**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM10-QSB**

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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 March 31, 2007**                                                                                                                                                                                                    |
|                                                                                                                                                                                                                                                  |       |                                                                                               |
| **OR**                                                                                                                                                                                                                                                |
|                                                                                                                                                                                                                                                  |       |                                                                                               |
| **o**                                                                                                                                                                                                                                                 | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                  |       |                                                                                               |
| **For the  transition period from                   to                   ** |
|                                                                                                                                                                                                                                                  |       |                                                                                               |
| **Commission  File Number 0-20191**                                                                                                                                                                                                                   |

 

**INTRUSIONINC.**

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

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

 

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

(Address of principalexecutive offices)

(Zip Code)

**(972)234-6400**

(Issuer’stelephone number, including area code)

**NotApplicable**

Former name, ifchanged since last report)

* * * * * * * * **

Indicate by check mark whether the Registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days:

Yes  x  No  o

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

The number of shares outstanding of the Registrant’sCommon Stock, $0.01 par value, on May 4, 2007 was 9,222,139.

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

 

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**INTRUSIONINC.**

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

 

2

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**PART I – FINANCIAL INFORMATION**

Item 1. FINANCIALSTATEMENTS

**INTRUSIONINC. AND SUBSIDIARIES**

UNAUDITEDCONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)
| ** **                                                                                                 | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                 |       |                     |       |                        |       |
| Current Assets:                                                                                            |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                 |       | $                        | 682        |                        | $          | 933 |   |
| Accounts  receivable, less allowance for doubtful accounts of $76 in 2007 and $90 in  2006                 |       | 809                      |       | 844                         |       |
| Inventories, net                                                                                           |       | 209                      |       | 209                         |       |
| Prepaid expenses                                                                                           |       | 152                      |       | 198                         |       |
| Total current assets                                                                                       |       | 1,852                    |       | 2,184                       |       |
| Property and equipment,  net                                                                               |       | 172                      |       | 162                         |       |
| Other assets                                                                                               |       | 45                       |       | 41                          |       |
| TOTAL ASSETS                                                                                               |       | $                        | 2,069      |                        | $          | 2,387 |   |
|                                                                                                       |       |                     |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                             |       |                     |       |                        |       |
|                                                                                                       |       |                     |       |                        |       |
| Current Liabilities:                                                                                       |       |                     |       |                        |       |
| Accounts payable  and accrued expenses                                                                     |       | $                        | 899        |                        | $          | 1,099 |   |
| Line of credit                                                                                             |       | 125                      |       | 200                         |       |
| Deferred revenue                                                                                           |       | 351                      |       | 367                         |       |
| Total current  liabilities                                                                                 |       | 1,375                    |       | 1,666                       |       |
|                                                                                                       |       |                     |       |                        |       |
| Stockholders’ Equity:                                                                                 |       |                     |       |                        |       |
| Preferred stock,  $0.01 par value: Authorized Shares – 5,000                                          |       |                     |       |                        |       |
| Series 1 shares  issued and outstanding — 260   Liquidation preference of $1,331 as of March 31, 2007 |       | 918                      |       | 918                         |       |
| Series 2 shares  issued and outstanding — 460   Liquidation preference of $1,155 as of March 31, 2007 |       | 724                      |       | 724                         |       |
| Series 3 shares  issued and outstanding — 469   Liquidation preference of $1,026 as of March 31, 2007 |       | 667                      |       | 667                         |       |
| Common stock,  $0.01 par value:                                                                            |       |                     |       |                        |       |
| Authorized  shares — 80,000                                                                           |       |                     |       |                        |       |
| Issued shares —  9,232 in 2007 and 8,306 in 2006                                                      |       |                     |       |                        |       |
| Outstanding  shares — 9,222 in 2007 and 8,296 in 2006                                                 |       | 92                       |       | 83                          |       |
| Common stock  held in treasury, at cost – 10 shares                                                   |       | (362                     | )          | (362                        | )          |
| Additional  paid-in capital                                                                                |       | 54,403                   |       | 53,947                      |       |
| Accumulated  deficit                                                                                       |       | (55,569                  | )          | (55,077                     | )          |
| Accumulated  other comprehensive loss                                                                      |       | (179                     | )          | (179                        | )          |
| Total stockholders’  equity                                                                           |       | 694                      |       | 721                         |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                            |       | $                        | 2,069      |                        | $          | 2,387 |   |

 

See accompanyingnotes.

3

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

(In thousands,except per share amounts)
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **March 31,  2007**         | ** ** | **March 31,  2006** | ** ** |
| Net product  revenue                                                        |       | $                                | 898        |   | $ | 418 |   |
| Net customer  support and maintenance revenue                               |       | 194                              |       | 433 |   |
| Total revenue                                                               |       | 1,092                            |       | 851 |   |
| Cost of product  revenue                                                    |       | 403                              |       | 257 |   |
| Cost of customer  support and maintenance revenue                           |       | 18                               |       | 130 |   |
| Total cost of  revenue                                                      |       | 421                              |       | 387 |   |
|                                                                        |       |                             |       |   |   |
| Gross profit                                                                |       | 671                              |       | 464 |   |
|                                                                        |       |                             |       |   |   |
| Operating  expenses:                                                        |       |                             |       |   |   |
| Sales and marketing                                                         |       | 515                              |       | 817 |   |
| Research and development                                                    |       | 423                              |       | 792 |   |
| General and administrative                                                  |       | 227                              |       | 348 |   |
|                                                                        |       |                             |       |   |   |
| Operating loss                                                              |       | (494                             | )          | (1,493 | ) |
|                                                                        |       |                             |       |   |   |
| Interest income,  net                                                       |       | 2                                |       | 18 |   |
|                                                                        |       |                             |       |   |   |
| Loss before  income tax provision                                           |       | (492                             | )          | (1,475 | ) |
|                                                                        |       |                             |       |   |   |
| Income tax  provision                                                       |       | —                           |       | — |   |
|                                                                        |       |                             |       |   |   |
| Net loss                                                                    |       | $                                | (492       | ) | $ | (1,475 | ) |
|                                                                        |       |                             |       |   |   |
| Preferred stock  dividends accrued                                          |       | (43                              | )          | (45 | ) |
| Net loss  attributable to common stockholders                               |       | $                                | (535       | ) | $ | (1,520 | ) |
|                                                                        |       |                             |       |   |   |
| Net loss per  share attributable to common stockholders (basic and diluted) |       | $                                | (0.06      | ) | $ | (0.22 | ) |
|                                                                        |       |                             |       |   |   |
| Weighted average common  shares outstanding, basic and diluted              |       | 8,471                            |       | 6,981 |   |

 

See accompanyingnotes.

