Table of Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 

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

 

**For the quarterly period ended September 30, 2010**

 

**OR**

 

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

 

**For thetransition period from                 to                       **

 

**Commission File Number 0-20191**

 

**INTRUSION INC.**

(Exactname of registrant as specified in its charter)

 

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

 

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

(Addressof principal executive offices)

(ZipCode)

 

**(972) 234-6400**

(Registrant’stelephone number, including area code)

 

**Not Applicable**

(Formername, former address and former fiscal year, if changed since last report)

 

** * * * * * * * *

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files).  Yes o No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reporting company. Seethe definitions of “large accelerated filer,” “accelerated filer” and “smallerreporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

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

 

The number of sharesoutstanding of the Registrant’s Common Stock, $0.01 par value, on October 29,2010 was 11,776,150.

 

 

 

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**INTRUSION INC.**

 

INDEX

 
| **PART I —  FINANCIAL INFORMATION**                                                                                    |       |
|----------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                                                                                             |       |
| Item 1.  Financial Statements                                                                                               |       |
|                                                                                                                             |       |
| Unaudited  Condensed Consolidated Balance Sheets as of September 30, 2010 and  December 31, 2009                       |       |
|                                                                                                                             |       |
| Unaudited Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2010 and 2009 | ** ** |
|                                                                                                                             |       |
| Unaudited Condensed  Consolidated Statements of Cash Flows for the three and nine months ended  September 30, 2010 and 2009 |       |
|                                                                                                                             |       |
| Notes  to Unaudited Condensed Consolidated Financial Statements                                                                  |       |
|                                                                                                                             |       |
| Item  2.  Management’s Discussion and  Analysis of Financial Condition and Results of Operations                       |       |
|                                                                                                                             |       |
| Item 4.  Controls and Procedures                                                                                            |       |
|                                                                                                                             |       |
| **PART II — OTHER  INFORMATION**                                                                                       |       |
|                                                                                                                             |       |
| Item  1.  Legal Proceedings                                                                                                 |       |
|                                                                                                                             |       |
| Item  1A.  Risk Factors                                                                                                     |       |
|                                                                                                                             |       |
| Item  6.  Exhibits                                                                                                          |       |
|                                                                                                                             |       |
| Signature  Page                                                                                                                  |       |

 

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**PART I — FINANCIAL INFORMATION**

 

Item 1. FINANCIAL STATEMENTS

 

**INTRUSION INC. AND SUBSIDIARIES**

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(Inthousands, except par value amounts)

 
| ** **                                                                                                             | ** ** | **September ****30,********2010** | ** ** | **December**** 31,  2009** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                             |       |                                   |       |                            |       |
| Current Assets:                                                                                                        |       |                                   |       |                            |       |
| Cash and cash equivalents                                                                                              |       | $                                      | 298        |                            | $          | 519 |   |
| Accounts receivable                                                                                                    |       | 466                                    |       | 351                             |       |
| Inventories, net                                                                                                       |       | 29                                     |       | 7                               |       |
| Prepaid expenses                                                                                                       |       | 32                                     |       | 68                              |       |
| Total current assets                                                                                                   |       | 825                                    |       | 945                             |       |
| Property and equipment, net                                                                                            |       | 135                                    |       | 146                             |       |
| Other assets                                                                                                           |       | 39                                     |       | 39                              |       |
| TOTAL ASSETS                                                                                                           |       | $                                      | 999        |                            | $          | 1,130 |   |
|                                                                                                                   |       |                                   |       |                            |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                        |       |                                   |       |                            |       |
|                                                                                                                   |       |                                   |       |                            |       |
| Current Liabilities:                                                                                                   |       |                                   |       |                            |       |
| Accounts payable and accrued expenses                                                                                  |       | $                                      | 639        |                            | $          | 674 |   |
| Dividends payable                                                                                                      |       | 35                                     |       | 360                             |       |
| Deferred revenue                                                                                                       |       | 107                                    |       | 93                              |       |
| Loan payable to officer                                                                                                |       | 670                                    |       | —                          |       |
|                                                                                                                   |       |                                   |       |                            |       |
| Total current liabilities                                                                                              |       | 1,451                                  |       | 1,127                           |       |
|                                                                                                                   |       |                                   |       |                            |       |
| Loan payable to officer                                                                                                |       | —                                 |       | 970                             |       |
|                                                                                                                   |       |                                   |       |                            |       |
| Commitments and contingencies                                                                                          |       |                                   |       |                            |       |
| Stockholders’ deficit:                                                                                            |       |                                   |       |                            |       |
| Preferred stock, $0.01 par value: Authorized  shares — 5,000                                                      |       |                                   |       |                            |       |
| Series 1 shares issued and outstanding — 220  Liquidation preference of $1,128 as of September 30, 2010 |       | 778                                    |       | 778                             |       |
| Series 2 shares issued and outstanding — 460  Liquidation preference of $1,155 as of September 30, 2010 |       | 724                                    |       | 724                             |       |
| Series 3 shares issued and outstanding — 354  Liquidation preference of $775 as of September 30, 2010   |       | 504                                    |       | 504                             |       |
| Common stock, $0.01 par value:                                                                                         |       |                                   |       |                            |       |
| Authorized shares — 80,000                                                                                        |       |                                   |       |                            |       |
| Issued shares — 11,786 in 2010 and 11,715 in 2009  Outstanding shares — 11,776 in 2010 and 11,705 in 2009    |       | 118                                    |       | 117                             |       |
| Common stock held in treasury, at cost — 10 shares                                                                |       | (362                                   | )          | (362                            | )          |
| Additional paid-in capital                                                                                             |       | 55,578                                 |       | 55,545                          |       |
| Accumulated deficit                                                                                                    |       | (57,566                                | )          | (58,094                         | )          |
| Accumulated other comprehensive loss                                                                                   |       | (226                                   | )          | (179                            | )          |
| Total stockholders’ deficit                                                                                       |       | (452                                   | )          | (967                            | )          |
| TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT                                                                       |       | $                                      | 999        |                            | $          | 1,130 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**UNAUDITED CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(Inthousands, except per share amounts)

