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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-KSB
ANNUAL REPORT

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2002

Commission file No. 0-11447

DATAKEY, INC.

(Name of small business issuer in its charter)


|                                                   |  |                                                
|-------------------------------------------------- |  | -----------------------------------------------
|MINNESOTA
(State of incorporation or organization) |  | 41-1291472
(I.R.S. Employer Identification No.)

407 West Travelers Trail, Burnsville, Minnesota 55337

(Address of principal executive offices)


Issuers telephone number, including area code:    (952) 890-6850

Securities registered pursuant to Section 12(b) of the Act:    NONE

Securities registered pursuant to Section 12(g) of the Act:    Common Stock, par value $.05 per share

Series B Preferred Stock Purchase Rights Pursuant to Rights Agreement

(Title of Class)


Check whether the Issuer (1) has filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the Issuer was required to file such
reports) and (2) has been subject to such filing requirements for the last 90
days.    YES  x    NO  o

Check if there is no disclosure of delinquent filers pursuant to Item 405 of
Regulation S-B contained herein and no disclosure will be contained, to the
best of Issuers knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. x

Issuers revenues for its most recent fiscal year: $8,127,000, which represents
$7,257,000 for continuing operations and $870,000 for discontinued operations.

The aggregate market value of the Issuers Common Stock held by non-affiliates
was approximately $6,924,582 based upon the closing sale price of the Issuers
Common Stock on March 21, 2003.

As of March 21, 2003, there were 10,125,032 shares of the Issuers Common Stock
outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Companys definitive Proxy Statement for its Annual
Meeting of Shareholders to be held on May 28, 2003 are incorporated by
reference pursuant to Rule 12b-23 into Items 9, 10, 11 and 12 of Part III.

Transitional Small Business Disclosure Format (check one)    YES  o    NO  x





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TABLE OF CONTENTS



|                                                 |                                                                                                                         |  |  |  |  |  |  | 
|------------------------------------------------ | ----------------------------------------------------------------------------------------------------------------------- |  |  |  |  |  |  | 
|PART I                                          
|                                                 | ITEM 1. DESCRIPTION OF BUSINESS                                                                                        
|                                                 | ITEM 2. DESCRIPTION OF PROPERTY                                                                                        
|                                                 | ITEM 3. LEGAL PROCEEDINGS                                                                                              
|                                                 | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                            
|PART II                                         
|                                                 | ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                                                       
|                                                 | ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION                                                      
|                                                 | ITEM 7. FINANCIAL STATEMENTS                                                                                           
|                                                 | ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                           
|PART III                                        
|                                                 | ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS, COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
|                                                 | ITEM 10. EXECUTIVE COMPENSATION                                                                                        
|                                                 | ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                                                
|                                                 | ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                
|                                                 | ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K                                                                              
|                                                 | ITEM 14. CONTROLS AND PROCEDURES                                                                                       
|SIGNATURES                                      
|CERTIFICATION OF CHIEF EXECUTIVE OFFICER        
|EXHIBIT INDEX                                   
|EX-3.1 Restated Articles of Incorporation       
|EX-3.2 Restated Bylaws                          
|EX-10.18 2003 Executive Incentive Plan          
|EX-10.19 Employment Agreement                   
|EX-23.1 Consent of Independent Accountant       
|EX-99.1 Certification of Chief Executive Officer
|EX-99.1 Certification of Chief Financial Officer



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PART I




ITEM 1. DESCRIPTION OF BUSINESS

General

Datakey Inc. was founded in 1976 as a manufacturer of rugged memory keys and
tokens to reliably store and transfer electronic data. For more than two
decades, the Companys unique, easy-to-use Data Keys were integrated into a
wide range of industrial and commercial applications throughout the world to
help businesses run their equipment and control their operations with
electronic information. One notable application for Datakey tokens was for
accessing a cryptographic telephone used to protect private and sensitive
communications between high-ranking government officials. Datakey delivered
more than 1 million tokens to operate these cryptographic telephones.

Recognizing the growing need to secure access to computer networks and to
protect electronic data  Datakey memory key technology was revised and
re-engineered to develop a prototype secure token for computer workstation
authentication in 1989. Based on this secure token, Datakey pioneered the first
cryptographic smart card used for digital signatures in 1991.

During the 1990s, Datakey continued to refine and set the standards for
cryptographic smart card technology, drawing upon its existing memory key
technology to form the basis of its new smart card product line. With the
divestiture of the companys traditional Electronics Products (memory key)
business unit in August 2001, Datakey today dedicates all its resources to
delivering smart card technology for access and identity management.

Interoperable Smart Card Solutions for Access and Identity Management
Datakey focuses on delivering complete smart card-based solutions that simplify
access and identity management throughout the enterprise. We believe our
solutions make it easier to administer digital identities and to manage access
to corporate resources. In turn, its more convenient and secure for users to
login to company resources by consolidating all credentials onto onesmart card
and automating access through a single smart card sign-on. The core components
of Datakeys solution set  its Management Center software, smart cards and
card management system  enable enterprises to identity users and open doors in
both the physical and online worlds.

A strict adherence to industry standards allows Datakey technology to plug and
play with more authentication/security software products than any other
technology. Customers and partners alike rely on Datakeys interoperable
technology as the foundation for securing a wide range of their existing
applications and environments.