4

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

(In thousands)
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **March 31,  2007**         | ** ** | **March 31,  2006** | ** ** |
| Operating  Activities:                                                       |       |                             |       |   |   |
| Net loss                                                                     |       | $                                | (492       | ) | $ | (1,475 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                |       | 17                               |       | 36 |   |
| Provision for doubtful accounts                                              |       | (14                              | )          | (13 | ) |
| Stock-based compensation                                                     |       | 8                                |       | 198 |   |
| Changes in  operating assets and liabilities:                                |       |                             |       |   |   |
| Accounts receivable                                                          |       | 49                               |       | (123 | ) |
| Inventories                                                                  |       | —                           |       | 25 |   |
| Prepaid expenses and other assets                                            |       | 42                               |       | 6 |   |
| Accounts payable and accrued expenses                                        |       | (216                             | )          | (159 | ) |
| Deferred revenue                                                             |       | (16                              | )          | (174 | ) |
| Net cash used in  operating activities                                       |       | (622                             | )          | (1,679 | ) |
| Investing  Activities:                                                       |       |                             |       |   |   |
| Purchases of property and equipment                                          |       | (27                              | )          | — |   |
| Financing  Activities:                                                       |       |                             |       |   |   |
| Net activity under line of credit                                            |       | (75                              | )          | — |   |
| Proceeds from the exercise of employee stock options                         |       | —                           |       | 1 |   |
| Dividends paid on preferred stock                                            |       | (27                              | )          | (47 | ) |
| Proceeds from the issuance of common stock                                   |       | 500                              |       | — |   |
| Net cash  provided by (used in) financing activities                         |       | 398                              |       | (46 | ) |
|                                                                         |       |                             |       |   |   |
| Net decrease in  cash and cash equivalents                                   |       | (251                             | )          | (1,725 | ) |
| Cash and cash  equivalents at beginning of period                            |       | 933                              |       | 2,844 |   |
| Cash and cash  equivalents at end of period                                  |       | $                                | 682        |   | $ | 1,119 |   |
|                                                                         |       |                             |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                   |       |                             |       |   |   |
|                                                                         |       |                             |       |   |   |
| Preferred stock  dividends accrued but not paid                              |       | $                                | 43         |   | $ | 42 |   |

 

See accompanyingnotes.

5

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**INTRUSIONINC. AND SUBSIDIARIES**

NOTESTO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1.     Description of Business

Wedevelop, market, and support a family of network intrusion prevention,intrusion detection, regulated information compliance, data privacy protectionand entity identification products. Our product families include the ComplianceCommanderTM for regulated information and data privacy protection, IntrusionSpySnareTM for real-time inline blocking of spyware and unwanted peer-to-peer(P2P) applications, Intrusion SecureNet for network intrusion prevention anddetection and TraceCopTM for identity identification. Intrusion’s products helpprotect critical information assets by quickly detecting, protecting, analyzingand reporting attacks or misuse of classified, private and regulatedinformation for government and enterprise networks.

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

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

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

As ofMarch 31, 2007, we had cash and cash equivalents of approximately $0.7million, down from approximately $0.9 million as of December 31, 2006. Weexpect our net operating losses and operating cash outflows to continue throughat least the second quarter of 2007 and possibly throughout the remainder offiscal year 2007. In addition, we are obligated to make payments of accrueddividends on all our outstanding shares of preferred stock that will reduce ouravailable cash resources. Of the $0.7 million in cash and cash equivalents atMarch 31, 2007, $0.5 million was derived from a private investment by our ChiefExecutive and Chief Financial Officers which closed on March 15, 2007. As ofMarch 31, 2007 we had approximately $42,000 in available funding under ourexisting credit lines. If necessary, we expect to fund our operations throughadditional investments of private equity, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhapssignificantly. On March 15, 2007, the Company received a written commitmentfrom our Chief Executive Officer to invest up to an additional $750,000 in theCompany through March 2008, should such funding by required by the Company, onterms and conditions yet to be determined. Any equity or debt financings, ifavailable at all, may be on terms which are not favorable to us and, in thecase of equity financings, may result in dilution to our stockholders. If ouroperations do not generate positive cash flow in the next few months, or if weare not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

2.     Basis of Presentation

The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesfor interim financial information and with the instructions to Form 10-QSB andItem 310 of Regulation S-B. Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States for complete financial statements. The December 31,2006 balance 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 areadequate to make the information presented not misleading. In our opinion, allthe adjustments (consisting of normal recurring adjustments) considerednecessary for fair presentation have been included. The results of operationsfor the three month period ending March 31, 2007 are not necessarily indicativeof the results that may be achieved for the full fiscal year or for any futureperiod. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in the Company’s annual report on Form 10-KSB forthe year ended December 31, 2006.

6

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3.     Inventories (In thousands)
|                          | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                     |       |                     |       |                        |       |
| Inventories  consist of: |       |                     |       |                        |       |
|                     |       |                     |       |                        |       |
| Finished goods           |       | $                        | 186        |                        | $          | 180 |   |
| Work in progress         |       | 8                        |       | 8                           |       |
| Demonstration  systems   |       | 15                       |       | 21                          |       |
| Net inventory            |       | $                        | 209        |                        | $          | 209 |   |

 

4.     Accounting for Stock-Based Compensation

AtMarch 31, 2007, we had three stock-based compensation plans, which aredescribed below. These plans were developed to retain and attract key employeesand directors.

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providedfor the issuance of both non-qualified and incentive stock options to ouremployees, officers, and employee-directors. The 1995 Plan expired by its termson March 21, 2005 and no options were available for future issuance after theexpiration. At March 31, 2007, 67,365 employee options have been exercisedand employee options to purchase a total of 382,748 shares of common stockare outstanding. A total of 2,290,295 options have been granted pursuantto the 1995 Plan, of which, 1,840,182 have been cancelled.

In 1995, we adopted the 1995 Non-Employee Director Stock Option Plan(the “1995 Non-Employee Director Plan”). The 1995 Non-Employee Director Planprovided for the issuance of non-qualified stock options to non-employeedirectors. The 1995 Non-Employee Director Plan was amended in April 2002 toincrease the number of shares available for issuance to 65,000 from40,000 shares. The 1995 Non-Employee Director Plan expired by its terms onMarch 21, 2005 and no options were available for future issuance after theexpiration. No options have been exercised under the 1995 Non-Employee DirectorPlan. Non-employee options to purchase a total of 32,500 shares of commonstock are outstanding at March 31, 2007. A total of 62,500 options havebeen granted to directors pursuant to the 1995 Non-Employee Director Plan, ofwhich, 30,000 have been cancelled.