 
| ** **                                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                        | ** ** | **September 30,  2010**     | ** ** | **September 30,  2009**    | ** ** | **September 30,  2010** | ** ** | **September 30,  2009** | ** ** |
| Net product revenue                                               |       | $                                | 1,522      |                            | $          | 1,194 |   | $ | 4,492 |   | $ | 3,171 |   |
| Net customer support and maintenance revenue                      |       | 55                               |       | 59                              |       | 158 |   | 230 |   |
| Total revenue                                                     |       | 1,577                            |       | 1,253                           |       | 4,650 |   | 3,401 |   |
| Cost of product revenue                                           |       | 589                              |       | 432                             |       | 1,681 |   | 1,133 |   |
| Cost of customer support and maintenance revenue                  |       | 5                                |       | 3                               |       | 15 |   | 12 |   |
| Total cost of revenue                                             |       | 594                              |       | 435                             |       | 1,696 |   | 1,145 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                                      |       | 983                              |       | 818                             |       | 2,954 |   | 2,256 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Operating expenses:                                               |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                                               |       | 179                              |       | 198                             |       | 639 |   | 733 |   |
| Research and development                                          |       | 379                              |       | 288                             |       | 1,024 |   | 904 |   |
| General and administrative                                        |       | 262                              |       | 235                             |       | 778 |   | 768 |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Operating income (loss)                                           |       | 163                              |       | 97                              |       | 513 |   | (149 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Other income                                                      |       | 47                               |       | —                          |       | 47 |   | — |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Interest expense, net                                             |       | (7                               | )          | (18                             | )          | (32 | ) | (44 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Income (loss) before income tax provision                         |       | 203                              |       | 79                              |       | 528 |   | (193 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Income tax provision                                              |       | —                           |       | —                          |       | — |   | — |   |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                                                 |       | $                                | 203        |                            | $          | 79 |   | $ | 528 |   | $ | (193 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Preferred stock dividends accrued                                 |       | (38                              | )          | (38                             | )          | (113 | ) | (116 | ) |
| Net income (loss) attributable to common  stockholders            |       | $                                | 165        |                            | $          | 41 |   | $ | 415 |   | $ | (309 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Net income (loss) per share attributable to common  stockholders: |       |                             |       |                            |       |   |   |   |   |
| Basic                                                             |       | $                                | 0.01       |                            | $          | 0.00 |   | $ | 0.04 |   | $ | (0.03 | ) |
| Diluted                                                           |       | $                                | 0.01       |                            | $          | 0.00 |   | $ | 0.03 |   | $ | (0.03 | ) |
|                                                              |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares outstanding:                       |       |                             |       |                            |       |   |   |   |   |
| Basic                                                             |       | 11,744                           |       | 11,704                          |       | 11,728 |   | 11,669 |   |
| Diluted                                                           |       | 14,126                           |       | 13,529                          |       | 13,898 |   | 11,669 |   |

 

Seeaccompanying notes.

 

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

(In thousands)

 
| ** **                                                                                          | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                          | ** ** | **September 30,  2010**    | ** ** | **September 30,  2009** | ** ** |
| Operating Activities:                                                                               |       |                            |       |   |   |
| Net income (loss)                                                                                   |       | $                               | 528        |   | $ | (193 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                                       |       | 56                              |       | 57 |   |
| Stock-based compensation                                                                            |       | 130                             |       | 71 |   |
| Extinguishment of France subsidiary cumulative  translation adjustment                              |       | (47                             | )          | — |   |
| Changes in operating assets and liabilities:                                                        |       |                            |       |   |   |
| Accounts receivable                                                                                 |       | (115                            | )          | 58 |   |
| Inventories                                                                                         |       | (22                             | )          | 3 |   |
| Prepaid expenses and other assets                                                                   |       | 36                              |       | (13 | ) |
| Accounts payable and accrued expenses                                                               |       | (47                             | )          | 81 |   |
| Deferred revenue                                                                                    |       | 15                              |       | (990 | ) |
| Net cash provided by (used in) operating  activities                                                |       | 534                             |       | (926 | ) |
| Investing Activities:                                                                               |       |                            |       |   |   |
| Purchases of property and equipment                                                                 |       | (46                             | )          | (16 | ) |
| Financing Activities:                                                                               |       |                            |       |   |   |
| Borrowings on loan from officer                                                                     |       | 200                             |       | 490 |   |
| Payments on loan from officer                                                                       |       | (500                            | )          | — |   |
| Dividends paid on preferred stock                                                                   |       | (410                            | )          | — |   |
| Proceeds from stock options exercised                                                               |       | 1                               |       | 1 |   |
| Net cash provided by (used in) financing  activities                                                |       | (709                            | )          | 491 |   |
|                                                                                                |       |                            |       |   |   |
| Net decrease in cash and cash equivalents                                                           |       | (221                            | )          | (451 | ) |
| Cash and cash equivalents at beginning of period                                                    |       | 519                             |       | 554 |   |
| Cash and cash equivalents at end of period                                                          |       | $                               | 298        |   | $ | 103 |   |
|                                                                                                |       |                            |       |   |   |
| Cash paid during the year for interest                                                              |       | $                               | 63         |   | $ | — |   |
|                                                                                                |       |                            |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH FINANCING  ACTIVITIES:                                          |       |                            |       |   |   |
|                                                                                                |       |                            |       |   |   |
| Preferred stock dividends accrued                                                                   |       | $                               | 113        |   | $ | 116 |   |
| Series 1 preferred stock converted to common  stock                                            |       | $                               | —     |   | $ | 140 |   |

 

Seeaccompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.     Description of Business

 

Wedevelop, market and support a family of entity identification, high speed datamining, regulated information compliance, data privacy protection and networkintrusion prevention/detection products. Our product families include:

 

·             TraceCopTM for identity discovery and disclosure,

·             SavantTM for network data mining,

·             Compliance CommanderTM for regulated information and dataprivacy protection, and

·             SecureNetTM for network intrusion prevention anddetection.

 

Wemarket and distribute our products through a direct sales force to:

 

·             end-users,

·             value-added resellers,

·             system integrators,

·             managed service providers, and

·             distributors.

 

Ourend-user customers include:

 

·             U.S. federal government entities,

·             foreign government entities,

·             local government entities,

·             banks,

·             credit unions,

·             other financial institutions,

·             hospitals and other healthcare providers, and

·             other customers.

 

Essentially,our end-users can be defined as ‘any end-user requiring network securitysolutions for protecting their mission critical data’.