Product Applications

Customers use Datakey smart cards and software for a diverse range of
applications:



| |  | Smart ID Badge
Datakey smart cards, when combined with building access control
technologies, function as both an employees physical ID as well as digital
ID. The same smart card that is used for network and computer security can
be personalized and printed with ID pictures to function as an employees ID
badge, and fitted with a magnetic stripe or RF proximity technology for door
access systems.                            
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | Password
Management/Consolidation of Credentials
Datakey smart cards offer a medium for storing all of a users access
credentials, including passwords, digital certificates, VPN/dial-up
credentials or biometric templates. Instead of having to remember multiple
passwords or maintain many certificates to access corporate applications and
protected web sites, the user only has to remember one PIN to activate their
smart card.

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| |  | Network Authentication
Datakey smart card technology is used to enable secure network logon.
Windows 2000, XP and later versions of Windows support smart card logon.
In addition, digital certificate/PKI products can be deployed together with
Datakey smart cards to enable secure network authentication and logon based
on PKI.
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Datakey smart card technology also works with dynamic password products to
enable an enterprise to use one-time authentication codes for network access
or application authentication. Datakey smart cards integrate seamlessly with
one-time password and authentication server products.



| |  | Single Sign On
Datakeys smart card solution enables Single Sign-On to company applications
and resources. When the user logs into the network by inserting their smart
card, they only enter their PIN one time for authentication. In doing so,
the user gains access not only to the network, but also to company
applications (accounting system, CRM, e-mail, etc.).                                                                                                                                                      
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | Secure E-mail
Microsoft Outlook and Outlook Express, and Netscape Messenger, support
Datakey smart cards for digitally signing and encrypting e-mail messages. A
user generates/stores their digital certificate and public/private key pair
on their smart card, and through the built-in support in Outlook and
Messenger, have the capability of digitally signing their e-mail message or
encrypting an e-mail message when they possess a valid certificate from
another user.                                            
| 
| |  | Computer Security
Datakey smart card technology protects access to an employees
desktop/laptop computer, as well as protects the data that resides on that
computer. Datakey smart cards can be used for pre-boot authentication,
file/folder encryption and computer lock-down functions.                                                                                                                                                                                                                                    
| 
| |  | Secure VPN access
VPN technology gives remote or traveling users the ability to connect to the
corporate network through a secure, encrypted tunnel. Many enterprises are
using Datakey smart cards as part of their VPN solution to enable greater
security for user authentication. A users credentials (whether
password-based or a digital certificate) are stored on a Datakey smart card
for greater flexibility, portability and security. These credentials travel
with the user anywhere they carry their smart card.
| 
| |  | Digital signature applications
Datakey smart cards have been integrated with a range of applications for
digitally signing XML-based forms, Adobe .pdf files and other documents.                                                                                                                                                                                                                                                                                                                                              

Product Descriptions

Datakey CIP (Cryptographic Interface Provider). Password-based software
programs that implement public-key cryptography technology for information
security offer easier operation and improved data integrity over older
symmetric cryptography software. Password-based security, however, is often
insufficient for public networks with connections, such as extranets and the
Internet, outside of the organization. Datakeys CIP allows enterprise users
to upgrade their software-only systems to token-based information security and
gain the benefit of secure Internet operation. Token-based information
security implements a two-level security schemesomething that is owned (a
hardware token) and something that is known (a password to activate the
token)for a much stronger level of security than password-based software
solutions. CIP provides token add-ons to Cryptoki (PKCS-11) standard
information security interface applications and for applications that
incorporate Microsofts CryptoAPI (CAPI). It offers load, plug and play
convenience for strong information security. CIP includes three elements:

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| |  | A user-unique smart card or smart key token that holds
critical information and performs the cryptographic functions
necessary for information security.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | A companion reader that plugs into a computers serial port, PCMCIA port or USB port.                                                                     
| 
| |  | Software that is installed in the workstation and interfaces to the application program.                                                                  

Datakey CIP Thin. During 2001, Datakey introduced a server-based version of
the client based CIP. CIP Thin contains all the features and functionality
of CIP but is installed on the server instead of on each individual
workstation.

Datakey DTK (Developers Tool Kit). DTK is a turnkey package to assist software
developers in integration of Datakey hardware tokens and a public key
infrastructure (PKI) into their applications. DTK is available in several
configurations ranging from a token with a reader/writer and integration
software, to the full PKI configuration that issues and manages hardware tokens
and digital certificates. This product flexibility allows developers who
utilize DTK to integrate just what is needed for their application.

Datakey CMS (Card Management System)CMS is a web-based smart card and digital
credential management solution for enterprises  used to issue, manage and
support Datakey cryptographic smart cards throughout the organization for
identity-based applications. Datakey CMS gives enterprise customers a powerful,
secure system that reduces the cost of deploying and supporting smart cards.
Through innovative, policy-based enrollment features, Datakey CMS significantly
reduces the time an enterprise must spend issuing and managing smart cards for
geographically distributed users. Datakey CMS makes it easier to perform a wide
range of critical digital credential management activities  everything from
requesting or renewing a users digital credentials to revoking or re-issuing
these credentials.

Datakey CIP DesktopCIP Desktop is a suite of complementary applications that
work seamlessly with Datakeys field-tested CIP software to extend the
usability of Datakey smart cards with functions like password management, data
storage and smart card configuration. CIP Desktop effectively extends the
flexibility, functionality and power of smart cards for desktop security while
continuing to enable the two-factor security and strong user authentication
increasingly required in enterprise network environments.

NEW PRODUCT FOR 2003

Datakey Axis. Axis is a smart card-based solution that simplifies access
control and identity management throughout the enterprise. Datakey Axis makes
it much more convenient and secure for users to login to company resources by
consolidating all credentials/user identities onto one smart card and
automating access through a Single Sign-On. With this product, we are
primarily targeting enterprises that do not currently intend to install a PKI.