On March 17, 2005,the Board approved the 2005 Stock Incentive Plan (the “2005 Plan”), which wasapproved by the stockholders on June 14, 2005. The 2005 Plan serves as areplacement for the 1995 Non-Employee Director Plan and the 1995 Option Planwhich expired by their terms on March 21, 2005. The approval of the 2005Plan had no effect on the 1995 Plans or any options granted pursuant to eitherplan. All options will continue with their existing terms and will be subjectto the 1995 Non-Employee Director Plan or the 1995 Plan, as applicable. Further,the Company will not be able to re-issue any option which is cancelled orterminated under the 1995 Non-Employee Director Plan or the 1995 Option Plan. The2005 Plan provides for the issuance of up to 750,000 shares of common stockupon exercise of options granted pursuant to the 2005 Plan. The 2005 Planconsists of three (3) separate equity incentive programs: the DiscretionaryOption Grant Program; the Stock Issuance Program; and the Automatic OptionGrant Program for non-employee Board members. Officers and employees,non-employee Board members and independent contractors are eligible toparticipate in the Discretionary Option Grant and Stock Issuance Programs. Participationin the Automatic Option Grant Program is limited to non-employee members of theBoard. Each non-employee Board member will receive an option grant for 10,000shares of Common Stock upon initial election or appointment to the Board,provided that individual has not previously been employed by the Company in thepreceding six (6) months. In addition, on the date of each annual stockholdersmeeting, each Board member will automatically be granted an option to purchase5,000 shares of Common Stock, provided he or she has served as a non-employeeBoard member for at least six (6) months. At March 31, 2007, no 2005 Planoptions have been exercised and employee and non-employee Board member optionsto purchase a total of 639,834 shares of common stock are outstanding. Atotal of 736,500 options have been granted under the 2005 Plan, of which 96,666have been cancelled and options for 110,166 shares remain available forfuture grant. No shares have been issued pursuant to the Stock IssuanceProgram.

TheCompensation Committee of our Board of Directors determines for all employeeoptions, the term of each option, option exercise price within limits set forthin the plans, number of shares for which each option is granted and the rate atwhich each option is exercisable (generally ratably over one, three or five yearsfrom grant date). However, the exercise price of any incentive stock option maynot be less than the fair market value of the shares on the date granted (orless than 110% of the fair market value in the case of optionees holding morethan 10% of our voting stock of the Company), and the term cannot exceed tenyears (five years for incentive stock options granted to holders of more than10% of our voting stock).

7

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The following tablesummarizes stock-based compensation expense under SFAS No. 123(R) for the threemonths ended March 31, 2007 (in thousands, except per share data) which wasallocated as follows:
|                                                        | ** ** | **For Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **March 31, 2007(1)**                     | ** ** | **March 31, 2006** | ** ** |
|                                                   |       |                                      |       |   |   |
| Cost of revenue                                        |       | $                                         | (1         | ) | $ | 24 |   |
| Research and development                               |       | 8                                         |       | 43 |   |
| Sales and marketing                                    |       | —                                    |       | 69 |   |
| General and administrative                             |       | 1                                         |       | 62 |   |
| Effect on net  loss                                    |       | $                                         | 8          |   | $ | 198 |   |
| Effect on basic and  diluted earnings per common share |       | $                                         | —     |   | $ | (0.03 | ) |

 

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(1) Represents an increase of the estimated forfeiturerate for January 2007 to 20% from 15%. The increase in the forfeiture rate isdue to greater than expected option terminations due to higher employeeturnover than in the past.

ValuationAssumptions

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions:
|                                         | ** ** | **For Three Months Ended** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **March 31, 2007**              | ** ** | **March 31, 2006** | ** ** |
|                                    |       |                                      |       |   |   |
| Weighted average  grant date fair value |       | $                                         | 0.49       |   | $ | 1.29 |   |
| Weighted average  assumptions used:     |       |                                      |       |   |   |
| Expected dividend yield                 |       | 0.0                                       | %          | 0.0 | % |
| Risk-free interest rate                 |       | 4.75                                      | %          | 4.3 | % |
| Expected volatility                     |       | 108.0                                     | %          | 97.4 | % |
| Expected life  (in years)               |       | 5.0                                       |       | 5.0 |   |
|                                         |            |                                           |            |  |  |  |  |

 

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour employee stock options have characteristics significantly different fromthose of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable single measureof the fair value of its employee stock options.

Expectedvolatility is based on historical volatility and in part on implied volatility.The expected term considers the contractual term of the option as well ashistorical exercise and forfeiture behavior. The risk-free interest rate isbased on the rates in effect on the grant date for U.S. Treasury instrumentswith maturities matching the relevant expected term of the award.

8

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Stock IncentivePlan Activity

Stockoption activity under the Company’s various long-term incentive and directorcompensation plans during the three months ended March 31, 2007, were asfollows:
|                                   | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **(in thousands)**     | ** ** | ** **                             | ** ** |
| ** **                        | ** ** | ** **                  | ** ** | ** **                             | ** ** |
| Outstanding at  December 31, 2006 |       | 1,086                       |       | $                                      | 3.23       |   |
| Granted                           |       | 10                          |       | 0.62                                   |       |
| Exercised                         |       | —                      |       | —                                 |       |
| Cancelled                         |       |                        |       |                                   |       |
| Forfeited                         |       | (33                         | )          | 1.42                                   |       |
| Expired                           |       | (8                          | )          | 3.19                                   |       |
|                              |       |                        |       |                                   |       |
| Outstanding at March  31, 2007    |       | 1,055                       |       | $                                      | 3.26       |   |

 

Summarizedinformation about outstanding stock options as of March 31, 2007, that arefully vested and those that are expected to vest in the future as well as stockoptions that are fully vested and currently exercisable, are as follows:
| As of March 31, 2007     | ** ** | **Outstanding Stock  Options (Fully Vested  and Expected to Vest)*** | ** ** | **Options that are  Exercisable** | ** ** |
|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                                                                         | ** ** | ** **                                  | ** ** |
| Number of  outstanding options*              |       | 1,053                                                                                              |       | 597                                         |       |
| Weighted average  remaining contractual life |       | 7.69                                                                                               |       | 6.90                                        |       |
| Weighted average  exercise price per share   |       | $                                                                                                  | 3.27       |                                        | $          | 5.26 |   |
| Intrinsic value                              |       | $                                                                                                  | 88         |                                        | $          | — |   |

 

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* Includes effectsof expected forfeitures

 

As ofMarch 31, 2007, the total unrecognized compensation cost related to non-vestedoptions not yet recognized in the statement of operations totaled approximately$96 thousand (including estimated forfeitures) and the weighted period overwhich these awards are expected to be recognized was 1.49 years.