 

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

 

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

 

Asof September 30, 2010, we had cash and cash equivalents of approximately$298,000, down from approximately $519,000 as of December 31, 2009, and aworking capital deficit totaling $0.6 million. We generated net income of $528,000 in the first nine months of 2010compared to a net loss of $193,000 for the first nine months of 2009.  As of September 30, 2010, in addition tocash and cash equivalents of $298,000, we had $30,000 in funding availableunder our $0.7 million note with G. Ward Paxton, the Company’s Chairman,President and Chief Executive Officer, and $1.5 million funding available froma written commitment to invest up to $1.5 million from G. Ward Paxton.  Based on projections of growth in revenue andnet income in the coming quarters, funding available under our $0.625 millionline of credit at Silicon Valley Bank (“SVB”) and the borrowings available previously mentioned, we believe that wewill have sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  We expect to fund our operations throughCompany profits, borrowings from the Company’s CEO, and possibly additionalinvestments of private equity and debt, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in 

 

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theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

2.     Basis of Presentation

 

The accompanying unauditedcondensed consolidated financial statements have been prepared in accordancewith accounting principles generally accepted in the United States for interimfinancial information and with the instructions to Form 10-Q and Item10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by accountingprinciples generally accepted in the United States for complete financial statements.  The December 31, 2009 balance sheet wasderived from audited financial statements, but does not include all thedisclosures required by accounting principles generally accepted in the UnitedStates.  However, we believe that the disclosuresare adequate to make the information presented not misleading.  In our opinion, all the adjustments(consisting of normal recurring adjustments) considered necessary for fairpresentation have been included.  Theresults of operations for the three and nine month periods ended September 30,2010 are not necessarily indicative of the results that may be achieved for thefull fiscal year or for any future period. The unaudited condensed consolidated financial statements includedherein should be read in conjunction with the consolidated financial statementsand notes thereto included in our annual report on Form 10-K for the yearended December 31, 2009, filed with the U.S. Securities and ExchangeCommission (the “SEC”) on March 29, 2010.

 

The Company calculates the fair value of itsassets and liabilities which qualify as financial instruments and includes thisadditional information in the notes to consolidated financial statements whenthe fair value is different than the carrying value of these financial instruments.The estimated fair value of accounts receivable, accounts payable and accruedexpenses, and dividends payable approximate their carrying amounts due to therelatively short maturity of these instruments. The carrying value of loanspayable to officer also approximates fair value since these instruments bearapproximate market rates of interest. None of these instruments are held fortrading purposes.

 

3.     Inventories (In thousands)

 
| ** **                     | ** ** | **September 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                           |       |                         |       |                        |       |
| Inventories consist of:        |       |                         |       |                        |       |
|                           |       |                         |       |                        |       |
| Finished goods                 |       | $                            | 29         |                        | $          | 5 |   |
| Demonstration systems          |       | —                       |       | 2                           |       |
| Reserve for obsolete inventory |       | —                       |       | —                      |       |
| Net inventory                  |       | $                            | 29         |                        | $          | 7 |   |

 

4.     Loan Payable to Officer

 

OnJanuary 30, 2008, and extended on October 24, 2008, March 19,2009, and February 4, 2010, the Company entered into an unsecuredrevolving promissory note to borrow up to $700,000 from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Under the terms of the note, the Company mayborrow, repay and reborrow on the loan as needed up to an outstanding principalbalance due of $700,000 at any given time.

 

OnMarch 20, 2008, and extended on November 7, 2008, and February 4,2010, we received a written commitment from our Chief Executive Officer toinvest up to an additional $1,500,000 in the Company until March 2011,should such funding be required by the Company, on terms and conditionsidentical to those described above on the $700,000 note.

 

Amountsborrowed from this officer accrue interest at a floating rate per annum equalto SVB’s prime rate plus 1% (5% at September 30, 2010).  All outstanding borrowings and accrued butunpaid interest is due on March 31, 2011. As of September 30, 2010, the borrowings outstanding totaled$670,000.  The Company incurred interestexpense of $7,000 in the third quarter of 2010 on the borrowings compared to$11,000 in the third quarter of 2009. The Company incurred interest expense of $31,000 in the nine monthsended September 30, 2010 on the borrowings compared to $26,000 in the ninemonths ended September 30, 2009.

 

5.     Line of Credit

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SVB toestablish a $1.0 million line of credit with SVB (the “2006 Credit Line”).  On June 30, 2008, we entered into anAmended and Restated Loan and Security Agreement with SVB to, among otherthings, replace the 2006 Credit Line with a $2.5 million line of credit (the “2008Credit Line”).  On June 28, 2009, weentered into the First Amendment to the Amended and Restated Loan and SecurityAgreement with SVB to replace the 2008 Credit Line with a $1.25 million line ofcredit (the “2009 Credit Line”).  On June 27,2010, we entered into the Second Amendment to the Amended and Restated Loan andSecurity Agreement (as amended, the “Loan Agreement”) with SVB to replace the2009 Credit Line 

 

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witha $0.625 million line of credit (the “Current Line of Credit”).  Our obligations under the Loan Agreement aresecured by substantially all of our assets, including all of our intellectualproperty.  In addition, G. Ward Paxton,the Company’s Chief Executive Officer, has established a Guaranty Agreement withSVB for all outstanding balances under the Current Line of Credit.  Borrowings under the Current Line of Creditare based on advances (each an “Advance”) against certain of our accountsreceivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate plus 2.0% or 7%.  Finance charges are payable at the same timeits related Advance is due.  Each Advanceis also subject to a monthly collateral handling fee of 0.5% of all outstandingAdvances, depending on certain qualifying financial factors specified in theLoan Agreement.  The collateral handlingfee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliestof (a) the date that the Eligible Account related to the Advance is paid, (b) thedate the Eligible Account is no longer eligible under the Loan Agreement, or (c) thedate on which any “Adjustment” (as defined in the Loan Agreement) is assertedto the Eligible Account.  On June 26,2011, the Loan Agreement terminates and all outstanding Advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofSeptember 30, 2010.

 

6.     Accounting for Stock-Based Compensation

 

Duringthe three month period ended September 30, 2010 and 2009, the Companygranted no stock options to employees and directors in each period.  The Company recognized $47,000 and $22,000,respectively, stock-based compensation expense for the three month period endedSeptember 30, 2010 and 2009.  Duringthe nine month period ended September 30, 2010 and 2009, the Companygranted 495,000 and 491,000, respectively, stock options to employees anddirectors.  The Company recognized$130,000 and $71,000, respectively, stock-based compensation expense for thenine month period ended September 30, 2010 and 2009.

 

Duringthe three month period ended September 30, 2010 and 2009, 4,000 and 0,respectively, options were exercised under the 2005 Plan.  During the nine month period ended September 30,2010 and 2009, 4,000 and 3,001, respectively, options were exercised under the2005 Plan.