For the administrator, Datakey Axis Rapid Deploy Technologyautomates policy,
credential and desktop management through a single, powerful Management Center.
It makes it much easier to configure and deploy smart cards for access to a
complete range of corporate resources  without requiring any changes to the
existing infrastructure.

We plan to have this production ready during the second quarter of 2003.
Success of this new product depends upon our demonstration that it does,
indeed, make management of multiple passwords very easy for the administrator
to maintain, that the smart cards convenience far outweighs the cost, and that
passwords in combination with smart cards are far more secure than passwords
alone.

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Large and medium-sized enterprises benefit from rapid return on investment
(ROI) through an increase in productivity and a reduction in administrator
workload.

OEM Private Label Products.Datakey also provides its family of information
security products to OEMs under their own private label.

OEM Technology Licensing.In addition to selling products, Datakey licenses
its smart card operating system and CIP software to OEMs for incorporation
into their products. Licenses are sold on a per seat basis with revenue
recognized at time of delivery to the customer, provided that Datakey has no
significant cost or obligation beyond the original authorization to the silicon
supplier.

Manufacturing

As a result of selling the Electronic Products business unit in August 2001,
the Company no longer maintains an internal manufacturing capability. We do,
however, control the manufacturing process for our cards with several outside
assembly operations, and we buy our readers, with an imprinted Datakey logo,
from several smart card reader companies.

Sources of Supply

The Company purchases a microprocessor, with its proprietary operating system
masked into the chip, from a single source supplier. The Company is currently
qualifying other suppliers of the microprocessor to reduce the dependency on
one supplier.

Due to the unique nature of these cryptographic microprocessors, there are
currently a limited number of alternative sources of supply and, due to
different operating systems and other characteristics, one suppliers
microprocessors are not easily interchangeable with another. Should the
present source of supply become inadequate or inferior to other offerings in
the future or should its secondary suppliers be inadequate, the Company would
be required to incur a significant cost and possibly experience a gap in supply
to switch to a new supplier.

The Company continues to offer a Smart Key version of the smart card offering.
Although this product has not received broad acceptance, several customers have
expressed interest in it as an alternative to the card. If we receive orders
for this product, the company that purchased our former EP business will be our
sole source of supply.

Significant Customers

Sales to a group of the Companys customers, representing agencies of the
Canadian Government, totaled approximately $2,127,000, or 29% of net sales,
during the year ended December 31, 2002, with one agency representing
approximately $1,300,000, or 18% of net sales. Export sales to international
customers, including Canada, from continuing operations, for 2002 and 2001 were
approximately $4,168,000 and $5,206,000, or 57% and 67% of total sales,
respectively. Direct and indirect sales to U.S. government agencies from
continuing operations were approximately $1,756,000 and $1,250,000, or 24% and
16% of total sales, in 2002 and 2001, respectively.

Markets Served

Datakey smart card technology represents a strong solution for many
organizations that face increasing challenges in the areas of access and
identity management. Whether a company relies on usernames/passwords or digital
certificates and PKI, Datakey smart card technology simplifies the experience
for the administrator and end-user by consolidating all credentials on one
smart card for complete corporate access. Datakey technology also continues to
be ideally suited for those organizations

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that require the highest practical level of security for users accessing
physical and logical resources like buildings, the corporate network and
applications.

Datakeys target customer base includes large and medium-size businesses
worldwide. We sell our products principally through value-added resellers
(VARs) and system integrators. Within the large enterprise segment, Datakey
partners with system integrators to more specifically target Global 2000
corporations, government organizations and financial institutions. Expanding
our base of VAR partners is critical to reaching the medium-size business
market where demand for information security products is growing rapidly.

We team with the top information security companies in the industry, including
Baltimore Technologies, Check Point Software, Computer Associates, Citrix,
Entrust, Nortel, Precise Biometrics, RSA Security, Secure Computing, VASCO and
VeriSign. We believe Datakey has earned the trust of these leading companies
because our solutions work immediately and effectively with their security
applications and software.

Customers

Currently, more than 800,000 users at more than 1,500 organizations worldwide
take advantage of Datakey smart card technology. Our established history and
widespread exposure to such a large number of demanding customer environments
has allowed us to maintain our technology lead, providing better products and
more responsive service than any other smart card developer.

The list of organizations using Datakey smart card technology speaks for
itself. Included among the customers that Datakey is allowed to publicly
identify are:



|  |  |                                              |  |   |  |                                
|- |  | -------------------------------------------- |  | - |  | -------------------------------
| |  | Bank of England                              |  |  |  | Siemens                        
| |  | Canadian Department of National Defence      |  |  |  | U.S. Bureau of Labor Statistics
| |  | Federal Deposit Insurance Corporation (FDIC) |  |  |  | U.S. Department of Energy      
| |  | ING Barings                                  |  |  |  | U.S. Department of State       
| |  | Rabobank                                     |  |  |  | Wells Fargo Bank               

In addition, industry-leaders such as Datacard, Rainbow Technologies (iKey 2000
series), SafeNet (SafeNet/Smart VPN), Clearstream and SWIFT rely on the
strength of Datakeys core technology and have integrated it as central
components of their own product lines.

Sales in North America are generally conducted through direct sales
representatives and value-added resellers. The Company has a number of
resellers in Europe, South America and Asia/Pacific and plans to add more
international resellers as appropriate to serve those markets. In 2002 and
2001, sales to domestic customers and the corresponding percentage of total
revenue, were approximately $3,089,000 (43%) and $2,609,000 (33%),
respectively. Sales to international customers, including Canada, and the
corresponding percentage of revenue, were approximately $4,168,000 (57%) and
$5,206,000 (67%), respectively, in 2002 and 2001.

