equivalents of approximately$365,000, down from approximately $519,000 as of December 31, 2009, and aworking capital deficit totaling $0.9 million. We generated net income of $204,000 in the first quarter of 2010compared to a net loss of $322,000 for the first quarter of 2009.  As of March 31, 2010, in addition tocash and cash equivalents of $365,000, we had $276,000 in funding availableunder our $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Based on projections ofgrowth in revenue and net income in the coming quarters, and the borrowingsavailable previously mentioned, we believe that we will have sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

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***Wehad a net income of $0.2 million for the quarter ended March 31, 2010, andhave an accumulated deficit of $57.9 million as of March 31, 2010.  To continue profitability, we must continueto generate current or increased revenue levels.***

 

For the quarter ended March 31,2010, we generated net income of $0.2 million and had an accumulated deficit ofapproximately $57.9 million as of March 31, 2010, compared to a net lossof $0.3 million for the quarter ended March 31, 2009 and an accumulateddeficit of approximately $58.1 million at December 31, 2009. ** **We need to sustaincurrent or greater revenue levels from the sales of our products if we are tosustain profitability.  If we are unableto achieve these revenue levels, losses could happen for the near term and possiblylonger, and we may not sustain profitability or generate positive cash flowfrom operations.

 

***A large percentage of our revenues are received from U.S.government entities/resellers and one commercial customer, 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/resellers and onecommercial customer.  If we were to loseone or more of these key relationships, our revenues could decline and ourbusiness and prospects may be materially harmed. We expect that even if we aresuccessful in developing relationships with non-governmental customers, ourrevenues will continue to be concentrated among government entities. For thequarter ended March 31, 2010, sales to U.S. government entities/resellerscollectively accounted for 86.0% of our revenues, compared to 89.3% ofour revenues as of March 31, 2009.  The loss ofany of these key relationships may send a negative message to other U.S.government entities/resellers or non-governmental customers concerning ourproduct offering.  We cannot assure youthat U.S. government entities/resellers will be customers of ours in future periodsor that we will be able to diversify our customer portfolio to adequatelymitigate the risk of loss of any of these customers.

 

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

 

We derived 87.0% ofrevenue in the first quarter of 2010 through indirect channels of mainlygovernment resellers, compared to 43.9% of our revenues in the quarter ended March 31,2009.   We must continue to expand our sales throughthese indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

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

 

On April 30,2010, we had 11,736,150 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have13,685,175 shares of common stock outstanding, approximately a 16.6% increasein the number of shares of our common stock outstanding.

 

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

 

Further, the occurrenceof certain events could entitle holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for acertain number of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amountsto the holders, (ii) paid all outstanding dividends, (iii) a volumeweighted average price of $0.85, which was the ten-day volume weighted averageclosing price of our common stock on April 30, 2010, and (iv) our11,736,150 shares of common stock outstanding on April 30, 2010, uponexercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 3,967,349 shares of our common stock.  This would represent an increase ofapproximately 34.0% in the number of shares of our common stock as of April 30,2010.

 

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

 

The holders of the sharesof our 5% Preferred Stock and warrants we issued in connection with the sale ofour 5% Preferred Stock who are not affiliates 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 April 30, 2010,780,000 shares of our 5% Preferred Stock had converted into 1,240,457 shares ofcommon stock.

 

The holders of the sharesof Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 

 

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Preferred Stock who arenot affiliates may freely convert their shares of preferred stock and exercisetheir warrants and sell the underlying shares of common stock pursuant to Rule 144of the Securities and Exchange Commission. As of April 30, 2010, 605,200 shares of Series 2 PreferredStock had converted into 605,200 shares of common stock.

 

The holders of the sharesof Series 3 5% Preferred Stock and warrants we issued in connection with thesale of our Series 3 Preferred Stock who are not affiliates may freelyconvert their shares of Series 3 Preferred Stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to Rule 144of the Securities and Exchange Commission. As of April 30, 2010, 210,551 shares of Series 3 PreferredStock had converted into 210,551 shares of common stock and 57,340 warrants hadconverted into 31,615 shares of common stock.

 

For the four weeks endedon April 30, 2010, the average daily trading volume of our common stock onThe OTCBB was 3,749 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity could cause a decline in the market price of our commonstock.  Furthermore, these sales, or thepotential for these sales, could encourage short sales, causing additionaldownward pressure on the market price of our common stock.

 

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

 

As of April 30,2010, our executive officers, directors and preferred stockholders beneficiallyown approximately 30% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we may contemplate the possibleissuance of shares of our Common Stock or of securities exercisable orconvertible into shares of our Common Stock in the future to our ChiefExecutive Officer.  Any such issuancewill increase the percentage of stock our Chief Executive Officer and ourmanagement group beneficially holds.

 

Item 6.                                Exhibits

 

The following Exhibitsare filed 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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**SI G N A T U R E S**

 

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

 

 
| ** **              | **INTRUSION  INC.**                                                      |
|-------------------------|--------------------------------------------------------------------------|
|                    |                                                                     |
| Date: May 13, 2010 | /s/ G. Ward Paxton                                                       |
|                    | G. Ward Paxton                                                           |
|                    | Chairman,  President & Chief Executive Officer                  |
|                    | (Principal Executive  Officer)                                           |
|                    |                                                                     |
|                    |                                                                     |
| Date: May 13, 2010 | /s/ Michael L. Paxton                                                    |
|                    | Michael L. Paxton                                                        |
|                    | Vice President, Chief Financial Officer,  Treasurer & Secretary |
|                    | (Principal  Financial & Accounting Officer)                     |

 

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