5.     Net Loss Per Share

Basic net loss per shareis computed by dividing net loss attributable to common stockholders for theperiod by the weighted average number of common shares outstanding for theperiod. Diluted net loss per share is computed by dividing the net lossattributable to common stockholders by the weighted average number of commonshares and common stock equivalents outstanding for the period. Our common stockequivalents include all common stock issuable upon conversion of preferredstock and the exercise of outstanding options and warrants. The aggregatenumber of common stock equivalents excluded from the diluted loss per sharecalculation for the periods ended March 31, 2007 and 2006 are 3,920,674 and3,764,187, respectively. Our common stock equivalents are not included in thediluted loss per share for the three month periods ended March 31, 2007 and2006, as they are antidilutive.

6.     New Accounting Pronouncement

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

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7.     Commitments and Contingencies

We are subject to legalproceedings and claims that arise in the ordinary course of business. We do notbelieve that the outcome of those matters will have a material adverse affecton our consolidated financial position, operating results or cash flows. However,there can be no assurance such legal proceedings will not have a materialimpact**.**

8.               Common Stock

On March 15, 2007,we completed a private placement of 925,926 shares of our common stock forgross proceeds totaling $500,000.

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

This report containsforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning: thedifficulties in forecasting future sales caused by current economic and marketconditions, the effect of military actions on government and corporate spendingon information security products, spending patterns of, and appropriations to,U.S. government departments, the impact of our cost reduction programs and ourrefocused product line, the difficulties and uncertainties in successfullydeveloping and introducing new products, market acceptance of our products, theimpact of sustained losses on our ability to successfully operate and grow ourbusiness, our stock price, the highly competitive market for our products, theeffects of sales and implementation cycles for our new products on ourquarterly results, difficulties in accurately estimating market growth, theconsolidation of the information security industry, the impact of changingeconomic conditions, business conditions in the information security industry,our ability to manage acquisitions effectively, our ability to managediscontinued operations effectively, the impact of market peers and theirproducts as well as risks concerning future technology and others identified inour Annual Report on Form 10-KSB and other Securities and Exchange Commissionfilings. Such forward-looking statements are generally accompanied by wordssuch as “plan,” “estimate,” “expect,” “believe,” “should,” “would,” “could,” “anticipate,”“may” or other words that convey uncertainty of future events or outcomes. Theseforward-looking statements and other statements made elsewhere in this reportare made in reliance on the Private Securities Litigation Reform Act of 1995. Thesection below entitled “Factors That May Affect Future Results ofOperations” sets forth and incorporates by reference certain factors that couldcause actual future results of the Company to differ materially from thesestatements.

Critical Accounting Policies and Estimates

Management’s discussionand analysis of financial condition and results of operations are based uponour unaudited condensed consolidated financial statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States. The preparation of these financial statements requires us tomake estimates and judgments that affect the reported amounts of assets,liabilities, revenues and expenses, and related disclosure of contingent assetsand liabilities. On an on-going basis, we evaluate our estimates, includingthose related to product returns, bad debts, inventories, income taxes,warranty obligations, restructuring, maintenance contracts and contingencies. Webase our estimates on historical experience and on various other assumptionsthat we believe are reasonable under the circumstances, the results of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

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

*RevenueRecognition*

Wegenerally recognize product revenue upon shipment of product. We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience. Revenue from maintenance contracts is deferred and recognized overthe contractual period the services are performed, generally one year. There isa risk that technical issues on new products could result in unexpectedwarranty costs and returns. However, as we migrate to more of a software-basedbusiness model, the warranty costs should continue to decline. To the extentthat they do decline, our warranty reserve from current sales will decrease. Tothe extent that our warranty costs exceed our expectations, we will increaseour warranty reserve to compensate for the additional expense expected to beincurred. We review these estimates periodically and determine the appropriatereserve percentage. However, to date, warranty costs and sales returns have notbeen material. Historically, our estimates for these items have not differedmaterially from actual results. Significant or subjective estimates associatedwith our revenue recognition policy include our estimate of warranty cost andsales returns.

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

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Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that are slowmoving or have been discontinued by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors andrelated gross profits are deferred until the distributors resell themerchandise. However, since we have legally sold the inventory to thedistributor and we no longer have care, custody or control over the inventory,we recognize the trade accounts receivable and reduce inventory related to thesale at the time of shipment to the distributor. Revenue, offset by deferredcost of sales, is included in deferred revenue in the accompanying financialstatements. Since the net balance in deferred revenue represents the salesprice less the cost of the product maintained by the distributors, the deferredcosts of these products are included in our obsolescence and slow-movinganalysis and are written down according to their estimated current value. Thistransaction effectively recognizes expense for the write-down, if any, andincreases the net liability in the deferred revenue account.

Wegenerally recognize service revenue upon delivery of the contracted service. Servicerevenue, primarily including maintenance, training and installation, arerecognized upon delivery of the service and typically are unrelated to productsales. These services are not essential to the functionality of the deliveredproduct. To date, training and installation revenue has not been material.

*Allowancefor Doubtful Accounts and Returns*

Wemaintain allowances for doubtful accounts for estimated losses resulting fromthe inability of our customers to make required payments. Our receivables areuncollaterized and we expect to continue this policy in the future. If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired. Historically, our estimates for sales returns and doubtful accountshave not differed materially from actual results.