Backlog

As of March 21, 2003, the Company had an order backlog from continuing
operations totaling approximately $352,000. Although the orders generally
contain scheduled shipment dates, they may be accelerated, delayed or canceled
at the customers request. The Company does not believe that the current
backlog is necessarily indicative of future backlog levels.

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Competition

Information Security Solutions.Datakey currently offers token-based (smart
card, smart key and iKey) information security solutions which are primarily
utilized for electronic mail privacy, remote network authentication private and
secure file transfer and digital signatures for electronic document
authentication. The Company is continuing a significant product development
effort to expand the applications and ease-of-use of its products and systems.
See ProductsInformation Security Solutions.

Competition in the information security business is varied with companies
offering hardware solutions, software solutions and combinations of hardware
and software solutions. As awareness for security on the Internet, company
intranets and on other local area networks has increased over the past few
years, many companies have introduced software and/or hardware based products
to provide security. These products range from software-based password only
systems to firewalls, which may be very sophisticated. Other applications are
using hand held hardware devices, commonly referred to as tokens, to provide
access to networks and, in some cases, use encryption and digital signatures to
further secure networks.

The Companys advanced information security products, some of which are
released and some of which are currently in development, are based upon a smart
card, smart key or iKey and utilize passwords, encryption and digital
signatures. They also include extensive software to make the system
user-friendly and seamless with common desktop software packages. There are
several companies operating in this highly competitive and rapidly changing
marketplace, however, and many of such companies have strong name recognition
and vast financial resources. The Company believes it can compete on the basis
of its unique design and ease of use. The initial reception to the Companys
products in the marketplace, beginning in late 1997, has been encouraging and
sales of evaluation units, pilot programs and initial deployments of production
programs have been progressing very well, although the worldwide economic
slowdown has hindered this progress. There are no assurances, however, that
the existing and future products will, in the long term, be accepted in the
marketplace.

The technology involved in information security systems is undergoing rapid
expansion and advancement which could result in the development of new products
and systems which may make the Companys present information security products
obsolete. The initial development effort for the Companys information
security products was completed in 1997, but the Company must continue to
improve its present information security products in order to remain
competitive.

Research and Development, Engineering and Technical Support

In 2002 and 2001, research and development, engineering and technical support
expenses (RDETS) were $2,314,000 and $2,325,000, respectively. The Company
expects that RDETS expenses in 2003 will decrease by about nine percent (9%) as
the Company plans to continue new product development and technical support at
a reduced rate in light of current economic conditions.

Employees

As of March 21, 2003, the Company employs 33 full-time employees, 3 in
procurement and materials handling, 3 in technical support, 11 in engineering,
10 in marketing/sales and 6 in general and administrative areas. The Companys
employees are not subject to a collective bargaining agreement, and the Company
believes that its employee relations are good.

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ITEM 2. DESCRIPTION OF PROPERTY

The Companys corporate offices and shipping/warehouse facility, located
at 407 West Travelers Trail, Burnsville, Minnesota, consist of approximately
25,000 square feet including approximately 13,000 square feet that is currently
under a sublease between the Company and Datakey Electronics. Of the space not
subleased, approximately one-third of the space is used for shipping and
warehousing, and the balance for present and future office space. All of this
space is rented under a lease that extends through June 2004. The annualized
rent expense for the space currently occupied is $178,000, plus a portion of
the operating expenses and real estate taxes. Sublease payments are
approximately $100,000 per year.




ITEM 3. LEGAL PROCEEDINGS

There are no material legal proceedings pending to which the Company is a
party or of which any of its property is the subject.




ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the
fourth quarter of fiscal year 2002.




PART II




ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

The Companys common stock is currently traded on the Nasdaq SmallCap Market
under the symbol DKEY. The high and low sale prices for the common stock by
quarter as reported by Nasdaq are set forth in the following table for 2002 and
2001.

On March 21, 2003, the Company had approximately 4,300 shareholders, including
approximately 4,000 beneficial owners. The Company has never paid dividends on
its common stock and does not plan to in the foreseeable future.

|     |             |  |             |      |     |  |   |      | 
|---- | ----------- |  | ----------- | ---- | --- |  | - | ---- | 
|     |             |  | Sale Prices
|     |             |  |            
|     |             |  | High        |      | Low
|     |             |  |             |      |    
|2002 |             |  |             |      |     |  |   |     
|     | 1st Quarter |  | $           | 6.99 |     |  | $ | 3.65 | 
|     | 2nd Quarter |  | $           | 5.05 |     |  | $ | 2.50 | 
|     | 3rd Quarter |  | $           | 3.60 |     |  | $ | 2.01 | 
|     | 4th Quarter |  | $           | 2.50 |     |  | $ | 1.35 | 
|2001 |             |  |             |      |     |  |   |     
|     | 1st Quarter |  | $           | 4.75 |     |  | $ | 2.00 | 
|     | 2nd Quarter |  | $           | 3.77 |     |  | $ | 1.63 | 
|     | 3rd Quarter |  | $           | 3.46 |     |  | $ | 1.58 | 
|     | 4th Quarter |  | $           | 6.35 |     |  | $ | 2.90 | 

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ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

Results of Operations

The table below summarizes changes in selected operating indicators, showing
certain income, cost and expense items as a percentage of total revenue from
continuing operations for each of the past two years. Inflation has not been a
significant factor in Datakeys operations to date.