 

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  September 30, 2010** | ** ** | **For Three Months  Ended  September 30, 2009** | ** ** | **For Nine  Months Ended  September 30, 2010** | ** ** | **For Nine  Months Ended  September 30, 2009** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
|                                   |       |                                                                |       |                                                                |       |                                                               |       |                                                               |       |
| Weighted average grant date fair value |       | —                                                              |       | —                                                              |       | $                                                                  | 0.40       |                                                               | $          | 0.26 |   |
| Weighted average assumptions used:     |       |                                                                |       |                                                                |       |                                                               |       |                                                               |       |
| Expected dividend yield                |       | —                                                              |       | —                                                              |       | 0.0                                                                | %          | 0.0                                                                | %          |
| Risk-free interest rate                |       | —                                                              |       | —                                                              |       | 2.2                                                                | %          | 1.9                                                                | %          |
| Expected volatility                    |       | —                                                              |       | —                                                              |       | 199.9                                                              | %          | 163.5                                                              | %          |
| Expected life (in years)               |       | —                                                              |       | —                                                              |       | 4.89                                                               |       | 4.85                                                               |       |
|                                        |            |                                                                     |            |                                                                     |            |                                                                    |            |                                                                    |            |  |  |

 

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

 

7.     Net Earnings (Loss) Per Share

 

Basicnet earnings (loss) per share is computed by dividing net earnings (loss)attributable to common stockholders for the period by the weighted averagenumber of common shares outstanding for the period.  Diluted net earnings (loss) per share iscomputed by dividing the net earnings (loss) attributable to commonstockholders by the weighted average number of common shares and dilutivecommon stock equivalents outstanding for the period.  Our common stock equivalents include allcommon stock issuable upon conversion of preferred stock and the exercise ofoutstanding options and warrants.  Theaggregate number of common stock equivalents excluded from the diluted earningsper share calculation for the three month periods ended September 30, 2010and 2009 are 1,043,284 and 1,069,444, respectively, as they are antidilutive.In addition, for the nine month periods ended September 30, 2010 and 2009,1,161,547 and 3,993,130, respectively, common stock equivalents are notincluded in the diluted loss per share as they are antidilutive.

 

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8.     Preferred Stock Warrants

 

Duringthe quarter ended September 30, 2010, warrants to purchase 57,340 sharesof our common stock were exercised and converted into 36,298 net shares of ourcommon stock.  During the nine monthperiod ended September 30, 2010, warrants to purchase 114,680 shares ofour common stock were exercised and converted into 67,913 net shares of ourcommon stock.

 

9.     Concentrations

 

Ouroperations are concentrated in one area—security software/entityidentification.  Sales to the U.S.Government through direct and indirect channels totaled 31.5% of total revenuesfor the third quarter of 2010 compared to 66.3% of total revenues for the thirdquarter of 2009.  During the thirdquarter of 2010 approximately 31.5% of total revenues are attributable to twogovernment customers compared to approximately 66.2% of total revenuesattributable to three government customers in the third quarter of 2009.  Also, during the third quarter of 2010approximately 65.1% of total revenues are attributable to one individualcommercial customer compared to approximately 28.8% of total revenuesattributable to one individual commercial customer in the third quarter of2009.  Our similar product and serviceofferings are not viewed as individual segments, as our management analyzes thebusiness as a whole and expenses are not allocated to each product offering.

 

10.  Commitments and Contingencies

 

We are subject from time totime to various legal proceedings and claims that arise during the ordinarycourse of our business.  We do notbelieve that the outcome of those “routine” legal matters should have amaterial adverse affect on our consolidated financial position, operatingresults or cash flows; however, we can provide no assurances that legal claimsthat may arise will not have such a material impact in the future.

 

11.  Dividends Payable

 

Duringthe quarter ended September 30, 2010, we accrued $14,000 in dividends tothe holders of our 5% Preferred Stock, $14,000 in dividends to the holders ofour Series 2 5% Preferred Stock and $10,000 in dividends to the holders ofour Series 3 5% Preferred Stock.  Asof September 30, 2010, we have $35,000 in accrued and unpaid dividendsincluded in current liabilities. Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.

 

12.  Recent Accounting Pronouncements

 

InOctober 2009, the FASB issued Topic 605—Revenue Recognition (EITF 08-1,  *Multiple-DeliverableRevenue Arrangements,* (amendments to FASB Topic 605, *Revenue Recognition*)) and Topic985—Software (EITF 09-3, *CertainArrangements That Include Software Elements*, (amendments to FASBTopic 985, *Software*)). Topic605—Revenue Recognition requires entities to allocate revenue in an arrangementusing estimated selling prices of the delivered goods and services based on aselling price hierarchy. The amendments eliminate the residual method ofrevenue allocation and require revenue to be allocated using the relativeselling price method. Topic 985—Software removes tangible products from thescope of software revenue guidance and provides guidance on determining whethersoftware deliverables in an arrangement that includes a tangible product arecovered by the scope of the software revenue guidance. Topic 605—RevenueRecognition and Topic 985—Software should be applied on a prospective basis forrevenue arrangements entered into or materially modified in fiscal yearsbeginning on or after June 15, 2010, with early adoption permitted. TheCompany is currently evaluating the impact of Topic 605—Revenue Recognition andTopic 985—Software on its consolidated financial statements.

 

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

 

ForwardLooking Statements

 

ThisQuarterly Report on Form 10-Q, including, without limitation, the sectionentitled “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” contains forward-looking statements within the meaningof Section 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Suchforward-looking statements are generally accompanied by words such as “estimate,”“expect,” “believe,” “should,” “would,” “could,” “anticipate,” “may” or otherwords that convey uncertainty of future events or outcomes.  These statements relate to future events orto our future financial performance, and involve known and unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance, or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by these forward-looking statements. Factors that may cause actualresults to differ materially from current expectations, which we describe inmore detail elsewhere in this Quarterly Report on Form 10-Q under theheading “Factors That May Affect Future Results of Operations,” and in our2009 Annual Report on Form 10-K in “Item 1 — Description of Business” include,but are not limited to:

 

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

 

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

 

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

 

·                  concentration of our revenues from U.S.government entities or commercial customers and the possible loss of one ofthese customers and the unique risks associated with government customers;

 

·                  our dependence on sales made through indirectchannels;

 

·                  our dependence on equity or debt financingprovided primarily by our Chief Executive Officer in order to meet our cashflow requirements;

 

·                  the effect that payment of accrued dividendson our preferred stock has on our cash resources and the substantial dilutionupon the conversion or redemption of our preferred stock and exercise ofoutstanding warrants;