*Inventory*

Wewrite down our inventory for estimated obsolescence or unmarketable inventoryequal to the difference between the cost of inventory and the estimated marketvalue based upon assumptions about future demand and market conditions. Ifactual market conditions are less favorable than those projected by management,additional inventory write-downs may be required. Historically, our estimatesfor inventory obsolescence 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** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Net product  revenue                              |       | 82.3                             | %          | 49.2 | % |
| Net customer  support and maintenance revenue     |       | 17.7                             |       | 50.8 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0 |   |
| Cost of product  revenue                          |       | 36.9                             |       | 30.2 |   |
| Cost of customer  support and maintenance revenue |       | 1.7                              |       | 15.3 |   |
| Total cost of  revenue                            |       | 38.6                             |       | 45.5 |   |
| Gross profit                                      |       | 61.4                             |       | 54.5 |   |
| Operating  expenses:                              |       |                             |       |   |   |
| Sales and marketing                               |       | 47.1                             |       | 96.0 |   |
| Research and development                          |       | 38.7                             |       | 93.1 |   |
| General and administrative                        |       | 20.8                             |       | 40.9 |   |
| Operating loss                                    |       | (45.2                            | )          | (175.4 | ) |
|                                              |       |                             |       |   |   |
| Interest income,  net                             |       | 0.1                              |       | 2.1 |   |
| Loss before  income tax provision                 |       | (45.1                            | )          | (173.3 | ) |
|                                              |       |                             |       |   |   |
| Income tax  provision                             |       | —                           |       | — |   |
|                                              |       |                             |       |   |   |
| Net loss                                          |       | (45.1                            | )%         | (173.3 | )% |
| Preferred stock  dividends accrued                |       | (3.9                             | )          | (5.3 | ) |
| Beneficial  conversion feature on preferred stock |       | —                           |       | — |   |
|                                              |       |                             |       |   |   |
| Net loss attributable  to common stockholders     |       | (49.0                            | )%         | (178.6 | )% |

 
|                      | ** ** | **Three Months Ended** | ** ** |
|----------------------|------------|----------------------------------|------------|
| ** **           | ** ** | **March 31, 2007**     | ** ** | **March 31, 2006** | ** ** |
| Domestic  revenues   |       | 88.0                             | %          | 85.8 | % |
| Export revenues  to: |       |                             |       |   |   |
| Europe               |       | 11.1                             |       | 8.1 |   |
| Canada               |       | 0.1                              |       | 3.4 |   |
| Asia                 |       | 0.8                              |       | 2.5 |   |
| Latin America        |       | 0.0                              |       | 0.2 |   |
|                 |       |                             |       |   |   |
| Net revenues         |       | 100.0                            | %          | 100.0 | % |

 

**NetRevenues**.  Net revenuesfor the quarter ended March 31, 2007 were $1.1 million, compared to $0.9million for the same period in 2006. Product revenues increased $0.5 millionfor the quarter ended March 31, 2007 compared to the same period in 2006. Customersupport and maintenance revenue decreased $0.2 million for the quarter endedMarch 31, 2007 compared to the same period in 2006.

**Concentrationof Revenues**.  Revenuesfrom sales to various U.S. government entities totaled $0.8 million, or 70.5 %of revenues, for the quarter ended March 31, 2007 compared to $0.6 million, or66.8% of revenues, for the same period in 2006. Although we expect ourconcentration of revenues to vary among customers in future quarters dependingupon the timing of certain sales, we anticipate that sales to governmentcustomers will continue to account for a significant portion of our revenues infuture quarters. Sales to the government present risks in addition to thoseinvolved in sales to commercial customers which could adversely affect ourrevenues, including potential disruption to appropriation and spending patternsand the government’s reservation of the right to cancel contracts and purchaseorders for its convenience. Although we do not believe that that any of ourrevenues with government customers are subject to renegotiation, a large numberof cancelled or renegotiated government orders could have a material adverse effecton our financial results. Currently, we are not aware of any proposedcancellation or renegotiation of any of our existing arrangement withgovernment entities and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

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**GrossProfit**.  Gross profitwas $0.7 million or 61.4% of net revenues for the quarter ended March 31, 2007,compared to $0.5 million or 54.5% of net revenues for the same period in 2006.Gross profit margins as a percentage of net revenues increased from the sameperiod in the prior year due to a favorable shift in product mix. Gross profiton product revenues for the quarter ended March 31, increased from 38.5% in2006 to 55.1% in 2007 due to an increase in sales volume and favorable productmix. Gross profit on customer support and maintenance revenues for the quarterended March 31, increased from 70.0% in 2006 to 90.7% in 2007.

Gross profit as apercentage of net revenues is impacted by several factors, including shifts inproduct mix, changes in channels of distribution, revenue volume, fluctuationsin third-party assembly costs, pricing strategies, and fluctuations in revenuesof integrated third-party products.

**Salesand Marketing**.  Salesand marketing expenses decreased to $0.5 million or 47.1% of net revenues forthe quarter ended March 31, 2007 compared to $0.8 million or 96.0% of netrevenues in 2006 primarily due to a planned reduction in sales relatedexpenses. Sales and marketing expenses may vary in the future. However, webelieve that these costs will remain relatively constant through the end of2007.

**Researchand Development**. Research and development expenses decreased to $0.4 million or 38.7% onnet revenues for the quarter ended March 31, 2007 from $0.8 million or 93.1% ofnet revenues for the same period in 2006. Research and development costs areexpensed in the period incurred. Research and development expenses decreased inthe three months ended March 31, 2007, compared to the same period in 2006primarily due to shifts from R&D expenses to cost of sales in relation toengineering contract jobs. Research and development expenses may vary in thefuture; however, we believe that these costs will remain relatively constantthrough the end of 2007.

**Generaland Administrative**. General and administrative expenses decreased to $0.2 million for thequarter ended March 31, 2007, compared to $0.3 million for the quarter endedMarch 31, 2006 primarily due to stock-based compensation expense totaling $62thousand recognized in 2006 under SFAS123(R). It is expected that general andadministrative expenses will remain relatively constant throughout theremainder of 2007, as no further cost reductions are anticipated. General andadministrative expense may vary in the future.

**Interest**.  Net interest income decreased to $2 thousandfor the quarter ended March 31, 2007 compared to $18 thousand for the sameperiod in 2006. The decrease in interest income was primarily due to a decreaseof cash and short-term investment balances when compared to the prior year. Netinterest income may vary in the future based on our cash flow and rate ofreturn on investments.

Liquidity and Capital Resources

Our principal source ofliquidity at March 31, 2007 is approximately $0.7 million of cash and cashequivalents. At March 31, 2007 working capital was $0.5 million compared to$1.4 million at March 31, 2006.

Cash used in operationsfor the three months ended March 31, 2007 was $0.6 million, primarily due to anet loss of $0.5 million, a decrease in accounts payable and accrued expensesof $216 thousand, a reduction in deferred revenue of $16 thousand, and areduction in the provision for doubtful accounts of $14 thousand. This cashdecrease was partially offset by stock-based compensation of $8 thousand,depreciation expense of $17 thousand, a decrease in accounts receivable of $49thousand, and a decrease in prepaid expenses and other assets of $42 thousand. Cashused in operations for the three months ended March 31, 2006 was $1.7 million,primarily due to a net loss of $1.5 million, a decrease in accounts payable andaccrued expenses of $0.2 million, a reduction in deferred revenue of $0.2million, an increase in accounts receivable of $0.1 million and a reduction inthe provision for doubtful accounts of $13 thousand. This cash decrease waspartially offset by stock-based compensation of $0.2 million, depreciationexpense of $36 thousand, a decrease in inventories of $25 thousand and adecrease in prepaid expenses and other assets of $6 thousand. Futurefluctuations in inventory balances, accounts receivable and accounts payablewill be dependent upon several factors, including, but not limited to,quarterly sales, our strategy in building inventory in advance of receivingorders from customers, and the accuracy of our forecasts of product demand andcomponent requirements.