|                                                            |                         |      |                             |      |  |  |     |     | 
|----------------------------------------------------------- | ----------------------- | ---- | --------------------------- | ---- |  |  | --- | --- | 
|                                                            |                         |      | Percentage of Total Revenue
|                                                            |                         |      |                            
|Year Ended December 31,                                     |                         | 2002 |                             | 2001
|                                                            |                         |      |                             |     
|Revenue                                                     |                         |      | 100                         | %    |  |  | 100 | %  
|Cost
and Expenses
Cost of goods sold                        |                         |      | 50                          |      |  |  | 43  |    
|Research and development, engineering
and technical support |                         |      | 31                          |      |  |  | 30  |    
|Marketing and sales                                         |                         |      | 46                          |      |  |  | 44  |    
|General and administrative                                  |                         |      | 10                          |      |  |  | 10  |    
|                                                            | Total cost and expenses |      |                             | 137  |  |  |     | 127 | 
|                                                            |                         |      |                             |      |  |  |     |    
|Operating loss                                              |                         |      | (37                         | )    |  |  | (27 | )  
|Interest income                                             |                         |      | 0                           |      |  |  | 1   |    
|                                                            |                         |      |                             |      |  |  |     |    
|Loss before income taxes                                    |                         |      | (37                         | )    |  |  | (26 | )  
|Income taxes                                                |                         |      |                            |      |  |  |    |    
|                                                            |                         |      |                             |      |  |  |     |    
|Net loss from continuing operations                         |                         |      | (37                         | )%   |  |  | (26 | )% 
|                                                            |                         |      |                             |      |  |  |     |    

Comparison of 2002 with 2001

Continuing Operations

Total revenue:Total revenue was $7,257,000 in 2002 compared to $7,815,000 in
2001. This decline in revenue was attributable primarily to a general
reduction in information technology spending as a result of the international
economic slowdown and a related delay in adoption of Public Key Infrastructure
(PKI) with which the Companys products have primarily been designed to work.
There is no assurance that the economy will improve materially or that
potential customers will be willing to invest in PKI, even if the economy
improves. The Company has not yet been able to prove that its products will
ever achieve sufficient market acceptance to attain profitability.

Gross margins: The gross profit margin decreased to 50 percent in 2002 from 57
percent in 2001 principally due to delivery of about $1.3 million of USB tokens
in the first quarter of 2002 for which the Company acts as a reseller and which
carry significantly lower margins than the Companys standard products.

Research and development, engineering and technical support (RDETS): Research
and development, engineering and technical support expense decreased by one
percent to $2,314,000 in 2002 from $2,325,000 in 2001. Such expenses
represented 31 and 30 percent of sales in 2002 and 2001, respectively. RDETS
decreased only slightly during 2002 as the Company continued the development
and support of its information security products in spite of the slow economy.

Marketing and sales, General and administrative: Marketing and sales expense
decreased three percent to $3,347,000 in 2002 from $3,461,000 in 2001. As a
percentage of revenue these expenses increased from 44 to 46 percent. The
decrease in 2002 marketing and sales expense primarily resulted from lower
commissions paid on the lower level of sales.

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General and administrative expenses decreased five percent to $707,000 in 2002
from $744,000 in 2001 primarily as a result of a reduction in payroll related
expenses.

Interest income: Interest income, net of interest expense, decreased to
$45,000 in 2002 from $79,000 in 2001, primarily due to a significant reduction
in the market rate of interest on interest bearing accounts and reduced account
in such balances due to use of cash to fund operating losses.

Income tax expense:As a result of the cumulative net operating loss
carryovers of approximately $20,129,000 at December 31, 2002, and $17,936,000
at December 31, 2001, the Company recorded no income tax expense in either
year.

Net loss.Net loss from continuing operations in 2002 was $2,668,000 compared
to $2,006,000 in 2001, primarily due to the decrease in revenue and gross
margin. Based on anticipated first quarter and 2003 revenues and profit
margins, the Company believes that it will record a loss for the year
comparable to the loss sustained in 2002.

Discontinued Operations

The Company announced in February 2001 that it planned to phase down or divest
its EP business segment. Subsequently, the operations were sold in August 2001.
As a result, the gain of $351,000, which was the result of the completion of
the final contract, in 2002 and loss of $487,000 in 2001 were reflected as
discontinued operations.

Comparison of 2001 with 2000

Continuing Operations

Total revenue:Total revenue was $7,815,000 in 2001 compared to $3,608,000 in
2000. The substantial increase in revenue was due to increasing acceptance and
demand for our information security solutions products.

Gross margins: The gross profit margin increased to 57 percent in 2001 from 47
percent in 2000 primarily due to a significant reduction in the costs of
materials used in cards and readers without a corresponding reduction in the
selling price.

Research and development, engineering and technical support (RDETS): Research
and development, engineering and technical support expense increased by 16
percent to $2,325,000 in 2001 from $2,003,000 in 2000. Such expenses
represented 30 and 56 percent of sales in 2001 and 2000, respectively. RDETS
expense increased during 2001 as the Company continued the development and
support activities of its information security products.

Marketing and sales, General and administrative: Marketing and sales expense
increased 56 percent to $3,461,000 in 2001 from $2,216,000 in 2000. As a
percentage of revenue these expenses decreased from 61 to 44 percent. The
increase in 2001 marketing and sales expense resulted from additions to the
sales staff, increased commissions due to higher revenue and continuing
promotional activities to promote the Companys information security products.
General and administrative expenses increased 28 percent to $744,000 in 2001
from $582,000 in 2000 primarily as a result of increases in legal, audit,
insurance and employment related expenses.