 

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

 

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

 

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

 

Ifone or more of these or other risks or uncertainties materialize, or if ourunderlying assumptions prove to be incorrect, actual results may varysignificantly from what we projected. These forward-looking statements andother statements made elsewhere in this report are made in reliance on thePrivate Securities Litigation Reform Act of 1995.  Any forward-looking statement you read inthis Quarterly Report on Form 10-Q or our Annual Report on Form 10-Kreflects our current views with respect to future events and is subject tothese and other risks, uncertainties and assumptions relating to ouroperations, results of operations, growth strategy and liquidity. We assume noobligation to publicly update or revise these forward-looking statements forany reason, or to update the reasons actual results could differ materiallyfrom those anticipated in these forward-looking statements, even if newinformation becomes available in the future. The Section 1A below entitled “Factors That May Affect FutureResults of Operations” sets forth and incorporates by reference certain factorsthat could cause actual future results of the Company to differ materially fromthese statements.

 

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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** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **September 30,  2010**     | ** ** | **September 30,  2009**    | ** ** | **September 30,  2010** | ** ** | **September 30,  2009** | ** ** |
| Net product revenue                                    |       | 96.5                             | %          | 95.3                            | %          | 96.6 | % | 93.2 | % |
| Net customer support and maintenance revenue           |       | 3.5                              |       | 4.7                             |       | 3.4 |   | 6.8 |   |
| Total revenue                                          |       | 100.0                            |       | 100.0                           |       | 100.0 |   | 100.0 |   |
| Cost of product revenue                                |       | 37.4                             |       | 34.5                            |       | 36.2 |   | 33.4 |   |
| Cost of customer support and maintenance revenue       |       | 0.3                              |       | 0.2                             |       | 0.3 |   | 0.3 |   |
| Total cost of revenue                                  |       | 37.7                             |       | 34.7                            |       | 36.5 |   | 33.7 |   |
| Gross profit                                           |       | 62.3                             |       | 65.3                            |       | 63.5 |   | 66.3 |   |
| Operating expenses:                                    |       |                             |       |                            |       |   |   |   |   |
| Sales and marketing                                    |       | 11.4                             |       | 15.8                            |       | 13.7 |   | 21.5 |   |
| Research and development                               |       | 24.0                             |       | 22.9                            |       | 22.1 |   | 26.6 |   |
| General and administrative                             |       | 16.6                             |       | 18.8                            |       | 16.7 |   | 22.6 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Operating income (loss)                                |       | 10.3                             |       | 7.7                             |       | 11.0 |   | (4.4 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Other income                                           |       | 3.0                              |       | —                          |       | 1.0 |   | — |   |
| Interest expense, net                                  |       | (0.4                             | )          | (1.4                            | )          | (0.7 | ) | (1.3 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Income (loss) before income tax provision              |       | 12.9                             |       | 6.3                             |       | 11.3 |   | (5.7 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Income tax provision                                   |       | —                           |       | —                          |       | — |   | — |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Net income (loss)                                      |       | 12.9                             | %          | 6.3                             | %          | 11.3 | % | (5.7 | )% |
| Preferred stock dividends accrued                      |       | (2.4                             | )          | (3.0                            | )          | (2.4 | ) | (3.4 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Net income (loss) attributable to common  stockholders |       | 10.5                             | %          | 3.3                             | %          | 8.9 | % | (9.1 | )% |

 
| ** **          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **          | ** ** | **September 30,  2010**     | ** ** | **September 30,  2009**    | ** ** | **September 30,  2010** | ** ** | **September 30,  2009** | ** ** |
| Domestic revenues   |       | 99.8                             | %          | 99.8                            | %          | 99.8 | % | 98.9 | % |
| Export revenues to: |       |                             |       |                            |       |   |   |   |   |
| Europe              |       | 0.1                              |       | 0.1                             |       | 0.1 |   | 1.0 |   |
| Canada              |       | —                           |       | —                          |       | — |   | — |   |
| Asia                |       | —                           |       | —                          |       | — |   | — |   |
| Latin America       |       | 0.1                              |       | 0.1                             |       | 0.1 |   | 0.1 |   |
|                |       |                             |       |                            |       |   |   |   |   |
| Net revenues        |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |

 

**NetRevenues**.  Netrevenues for the quarter and nine months ended September 30, 2010 were $1.6million and $4.7 million, respectively, compared to $1.3 million and $3.4million for the same periods in 2009. Product revenues increased $328 thousand for the quarter ended September30, 2010, and increased $1.3 million for the nine months ended September 30,2010 compared to the same periods in 2009. Increased product revenues are due to an increase in sales of ourTraceCop product line.  TraceCop revenueswere $1.5 million for the quarter ended September 30, 2010, compared to $1.2million for the same quarter in 2009. Customer support and maintenance revenue decreased $4 thousand and $72thousand for the quarter and nine months ended September 30, 2010,respectively, compared to the same periods in 2009.  This decrease was due to the current salesmix with a high concentration of sales not requiring a maintenance contract.

 

**Concentrationof Revenues**.  Revenuesfrom sales to various U.S. government entities totaled $0.5 million, or 31.5%of revenues, for the quarter ended September 30, 2010 compared to $0.8 million,or 66.3% of revenues, for the same period in 2009.  

 

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Revenues from sales tovarious U.S. government entities totaled $3.0 million, or 65.5% of revenues,for the nine months ended September 30, 2010 compared to $2.8 million, or 82.7%of revenues, for the same period in 2009. Although we expect our concentration of revenues to vary among customersin future periods depending upon the timing of certain sales, we anticipatethat sales to government customers will continue to account for a significantportion of our revenues in future periods. Sales to the government present risks in addition to those involved insales to commercial customers which could adversely affect our revenues,including, without limitation, potential disruption to appropriation andspending patterns and the government’s reservation of the right to cancelcontracts and purchase orders for its convenience.  Although we do not anticipate that any of ourrevenues with government customers will be renegotiated, a large number ofcancelled or renegotiated government orders could have a material adverseeffect on our financial results. Currently, we are not aware of any proposed cancellation orrenegotiation of any of our existing arrangements with government entities and,historically, government entities have not cancelled or renegotiated orderswhich had a material adverse effect on our business.