There was $27 thousand ofcash used in investing activities in the three months ended March 31, 2007 fornet purchases of property and equipment, compared to no cash used in investingactivities in the three months ended March 31, 2006.

Cash provided infinancing activities in the three months ended March 31, 2007 was $0.4 million,primarily consisting of the proceeds from the issuance of common stock of $0.5million, payment of dividends on preferred stock of $27 thousand and netactivity under the line of credit of $75 thousand, compared to cash used infinancing activities in the three months ended March 31, 2006 was $46 thousand,primarily consisting of the payment of dividends on preferred stock.

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At March 31, 2007, the Company did not have any material commitmentsfor capital expenditures.

During the three months ended March 31, 2007, the Company funded itsoperations through the use of cash and cash equivalents.

OnMarch 15, 2007, we completed a private placement of 925,926 shares of ourCommon Stock for gross proceeds of $500,000.

OnMarch 29, 2006, we established a $1,000,000 line of credit with Silicon ValleyBank. Under the terms of this agreement, we may borrow an amount equal up to80% of eligible accounts receivable balances. In addition, we may obtaininventory advances equal to 35% of finished good inventory, capped at thelesser of the inventory availability, $300,000 or 35% of our total borrowingbase. If our credit line increases to $2,000,000, inventory advances will becapped at the lesser of the inventory availability, $600,000 or 35% of ourborrowing base. Amounts we borrow under the credit line accrue interest at anannual rate of prime plus 1% and are secured by a lien on all of our assets. Accruedinterest on all outstanding amounts is payable monthly in arrears and alloutstanding principal and accrued but unpaid interest on the amounts we borroware due on March 28, 2008. Our ability to receive advances under this creditline will increase if we generate additional receivables and inventory. We havea current balance due under this credit line of $125,000 at March 31, 2007. Also,assuming receivables and inventory equal to the $809,000 of net accountsreceivable and the $186,000 of finished goods inventory we had at March 31,2007, we could borrow up to an additional $42,000 under our credit line atMarch 31, 2007. The line of credit was renewed on March 29, 2007, accruedinterest on all outstanding amounts is payable monthly in arrears and alloutstanding principal and accrued but unpaid interest on the amounts we borroware due on March 28, 2008.

Weexpect our net operating losses and operating cash outflows to continue throughat least the second quarter of 2007 and possibly throughout the remainder offiscal year 2007. The sufficiency of our cash resources may depend to a certainextent on general economic, financial, competitive or other factors beyond ourcontrol. In addition, we are obligated to make payments of accrued dividends onall our outstanding shares of preferred stock that will reduce our availablecash resources. Of the $0.7 million in cash and cash equivalents at March 31,2006, $0.5 million was derived from a private investment by our Chief Executiveand Chief Financial Officers which closed on March 15, 2007. As of March 31,2007 we had approximately $42,000 in available funding under our existingcredit line. Based on projections for increased revenues in 2007, the closingof the $0.5 million private placement on March 15, 2007 and a commitment fromthe Company’s CEO to advance the Company up to $0.75 million in funding shouldit be necessary, 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. It is possible thatwe may need to fund our operations through additional investments of privateequity, which, if we are able to obtain, will have the effect of diluting ourexisting common stockholders, perhaps significantly. 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. If our operations do not generate positive cash flow in the nextfew months, or if we are not able to obtain additional debt or equity financingon terms and conditions acceptable to us, if at all, we may be unable toimplement our business plan, fund our liquidity needs or even continue ouroperations.

We may explore thepossible acquisitions of businesses, products and technologies that arecomplementary to our existing business. We are continuing to identify and prioritizeadditional security technologies, which we may wish to develop, eitherinternally or through the licensing, or acquisition of products from thirdparties. While we may engage from time to time in discussions with respect topotential acquisitions, there can be no assurances that any such acquisitionswill be made or that we will be able to successfully integrate any acquiredbusiness. In order to finance such acquisitions and working capital it may benecessary for us to raise additional funds through public or privatefinancings. Any equity or debt financings, if available at all, may be onterms, which are not favorable to us and, in the case of equity financings, mayresult in dilution to our stockholders.

Off-Balance Sheet Arrangements.

As of March 31, 2007, wedid not have any significant off-balance sheet arrangements, as defined by Item303(c)(2) of Regulation S-B.

Factors That May Affect Future Results of Operations 

Numerous factors mayaffect our business and future results of operations. These factors includecurrent economic and market conditions, the effect of military actions ongovernment and corporate spending on information security products, spendingpatterns of, and appropriations to, U.S. government departments, technologicalchanges, competition and market acceptance, acquisitions, product transitions,timing of orders, manufacturing and suppliers, reliance on outsourcing vendorsand other partners, intellectual property and licenses, third-party products,dependence on government customers, international operations, intellectualproperty issues, liquidity and cash resources and effects of restructuringplans and cost reductions. The discussion below addresses

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some of these and other factors. For a more thoroughdiscussion of these and other factors that may affect our business and futureresults, see the discussion under the caption “Factors That May Affect FutureResults of Operations” in our Annual Report on Form 10-KSB for the year endedDecember 31, 2006.

***Ourcash and cash equivalents decreased from $0.9 million at December 31, 2006to $0.7 million at March 31, 2007. As a result of our expected continuingnet cash outflows, we may not have sufficient cash to operate our business andmay not be able to maintain certain liquidity requirements.***

As ofMarch 31, 2007, we had cash and cash equivalents of approximately $0.7million, down from approximately $0.9 million as of December 31, 2006. Weexpect our net operating losses and operating cash outflows to continue throughat least the second quarter of 2007 and possibly throughout the remainder offiscal year 2007. In addition, we are obligated to make payments of accrueddividends on all our outstanding shares of preferred stock that will reduce ouravailable cash resources. Of the $0.7 million in cash and cash equivalents atMarch 31, 2007, $0.5 million was derived from a private investment by our ChiefExecutive and Chief Financial Officers which closed on March 15, 2007. As ofMarch 31, 2007 we had approximately $42,000 in available funding under ourexisting credit lines. If necessary, we expect to fund our operations throughadditional investments of private equity, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhaps significantly.On March 15, 2007, the Company received a written commitment from our ChiefExecutive Officer to invest up to an additional $750,000 in the Company throughMarch 2008, should such funding by required by the Company, on terms andconditions yet to be determined. Any equity or debt financings, if available atall, 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 next few months, 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.