Interest income: Interest income, net of interest expense, decreased to
$79,000 in 2001 from $145,000 in 2000, primarily due to a significant reduction
in the market rate of interest on interest bearing accounts.

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Income tax expense:As a result of the cumulative net operating loss
carryovers of approximately $17,936,000 at December 31, 2001, and $13,514,000
at December 31, 2000, the Company recorded no income tax expense in either
year.

Net loss.Net loss in 2001 was $2,006,000 compared to $2,953,000 in 2000,
primarily due to the substantial increase in revenue and gross margin that more
than offset the increase in expenses.

Liquidity and Capital Resources

Cash as of December 31, 2002, was $2,563,000 as compared to $4,112,000 as of
December 31, 2001. The Company had a $1,550,000 use of cash in 2002 as
compared to a $2,580,000 increase in cash in 2001. The 2001 increase was due
to proceeds from the sale of common stock during the year of $4,752,000, offset
by the net loss of $2,493,000. The 2002 reduction in cash was primarily due to
the $2,317,000 net loss. The net loss was due, in part, to significant
expenditures totaling $5,661,000 in research, development, engineering,
technical support, and sales and marketing which were related to the Companys
information security products. The Company invested $317,000 in equipment,
licenses and patents in 2002 compared to $307,000 in 2001. Based on the
Companys projected quarterly burn rate, the Company will be able to fund its
operations in 2003. Its ability to fund its operations in 2003 and thereafter
will depend on its revenue, profitability and cash flow trends which
significantly influence its need for and ability to obtain needed debt or
equity financing. There is no assurance that such financing will be available
when required.

Datakeys balance sheet reflected $3,953,000 in working capital and a current
assets to current liabilities ratio of 3.9 to 1 as of December 31, 2002.

Contractual Cash Obligations
The Company presently has no long-term debt outstanding and its only
contractual cash obligations are those from operating lease obligations. These
lease obligations total $429,000 over the next three years as shown in Note 7
to the financial statements.

We believe that our cash balance, along with moderate increases in revenue and
tight control over expenditures, will fund our operations through at least the
next 12 months.

Critical Accounting Policies
Our significant accounting policies are summarized in the notes to our
financial statements. Some of the most critical policies are also discussed
below.

Revenue Recognition and Deferred
Revenue: The revenue from products and
systems sold is recognized upon shipment to the customer as we have no future
obligation for support, upgrades or other services. If the customer purchases
an extended maintenance contract, revenue from the contract is deferred and
recognized over the term of the contract.

Shipping and handling charges to customers are included in net sales. Shipping
and handling costs incurred by us are included in cost of goods sold.

Software Development Costs: Our policy on software development costs is to
charge to expense those costs of software development incurred until the point
of technical feasibility is attained, at which time such costs are capitalized.

Technical feasibility for our current products was attained several years ago,
before we were able to ascertain the market acceptance of the products. As a
result, we charged these costs to operations, as the net realizable value was
not determinable at that time. Costs in recent years have been comprised
primarily of maintenance and customer support, which have been charged to
operations. New product

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##### Table of Contents



development and/or significant product enhancements in the future may result in
an increased level of capitalized software costs.

Reserves and Review for
Impairment: As a matter of policy, we review our major
assets for impairment. Our major operating assets are accounts receivable,
inventory, license agreements and equipment and leasehold improvements. We
have not experienced significant bad debts expense and our reserve for doubtful
accounts of $55,000 should be adequate for any exposure to loss in our December
31, 2002 accounts receivable. We have also established reserves for slow
moving and obsolete inventories and believe the reserve of $165,000 is
adequate. We have also reserved $7,870,000, at December 31, 2002, for our
deferred tax assets as realization is uncertain until we have sustained
profitable operations.

We depreciate our property and equipment and license agreements over their
estimated useful lives, and we have not identified any items that are impaired
except for one license agreement for which we wrote off $49,000 in 2002 and
$45,000 in 2001.

Recently Issued Accounting Pronouncements
In June 2002, the Financial Accounting Standards Board (FASB) issued
Statement No. 146, Accounting for Costs Associated With Exit or Disposal
Activities. This statement requires the recognition of a liability for a cost
associated with an exit or disposal activity when the liability is incurred
versus the date the Company commits to an exit plan. In addition, this
statement states the liability should be initially measured at fair value. The
statement is effective for exit or disposal activities that are initiated after
December 31, 2002. The Company does not believe that the adoption of this
pronouncement will have a material effect on its financial statements.

In January 2003, the FASB issued Statement No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure. This statement provides alternative
methods of transition for a voluntary change to the fair value-based method of
accounting for stock-based employee compensation. In addition, this statement
also amends the disclosure requirements of SFAS No. 123 to require more
prominent and frequent disclosures in the financial statements about the
effects of stock-based compensation. The transitional guidance and annual
disclosure provisions of this statement are effective for the December 31,
2002, financial statements. The interim reporting disclosure requirements will
be effective for the Companys Form 10-QSB for the quarter ending March 31,
2003. Because the Company continues to account for employee stock-based
compensation under APB Opinion No. 25, the transitional guidance of Statement
No. 148 had no effect on the Companys financial statements. However, the
December 31, 2002, financial statements have incorporated the enhanced
disclosure requirements of Statement No. 148.