 

**GrossProfit**.  Gross profit was $1.0 millionor 62.3% of net revenues for the quarter ended September 30, 2010, compared to$0.8 million or 65.3% of net revenues for the quarter ended September 30,2009.  Gross profit was $3.0 million or63.5% of net revenues for the nine months ended September 30, 2010 compared to$2.3 million or 66.3% of net revenues for the nine months ended September 30,2009.  Gross profit on product revenuesfor the quarter and nine months ended September 30, trended from 63.8% and64.3%, respectively, in 2009 to 61.3% and 62.6%, respectively, in 2010 due to ashift in product mix.  Gross profit oncustomer support and maintenance revenues for the quarter and nine months endedSeptember 30, trended from 95.5% and 94.8%, respectively, in 2009 to 90.1% and90.6%, respectively, in 2010.  Grossprofit as a percentage of net revenues is impacted by several factors,including shifts in product mix, changes in channels of distribution, revenuevolume, pricing strategies, and fluctuations in revenues of integratedthird-party products.

 

**Sales andMarketing**.  Sales andmarketing expenses remained constant at $0.2 million for the quarters endedSeptember 30, 2010 and 2009.  Sales andmarketing expenses decreased to $0.6 million for the nine months endedSeptember 30, 2010 compared to $0.7 million for the same period in 2009.  The decrease was primarily due to shiftsbetween sales and marketing labor expenses and cost of sales in relation toengineering contract jobs.  Sales andmarketing expenses may vary in the future. We believe that these costs will increase through the end of 2010, withincreases in revenue.

 

**Researchand Development**.  Researchand development expenses increased to $0.4 million for the quarter endedSeptember 30, 2010 compared to $0.3 million for the same period in 2009.  Research and development expenses increasedto $1.0 million for the nine months ended September 30, 2010 compared to $0.9million for the same period in 2009. Research and development costs are expensed in the period incurred.  Any fluctuations in research and developmentexpenses in the three months and nine months ended September 30, 2010, comparedto the same periods in 2009 are primarily due to shifts between research anddevelopment labor expenses and cost of sales in relation to engineeringcontract jobs.  Research and developmentexpenses may vary in the future; however, we believe that these costs willremain relatively constant through the end of 2010, although expenses may beincreased relative to increases in revenue.

 

**General andAdministrative**.  General andadministrative expenses increased to $0.3 million for the quarter endedSeptember 30, 2010 compared to $0.2 million for the same period in and2009.  General and administrativeexpenses remained constant at $0.8 million for the nine months ended September30, 2010, and 2009.  It is expected thatgeneral and administrative expenses will remain relatively constant throughoutthe remainder of 2010, although expenses may be increased relative to increasesin revenue.

 

**OtherIncome**.  Other income increased to $47thousand for the quarter and nine months ended September 30, 2010 compared tonone for the same period in 2009.  Theincrease in other income was due to a cumulative translation adjustment fromthe disposition of a foreign subsidiary. Other income may vary in the future.

 

**Interest**.  Net interest expense decreased to $7 thousandfor the quarter ended September 30, 2010 compared to $18 thousand for the sameperiod in 2009.  Net interest expensedecreased to $32 thousand for the nine months ended September 30, 2010 comparedto $44 thousand for the same period in 2009. The decrease in interest expense was primarily due to a decrease ininterest expenses related to borrowings from a loan payable to an officer.  Net interest expense may vary in the futurebased on our level of borrowing, which will be affected by our cash flow,operating income and capital expenditures.

 

Liquidity and CapitalResources

 

Our principal source ofliquidity at September 30, 2010, is approximately $298 thousand of cash andcash equivalents.  At September 30, 2010,we had a working capital deficiency of $0.6 million compared to a $1.5 milliondeficiency at September 30, 2009.

 

Net cash provided byoperations for the nine months ended September 30, 2010, was $534 thousandprimarily due to net income of $528 thousand and the following sources of cashand non-cash items: a $36 thousand decrease in prepaid expenses and otherassets, a $15 thousand increase in deferred revenue, $130 thousand instock-based compensation, and $56 thousand in 

 

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depreciation expense.  This was partially offset by the followinguses of cash: a $115 thousand increase in accounts receivable, a $22 thousandincrease in inventories, a $47 thousand decrease in accounts payable andaccrued expenses, and a $47 thousand write-off of France’s cumulativetranslation adjustment.  Cash used inoperations for the nine months ended September 30, 2009 was $0.9 million,primarily due to a net loss of $0.2 million, decreases in deferred revenue of$1.0 million and an increase in prepaid expenses and other assets of $13thousand.  This cash decrease waspartially offset by depreciation expense of $57 thousand, stock-basedcompensation expense of $71 thousand, a decrease in accounts receivable of $58thousand, a decrease in inventories of $3 thousand, and an increase accountspayable and accrued expenses of $81 thousand. Future fluctuations in inventory balances, accounts receivable andaccounts payable will be dependent upon several factors, including, but notlimited to, quarterly sales, our strategy in building inventory in advance ofreceiving orders from customers, and the accuracy of our forecasts of productdemand and component requirements.

 

Net cash used in investingactivities for the nine months ended September 30, 2010, was $46 thousandcompared to $16 thousand of cash used in investing activities in the ninemonths ended September 30, 2009 for net purchases of property and equipment.

 

Net cash used in financingactivities for the nine months ended September 30, 2010, was primarily due to$410 thousand for payments of accrued dividends on preferred stock and apayment (net) of $300 thousand on the loan by our CEO, G. Ward Paxton.  This is compared to net cash provided byfinancing activities in the nine months ended September 30, 2009 was $0.5million, primarily consisting of the proceeds from a promissory note andcommitment by our CEO, G. Ward Paxton, for $0.5 million.

 

AtSeptember 30, 2010, the Company did not have any material commitments forcapital expenditures.

 

Duringthe three months ended September 30, 2010, the Company funded its operationsthrough the use of cash and cash equivalents, and borrowings from our CEO, G.Ward Paxton.