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

We havetransitioned our sales strategy focus from SecureNet to Compliance Commanderand TraceCop. During this transition, sales of our newer products have notoffset the losses in sales associated with our older products. As a result, ournet revenues declined from $6.0 million in 2005 to $5.2 million in 2006 andonly increased by $0.2 million in the first quarter of 2007. We can provide noassurances that sales of our newer products will ever offset the losses insales of older products or generate sufficient revenues to sustain ourbusiness.

Our new networksecurity products, regulated information compliance systems and entityidentification products have only been in the market place for a limited periodof time and may have longer sales cycles than our previous products. Accordingly,we may not achieve the meaningful revenue growth needed to sustain operations. Ifwe are unable to recognize revenues due to longer sales cycles or otherproblems, our results of operations will be adversely affected, perhapsmaterially.

We have not yetreceived broad market acceptance for our newer products. We cannot assure youthat our present or future products will achieve market acceptance on asustained basis. In order to achieve market acceptance and achieve futurerevenue growth, we must introduce complementary security products, incorporatenew technologies into our existing product lines and design, develop andsuccessfully commercialize higher performance products in a timely manner. Wecannot assure you that we will be able to offer new or complementary productsthat gain market acceptance quickly enough to avoid decreased revenues duringcurrent or future product introductions or transitions.

***Wehad a net loss of $0.5 million and an accumulated deficit of $55.6 million forthe quarter ended March 31, 2007. As a result, we must generatesubstantially greater revenues from sales in order to achieve profitability.***

We incurredsignificant operating losses for the quarter ended March 31, 2007 and haveincurred operating losses in previous quarters. For the year endedDecember 31, 2006, we incurred a net loss of $3.0 million and had anaccumulated deficit of approximately $55.1 million. We need to generate andsustain substantially greater revenues from the sales of our products if we areto achieve profitability. If we are unable to achieve these greater revenues,our losses will continue for the near term and possibly longer, and we maynever achieve or sustain profitability or generate positive cash flow fromoperations.

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

A large percentageof our revenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the quarter ended March 31, 2007,sales to U.S. government entities collectively accounted for 70.5% of our totalnet revenues.  For the years endedDecember 31, 2004, 2005****and 2006,sales to U.S. government entities collectively accounted for 53.6%, 70.7% and73.6% of our total net revenues, respectively. The loss of any of these keyrelationships may send a negative message to other U.S. governmententities or non-governmental customers concerning our product offering.  We cannot assure you that U.S.government entities will be customers of ours in future periods or that we will be able todiversify our customer portfolio to adequately mitigate the risk of loss of anyof these customers.

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

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

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

For the yearsended December 31, 2004, 2005 and 2006, we derived 36.9%, 36.2% and 17.3%of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We derived 18.3% of our revenues in the first quarter of 2007 from suchsales channels.  We must expand our salesthrough these indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of our products.

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

Revenues fromforeign customers for the fiscal years ended December 31, 2004, 2005 and 2006accounted for approximately 19.2%, 10.7% and 9.4%, respectively, of ourrevenues. Foreign revenues in the first quarter 2007 were 12.0% of revenues. Weexpect sales to foreign customers to continue to represent a significant portionof our revenues in the future. Our international operations are subject to manyinherent risks that may adversely affect our business, financial condition andoperating results, including:

·                  political,social and economic instability;

·                  traderestrictions;

·                  increasesin duty rates and other potentially adverse tax consequences;

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

·                  burdensof complying with a variety of foreign laws;

·                  unexpectedchanges in regulatory requirements;

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

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·                  fluctuationsin currency exchange rates; and

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

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

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

On March 25, 2004,we completed a $5,000,000 private placement pursuant to which we issued1,000,000 shares of our 5% Convertible Preferred Stock (the “Series 1 PreferredStock”) and warrants to acquire 556,619 shares of our common stock. The conversionprice for the Series 1 Preferred Stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As of April30, 2007, there were 259,696 shares of the Series 1 Preferred Stockoutstanding, representing approximately 413,003 shares of common stock uponconversion, and warrants to purchase 621,027 shares of common stockoutstanding.

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

On December 2,2005, we completed a $1,230,843 private placement pursuant to which we issued564,607 shares of our Series 3 5% preferred stock  (the “Series 3 Preferred Stock”) and warrantsto acquire 282,306 shares of our common stock. We also issued two affiliates of our placement agent warrants topurchase an aggregate of 27,531 shares of common stock.  The conversion price of the Series 3Preferred Stock is $2.18 per share and the exercise price of the warrants is$2.58 per share.  As of April 30, 2007, therewere 468,735 shares of Series 3 Preferred Stock outstanding, representing468,735 shares of common stock upon conversion, and warrants to purchase309,837 shares of common stock outstanding.

During the fiscalyear ended December 31, 2006, we paid $66,000 in dividends to the holders ofour 5% Preferred Stock, $74,000 in dividends to the holders of our Series 2 5%Preferred Stock and $53,000 in dividends to the holders of our Series 3 5%Preferred Stock.  At March 31, 2007,we have dividends accrued of $32,373 related to our 5% Preferred Stock, $4,884related to our Series 2 5% Preferred Stock and $4,339 related to ourSeries 3 5% Preferred Stock.

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

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

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

On April 30, 2007,we had 9,222,139 shares of common stock outstanding.  Upon conversion of all outstanding shares ofour preferred stock and exercise of the warrants, we would have 12,087,731shares of common stock outstanding, an increase of approximately 31.1% in thenumber of shares of our common stock outstanding.

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Further, theoccurrence of certain events entitles holders of our Series 2 Preferred Stockand Series 3 Preferred Stock to require us to redeem their shares for a certainnumber of shares of our common stock. Assuming (i) we have paid all liquidated damages and other amounts tothe holders, (ii) incurred accrued but unpaid dividends on April 30, 2007 of$23,484, (iii) a volume weighted average price of $0.48, which was the ten-dayvolume weighted average closing price of our common stock on April 30, 2007,and (iv) our 9,222,139 shares of common stock outstanding on April 30, 2007,upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 13,107,243 shares of our common stock.  This would represent an increase ofapproximately 158.0% in the number of shares of our common stock as of April30, 2007.