In January 2003, the FASB issued Interpretation No. 45 (FIN 45), Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others. FIN 45 clarifies that a guarantor is
required to recognize, at the inception of a guarantee, a liability for the
fair value of the obligation undertaken in issuing certain guarantees. It also
elaborates on the disclosures in FASB Statement No. 5, Accounting for
Contingencies, which are to be made by a guarantor in its interim and annual
financial statements about its obligations under certain guarantees that it has
issued, even when the likelihood of making any payments under the guarantees is
remote. The Company does not believe that the adoption of this pronouncement
will have a material effect on its financial statements. The December 31, 2002
financial statements have incorporated the enhanced disclosure requirements of
FIN 45, as discussed in Note 1 to the financial statements under the caption
product warranty.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities. This interpretation establishes
standards for identifying a variable interest entity and for determining under
what circumstances a variable interest entity should be consolidated with its
primary beneficiary. Until now, a company generally has included another entity
in its consolidated financial statements only if it controlled the entity
through voting interests. FIN 46 changes that by requiring a variable interest
entity to be consolidated by a company if that company is subject to a majority
of the risk

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##### Table of Contents



of loss from the variable interest entitys activities or is entitled to
receive a majority of the entitys residual returns or both. The disclosure
requirements of FIN 46 currently apply to the Company and the balance of the
requirements will apply to the Company as of the 3rd Quarter of 2003. The
Company does not believe that the adoption of this pronouncement will have a
material effect on its consolidated financial statements.

Outlook & Risks

Certain statements in this Annual Report are forward looking, are based upon
current expectations and actual results may differ materially due to certain
risks and uncertainties, including those set forth below.

Revenue: Revenue in the first quarter of 2003 is expected to be down
significantly from the $2,500,000 in the first quarter of 2002, but is expected
to increase gradually during the year. Revenue increases depend on customer
acceptance and demand of the Companys existing products as well as the new
Axis product, the effectiveness of the Companys marketing and sales
organization, as well as general business, economic and competitive conditions.

If a well-established company with much greater resources develops or begins to
aggressively market a competitive product, if new technology emerges that
surpasses that of the Company, or if similar technology is offered at a
significantly lower price, the Company could face significant competition
obstacles that would further negatively impact the Companys ability to meet
its revenue goals. Based on anticipated first quarter revenues, there is no
assurance that the Company will achieve its revenue plan.

Gross margins: A gradual improvement in gross profit margins during 2003 is
expected through effective material purchasing and additional contribution from
software applications being developed. Such an increase in gross margin depends
on achievement of the expected purchasing prices, realization of the revenue
increases, a continuation of improvement in manufacturing processes and general
market conditions.

The Companys gross profit margin will continue to be negatively impacted due
to the resale of certain products for which we do not act as a principal
supplier. Revenue, if any, from technology licensing fees would positively
impact revenue because they carry a very high margin. Less than 5 percent of
revenue in 2002 and 2001 arose from technology licensing fees.

On balance, therefore, the gross profit margin in 2003 may increase or decrease
depending on how significant revenue from resale of products becomes in
relation to technology licensing fees, and the extent to which we are
successful in achieving additional reductions in material costs.

Research and development, engineering and technical support: The Company
intends to reduce, by about 9 percent, funding for product development and
support activities in 2003 compared to the level in 2002. The ability to
maintain such funding depends in significant part on the Companys ability to
meet its 2003 revenue plan.

Marketing and sales, General and administrative: Marketing and sales expenses
are expected to decrease by about 7 percent in 2003 to bring overall expenses
in line with expected revenue and to conserve cash.

General and administrative expenses in 2003 are expected to decrease about 30
percent reflecting significant reductions in outside services, payroll and
employee benefits expenses.

Profit unlikely: The Companys goal is to gradually increase revenue and
tightly control expenses during the year so that there is a higher likelihood
of approaching profitability by year end, but the ability to achieve this goal
depends on significantly improved revenues in the remaining three quarters and
there is no assurance this will occur.

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Financial resources.In 2003, the Company plans to maintain expenditures for
product development, marketing activities and inventory levels to support
anticipated revenue growth. The Companys current plan estimates annual
revenue will increase modestly over the 2002 level. The Company believes its
working capital will be sufficient to fund its planned operations and product
development and promotional activities in 2003. If the Companys cash burn
rate is increased significantly as a result of a continued decrease in revenue,
the Company may be required to seek debt or equity financing prior to the end
of 2003. In this circumstance, the Companys ability to obtain financing of
any kind could be problematic, and its ability to fund its operations could be
materially adversely affected.

Change to Use of Calendar Quarters. During 2003, the Company has changed its
quarterly reporting cycle from 13-week intervals, more commonly employed by
manufacturing companies, to calendar quarters. The Company does not believe
the change in reported results will be material to quarterly results and will
not affect comparisons to results in previous quarters.




|        |  |                     
|------- |  | --------------------
|ITEM 7. |  | FINANCIAL STATEMENTS

The following financial statements of the Company are included herein
following the signature page of this Report on the pages set forth:

|                                                                              |  |  |     | 
|----------------------------------------------------------------------------- |  |  | --- | 
|Independent Auditors Report                                                  |  |  | F-1 | 
|Balance Sheets as of December 31, 2002 and 2001                               |  |  | F-2 | 
|Statements of Operations for Years Ended December 31, 2002 and 2001           |  |  | F-4 | 
|Statements of Stockholders Equity for Years Ended December 31,
2002 and 2001 |  |  | F-5 | 
|Statements of Cash Flows for Years Ended December 31, 2002 and 2001           |  |  | F-6 | 
|Notes to Financial Statements                                                 |  |  | F-7 | 




|        |  |                                                                                     
|------- |  | ------------------------------------------------------------------------------------
|ITEM 8. |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.