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SVB toestablish a $1.0 million line of credit with SVB (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amendedand Restated Loan and Security Agreement with SVB to, among other things,replace the 2006 Credit Line with a $2.5 million line of credit (the “2008Credit Line”).  On June 28, 2009, weentered into the First Amendment to the Amended and Restated Loan and SecurityAgreement with SVB to replace the 2008 Credit Line with a $1.25 million line ofcredit (the “2009 Credit Line”).  On June27, 2010, we entered into the Second Amendment to the Amended and Restated Loanand Security Agreement (as amended, the “Loan Agreement”) with SVB to replacethe 2009 Credit Line with a $0.625 million line of credit (the “Current Line ofCredit”).  Our obligations under the LoanAgreement are secured by substantially all of our assets, including all of ourintellectual property.  In addition, G.Ward Paxton, the Company’s Chief Executive Officer, has established a GuarantyAgreement with SVB for all outstanding balances under the Current Line ofCredit.  Borrowings under the CurrentLine of Credit are based on advances (each an “Advance”) against certain of ouraccounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB may determinein its sole discretion.  Each Advance issubject to a finance charge calculated at a daily rate that is based on a360-day annual rate of the greater of the prime rate plus 2.0% or 7%.  Finance charges are payable at the same timeits related Advance is due.  Each Advanceis also subject to a monthly collateral handling fee of 0.5% of all outstandingAdvances, depending on certain qualifying financial factors specified in theLoan Agreement.  The collateral handlingfee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliestof (a) the date that the Eligible Account related to the Advance is paid, (b)the date the Eligible Account is no longer eligible under the Loan Agreement,or (c) the date on which any “Adjustment” (as defined in the Loan Agreement) isasserted to the Eligible Account.  OnJune 26, 2011, the Loan Agreement terminates and all outstanding Advances,accrued but unpaid finance charges, outstanding collateral handing fees, andother amounts become due under the Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofSeptember 30, 2010.

 

Asof September 30, 2010, we had cash and cash equivalents of approximately$298,000, down from approximately $519,000 as of December 31, 2009, and aworking capital deficit totaling $0.6 million. We generated net income of $528,000 in the first nine months of 2010compared to a net loss of $193,000 for the first nine months of 2009.  As of September 30, 2010, in addition to cashand cash equivalents of $298,000, we had $30,000 in funding available under our$0.7 million note with G. Ward Paxton, the Company’s Chairman, President andChief Executive Officer, and $1.5 million funding available from a writtencommitment to invest up to $1.5 million from G. Ward Paxton.  Based on projections of growth in revenue andnet income in the coming quarters, funding available under our $0.625 millionline of credit at Silicon Valley Bank (“SVB”) and the borrowings available previously mentioned, we believe that wewill have sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  We expect to fund our operations throughCompany profits, borrowings from the Company’s CEO, and possibly additionalinvestments of private equity and debt, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhapssignificantly.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

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

 

Item 4.                                CONTROLS ANDPROCEDURES

 

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

 

Ourmanagement, including our principal executive officer and principal financialofficer, evaluated the effectiveness of the design and operation of ourdisclosure controls and procedures as of September 30, 2010, and concluded thatthe disclosure controls and procedures were effective.

 

Ourmanagement, with the participation of our principal executive officer andprincipal financial officer, evaluated our “internal control over financialreporting” (as defined in Rule 13a-15(f) under the Exchange Act) as ofSeptember 30, 2010, and concluded that there have not been any changes in ourinternal control over financial reporting that occurred during the quarterended September 30, 2010, that have materially affected, or are reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II — OTHER INFORMATION**

 

Item 1.                                LEGALPROCEEDINGS

 

We are subject from time totime to various legal proceedings and claims that arise during the ordinarycourse of our business.  We do notbelieve that the outcome of those “routine” legal matters should have amaterial adverse affect on our consolidated financial position, operatingresults or cash flows; however, we can provide no assurances that legal claimsthat may arise will not have such a material impact in the future.

 

Item 1A.                                         RISK FACTORS

 

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

 

Weare providing the following information regarding changes that have occurred topreviously disclosed risk factors from our Annual Report on Form 10-K for theyear ended December 31, 2009.  Inaddition to the other information set forth below and elsewhere in this report,you should consider the factors discussed under the heading “Factors That MayAffect Future Results of Operations” in our Form 10-K for the year endedDecember 31, 2009 and on Form 10-Q for the quarters ended March 31, 2010 andJune 30, 2010.  The risks described inour Quarterly Reports on Form 10-Q are not the only risks facing ourCompany.  Additional risks anduncertainties not currently known to us or that we currently deem to beimmaterial also may materially adversely affect our business, financialcondition and/or operating results.

 

***Our cash, cash equivalents, and investments decreased to $298,000 atSeptember 30, 2010, compared to $519,000 at December 31, 2009.  We may not have sufficient cash to operateour business and may not be able to maintain certain liquidity requirementsunder our existing debt instruments. Additional debt and equity offerings to fund future operations may notbe available and, if available, may significantly dilute the value of ourcurrently outstanding common stock.***

 

Asof September 30, 2010, we had cash and cash equivalents of approximately$298,000, down from approximately $519,000 as of December 31, 2009, and aworking capital deficit totaling $0.6 million. We generated net income of $528,000 in the first nine months of 2010compared to a net loss of $193,000 for the first nine months of 2009.  As of September 30, 2010, in addition to cashand cash equivalents of $298,000, we had $30,000 in funding available under our$0.7 million note with G. Ward Paxton, the Company’s Chairman, President andChief Executive Officer, and $1.5 million funding available from a writtencommitment to invest up to $1.5 million from G. Ward Paxton.  Based on projections of growth in revenue andnet income in the coming quarters, funding 

 

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availableunder our $0.625 million line of credit at Silicon Valley Bank (“SVB”)  and the borrowings available previouslymentioned, we believe that we will have sufficient cash resources to financeour operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operationsthrough Company profits, borrowings from the Company’s CEO, and possiblyadditional investments of private equity and debt, which, if we are able toobtain, will have the effect of diluting our existing common stockholders,perhaps significantly.  Any equity ordebt financings, if available at all, may be on terms which are not favorableto us and, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

***We had a net income of $0.2 million for the quarter ended September 30,2010, a net income of $0.5 million for the nine months ended September 30, 2010and have an accumulated deficit of $57.6 million as of September 30, 2010.  To continue profitability, we must continueto generate current or increased revenue levels.***

 

Forthe quarter ended September 30, 2010, we incurred a net income of $0.2million and had an accumulated deficit of approximately $57.6 million as ofSeptember 30, 2010, compared to a net income of $0.08 million for the quarterended September 30, 2009 and an accumulated deficit of approximately $58.5million as of September 30, 2009. ** **We need to sustain current orgreater revenue levels from the sales of our products if we are to sustainprofitability.  If we are unable toachieve these revenue levels, losses could happen for the near term and possiblylonger, and we may not sustain profitability or generate positive cash flowfrom operations.