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

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

The holders of theshares of our 5% Preferred Stock and warrants we issued in connection with thesale of our 5% Preferred Stock may convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock.  As of April 30, 2007, 740,304 shares of our5% Preferred Stock had converted into 1,177,327 shares of common stock.

The holders of theshares of Series 2 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 2 Preferred Stock may convert their shares of preferredstock and exercise their warrants and sell the underlying shares of commonstock.  As of April 30, 2007, 605,200shares of Series 2 Preferred Stock had converted into 605,200 shares of commonstock.

The holders of theshares of Series 3 5% Preferred Stock and warrants we issued in connection withthe sale of our Series 3 Preferred Stock, may convert their shares of Series 3Preferred Stock and exercise their warrants and sell the underlying shares ofcommon stock pursuant to an effective registration statement we filed with theCommission on April 26, 2007.  As ofApril 30, 2007, 95,872 shares of Series 3 Preferred Stock had converted into95,872 shares of common stock.

For the four weeksended on April 27, 2007, the average daily trading volume of our common stockon The OTCBB was 12,618 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.

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

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

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

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

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

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

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

·                  ourability to manage costs and expenses;

·                  ourdependence on key personnel;

·                  ourability to obtain financing on acceptable terms; and

·                  ourability to offer greater value than our competitors.

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

***Our management and larger stockholders exercise significant controlover our company and have the ability approve or take actions that may be adverse to your interests.***

As ofApril 30, 2007, our executive officers, directors and preferredstockholders beneficially own approximately 41.7% of our voting power.  As a result, these stockholders will be ableto exercise significant control over all matters requiring stockholderapproval, including the election of directors and approval of significantcorporate transactions, which could delay or prevent someone from acquiring ormerging with us.  These stockholders mayuse their influence to approve or take actions that may be adverse to yourinterests.  Further, the Companycontemplates the possible issuance of shares of our Common Stock or ofsecurities exercisable or convertible into shares of our Common Stock inconnection with a future investment by our Chief Executive Officer, pursuant tohis written commitment to fund in an amount up to $750,000, should the Companyrequire such funds.  Any such issuancewill increase the percentage of stock our Chief Executive Officer and ourmanagement group beneficially holds.

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

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

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

·                  greaterfinancial, technical and marketing resources;

·                  bettername recognition;

·                  morecomprehensive security solutions;

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·                  betteror more extensive cooperative relationships; and

·                  largercustomer base.

We cannot assureyou that we will be able to compete successfully with our existing or 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 to respond to rapid technological changes in thenetwork security industry, we may lose customers or our products may becomeobsolete.***

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

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

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

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

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

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

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

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

Section 404 of theSarbanes-Oxley Act of 2002 requires our management to report on 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 404 complianceon an ongoing basis. In the event that our chief executive officer, chieffinancial officer or independent registered public accounting firm determine inthe future that our internal controls over financial reporting are noteffective as defined under Section 404, investor perceptions may be adverselyaffected and could cause a decline in the market price of our stock.

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

The sale andimplementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a 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 in the network security industry may limitmarket acceptance of our products.***

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

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

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

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

There are numerouspatents held by many companies relating to the design and manufacture ofnetwork security systems.  Third partiesmay claim that our products infringe on their intellectual property rights.  Any claim, with or without merit, couldconsume our management’s time, result in costly litigation, cause delays insales or implementations of our products or require us to enter into royalty orlicensing agreements. Royalty and licensing agreements, if required andavailable, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

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

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

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

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

·                  variationsin our quarterly operating results;

·                  changesin estimates of our financial performance by securities analysts;

·                  changesin market valuations of our competitors;

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

·                  productor design flaws, product recalls or similar occurrences;

·                  additionsor departures of key personnel;

·                  salesof common stock in the future; and

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

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

We rely upon thecontinued service of a relatively small number of key technical, sales andsenior management personnel.  Our futuresuccess depends on retaining our key employees and our continuing ability toattract, train and retain other highly qualified technical, sales and managerialpersonnel.  We do not have employmentagreements with our key technical, sales and senior management personnel.  As a result, our employees could resign withlittle or no prior notice.  We may not beable to attract, assimilate or retain other highly qualified technical, salesand managerial personnel in the future. The loss of any of our key technical, sales and senior managementpersonnel or our inability to attract, train and retain additional qualifiedpersonnel could seriously harm our business.

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

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

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

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

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

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

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

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

·                  reducingor delaying government, military or corporate spending on network securityproducts;

·                  increasingthe cost and difficulty in obtaining materials or shipping products; and

·                  affectingour ability to conduct business internationally.

Should these events occur, our business, operating results andfinancial condition could be materially and adversely affected.

Item 3.                                CONTROLSAND PROCEDURES

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

Our management,including our principal executive officer and principal financial officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures as of March 31, 2007 and concluded that thedisclosure controls and procedures were effective.

There were nochanges in our internal control over financial reporting that occurred duringthe quarter ended March 31, 2007 that have materially affected, or arereasonable likely to materially affect, our internal control over financialreporting.

At the end of2007, Section 404 of the Sarbanes-Oxley Act will require our management toprovide an assessment of the effectiveness of our internal control overfinancial reporting, and at the end of 2008, our independent registered publicaccountants will be required to audit management’s assessment. We are in theprocess of performing the system and process documentation, evaluation andtesting required for management to make this assessment and for its independentregistered public accountants to provide their attestation report. We have notcompleted this process or its assessment, and this process will requiresignificant amounts of management time and resources. In the course ofevaluation and testing, management may identify deficiencies that will need tobe addressed and remediated.

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**PART II – OTHER INFORMATION**

Item 1.                                LEGALPROCEEDINGS

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

Item 6.                                EXHIBITS

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

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                     | ** ** | **INTRUSION INC.**                                                   |
|---------------------|------------|----------------------------------------------------------------------|
|                |       |                                                                 |
| Date: May 15,  2007 |       | /s/ G. Ward Paxton                                                   |   |
|                |       | G. Ward Paxton                                                       |
|                |       | Chairman, President  & Chief Executive Officer                   |
|                |       | (Principal Executive  Officer)                                       |
|                |       |                                                                 |
|                |       |                                                                 |
| Date: May 15,  2007 |       | /s/ Michael L. Paxton                                                |   |
|                |       | Michael L. Paxton                                                    |
|                |       | Vice President, Chief  Financial Officer,  Treasurer & Secretary |
|                |       | (Principal Financial  & Accounting Officer)                      |

 

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