 

***A large percentage of our revenues arereceived from U.S. government entities/resellers and one commercial customer,and the loss of one of these customers could reduce our revenues and materiallyharm our business and prospects.***

 

Alarge percentage of our revenues result from sales to U.S. governmententities/resellers and one commercial customer. If wewere to lose one or more of these key relationships, our revenues could declineand our business and prospects may be materially harmed. We expect that even ifwe are successful in developing relationships with non-governmental customers,our revenues will continue to be concentrated among government entities.  For the quarter ended September 30, 2010,sales to U.S. government entities/resellers collectively accounted for 31.5% ofour revenues, compared to 66.3% of our revenues as of September 30,2009.  The loss of any of these key relationshipsmay send a negative message to other U.S. government entities/resellersor non-governmental customers concerning our product offering. We cannot assure you that U.S. government entities/resellers will be customersof ours in future periods or that we will be able to diversify our customerportfolio to adequately mitigate the risk of loss of any of these customers.

 

***A large percentage of our revenues are fromone product line, and the decrease of revenue from sales of this product linecould materially harm our business and prospects.***

 

Alarge percentage of our revenues result from sales of our TraceCop productline.  TraceCop revenues were $1.5million for the quarter ended September 30, 2010, compared to $1.2 million forthe same quarter in 2009.  If sales of this key productline were to decrease, our revenues could decline and our business andprospects may be materially harmed.

 

***We are highly dependent on sales made through indirect channels, theloss of which would materially adversely affect our operations.***

 

Wederived 32.6% of revenue in the third quarter of 2010 through indirectchannels, compared to 62.8% of our revenues in the quarter ended September 30,2009.  We must continue to strive forexpansion of our sales through these indirect channels in order to increase ourrevenues.  We cannot assure you that ourproducts will gain market acceptance in these indirect sales channels or thatsales through these indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

***You will experience substantial dilution upon the conversion orredemption of the shares of preferred stock and the exercise of warrants thatwe issued in our recent private placements or in the event we raise additionalfunds through the issuance of new shares of our common stock or securitiesconvertible or exercisable into shares of common stock.***

 

OnOctober 29, 2010, we had 11,776,150 shares of common stock outstanding.  Upon conversion of all outstanding shares ofpreferred stock and exercise of the outstanding warrants, we will have13,135,235 shares of common stock outstanding, approximately an 11.5% increase inthe number of shares of our common stock outstanding.

 

Inaddition, management may issue additional shares of common stock or securitiesexercisable or convertible into shares of common stock in order to finance ourcontinuing operations.  Any futureissuances of such securities would have additional dilutive effects on theexisting holders of our Common Stock.

 

Further,the occurrence of certain events could entitle holders of our Series 2Preferred Stock and Series 3 Preferred Stock to 

 

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requireus to redeem their shares for a certain number of shares of our commonstock.  Assuming, (i) we have paid allliquidated damages and other amounts to the holders, (ii) paid all outstandingdividends, (iii) a volume weighted average price of $0.81, which was theten-day volume weighted average closing price of our common stock on October29, 2010, and (iv) our 11,776,150 shares of common stock outstanding on October29, 2010, upon exercise of their redemption right by the holders of the Series3 Preferred Stock and the Series 2 Preferred Stock, we could be obligated toissue approximately 3,500,000 shares of our common stock.  This would represent an increase ofapproximately 30.0% in the number of shares of our common stock as of October29, 2010.

 

***The conversion of preferred stock or exercise of warrants we issued inthe private placements may cause the price of our common stock to decline.***

 

Theholders of the shares of our 5% Preferred Stock and warrants we issued inconnection with the sale of our 5% Preferred Stock who are not affiliates mayfreely convert their shares of preferred stock and exercise their warrants andsell the underlying shares of common stock pursuant to Rule 144 of theSecurities and Exchange Commission.  Asof October 29, 2010, 780,000 shares of our 5% Preferred Stock had convertedinto 1,240,457 shares of common stock.

 

Theholders of the shares of Series 2 5% Preferred Stock and warrants we issued inconnection with the sale of our Series 2 Preferred Stock who are not affiliatesmay freely convert their shares of preferred stock and exercise their warrantsand sell the underlying shares of common stock pursuant to Rule 144 of theSecurities and Exchange Commission.  Asof October 29, 2010, 605,200 shares of Series 2 Preferred Stock had convertedinto 605,200 shares of common stock.

 

Theholders of the shares of Series 3 5% Preferred Stock and warrants we issued inconnection with the sale of our Series 3 Preferred Stock who are not affiliatesmay freely convert their shares of Series 3 Preferred Stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to Rule 144 ofthe Securities and Exchange Commission. As of October 29, 2010, 210,551 shares of Series 3 Preferred Stock hadconverted into 210,551 shares of common stock and 114,680 warrants hadconverted into 67,913 shares of common stock.

 

Forthe four weeks ended on October 29, 2010, the average daily trading volume ofour common stock on The OTCBB was 2,237 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity could cause a decline in the market price of our commonstock.  Furthermore, these sales, or thepotential for these sales, could encourage short sales, causing additionaldownward pressure on the market price of our common stock.

 

***Our management and larger stockholdersexercise significant control over our company and have the ability to approveor take actions that may be adverse to your interests.***

 

Asof October 29, 2010, our executive officers, directors and preferredstockholders beneficially own approximately 30% 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, we may contemplatethe possible issuance of shares of our Common Stock or of securitiesexercisable or convertible into shares of our Common Stock in the future to ourChief Executive Officer.  Any suchissuance will increase the percentage of stock our Chief Executive Officer andour management group beneficially holds.

 

Item 6.                                Exhibits

 

Thefollowing Exhibits are filed with this report form 10-Q:

 
| 31.1 |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                        |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of Chief Financial  Officer Pursuant to Rule 13a-14(a) of the Exchange Act.                                                                        |
| 32.1 |   | Certification Pursuant to  Rule 13a-14(b) of the Exchange Act and 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

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

 

 
| ** **              | ** ** | **INTRUSION INC.**                                 |
|-------------------------|------------|----------------------------------------------------|
|                    |       |                                               |
| Date: November 10, 2010 |       | /s/  G. Ward Paxton                                |
|                    |       | G.  Ward Paxton                                    |
|                    |       | Chairman,  President & Chief Executive Officer |
|                    |       | (Principal  Executive Officer)                     |
|                    |       |                                               |
|                    |       |                                               |
| Date: November 10, 2010 |       | /s/  Michael L. Paxton                             |
|                    |       | Michael  L. Paxton                                 |
|                    |       | Vice  President, Chief Financial Officer,          |
|                    |       | Treasurer  & Secretary                         |
|                    |       | (Principal  Financial & Accounting Officer)    |

 

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