PART III




|        |  |                                                                                                                
|------- |  | ---------------------------------------------------------------------------------------------------------------
|ITEM 9. |  | DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS, COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT

The information required by Item 9 regarding the Companys directors and
executive officers is incorporated by reference to the Companys proxy
statement for its 2003 Annual Meeting of Shareholders under the captions
Determination of Number and Election of Directors and Executive Officers of
the Company. The Companys proxy statement will be filed pursuant to Rule
14a-3 within 120 days after the close of the fiscal year for which this report
is filed.

The information relating to compliance with Section 16(a) of the Exchange
Act is incorporated by reference to the Companys proxy statement for its 2003
Annual Meeting of Shareholders under the caption Section 16(a) Beneficial
Ownership Compliance.




|         |  |                       
|-------- |  | ----------------------
|ITEM 10. |  | EXECUTIVE COMPENSATION

The information required by Item 10 is incorporated by reference to the
Companys proxy statement for its 2003 Annual Meeting of Shareholders under the
caption Executive Compensation.

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|         |  |                                                               
|-------- |  | --------------------------------------------------------------
|ITEM 11. |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT

The information required by Item 11 with respect to security ownership of
certain individuals is incorporated by reference to the Companys proxy
statement for its 2003 Annual Meeting of Shareholders under the caption
Security Ownership of Management and Certain Beneficial Owners.

The following table provides information concerning the Companys equity
compensation plans as of December 31, 2002.

|                                                              |  |                       |           |                   |  |                          |      |                         |  |                      |         |    
|------------------------------------------------------------- |  | --------------------- | --------- | ----------------- |  | ------------------------ | ---- | ----------------------- |  | -------------------- | ------- | ---
|                                                              |  |                       |           |                   |  |                          |      |                         |  | Number of securities
|                                                              |  | Number of securities  |           |                   |  |                          |      | remaining available for
|                                                              |  | to be issued upon     |           | Weighted average  |  | future issuance under   
|                                                              |  | exercise of           |           | exercise price of |  | equity compensation     
|                                                              |  | outstanding           |           | outstanding       |  | plans                   
|                                                              |  | options, warrants and |           | options, warrants |  | (excluding securities   
|Plan Category                                                 |  | rights                |           | and rights        |  | reflected in column (a))
|                                                              |  |                       |           |                   |  |                         
|                                                              |  | (a)                   |           | (b)               |  | (c)                     
|                                                              |  |                       |           |                   |  |                         
|Equity compensation
plans approved by
security holders        |  |                       | 1,403,515 |                   |  | $                        | 3.51 |                         |  |                      | 416,173 | (2)
|Equity compensation
plans not approved
by security
holders(1) |  |                       | 35,000    |                   |  | $                        | 3.63 |                         |  |                      | 50,000  |    
|                                                              |  |                       |           |                   |  |                          |      |                         |  |                      |         |    
|TOTAL                                                         |  |                       | 1,438,515 |                   |  | $                        | 3.51 |                         |  |                      | 466,173 |    
|                                                              |  |                       |           |                   |  |                          |      |                         |  |                      |         |    



|(1) |  | The only plan not approved by the Companys shareholders is the 1994
Consultant Stock Option Plan (the Plan) adopted in 1994. The Plan
provides for the granting of stock options to distributors, consultants,
sales agents and dealers who are not employees of the Company, which
options can be granted with such terms as determined by the Board of
Directors. The only outstanding option under the Plan was granted at the
fair market value on the date of grant, became exercisable in three annual
increments and expires on October 31, 2005. No options have been granted
pursuant to the Plan since November 1995.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) |  | Includes 56,121 shares available
for issuance under the Company's 1998 Employee Stock Purchase Plan.
|--- |  | ----------------------------------------------------------------------------------------------------




|         |  |                                               
|-------- |  | ----------------------------------------------
|ITEM 12. |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by Item 12 is incorporated by reference to the
Companys proxy statement for its 2003 Annual Meeting of Shareholders under the
caption Certain Relationships and Related Transactions.




|         |  |                                 
|-------- |  | --------------------------------
|ITEM 13. |  | EXHIBITS AND REPORTS ON FORM 8-K



| | (a) |  | Exhibits.
| | --- |  | ---------

The following exhibits are included in this report: See Exhibit Index
immediately following the financial statements following the signature page of
this Form 10-KSB.



| | (b) |  | Reports on Form 8-K.
| | --- |  | --------------------

Datakey filed no reports on Form 8-K during the fourth quarter of 2002,
but it did file a Form 8-K dated March 3, 2003 announcing the resignation of
Carl Boecher as its President and Chief Executive Officer and the appointment
of Tim Russell as President and Chief Executive Officer.

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|         |  |                        
|-------- |  | -----------------------
|ITEM 14. |  | CONTROLS AND PROCEDURES

Within 90 days prior to the date of this report, we carried out an evaluation,
under the supervision and participation of management, including our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures. Based upon the
evaluation, our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures are effective in timely alerting
them to material information required to be included in our periodic SEC
filings. No significant change has occurred in the Companys internal controls
since the date of the evaluation that could significantly affect these controls
subsequent to the date of the evaluation.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Issuer has caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

|                      |  |               |  |                                                                                                
|--------------------- |  | ------------- |  | -----------------------------------------------------------------------------------------------
|Dated: March 26, 2003 |  | DATAKEY, INC.
|                      |  |               |  |                                                                                                
|                      |  | BY:           |  | /s/ Timothy L. Russell
Timothy L. Russell
Chief Executive Officer
(Principal Executive Officer)

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the Company, in
the capacities, and on the dates, indicated:

POWER OF ATTORNEY

Each person whose signature appears below constitutes and appoints Timothy
L Russell and Alan G. Shuler as his true and lawful attorneys-in-fact and
agents, each acting alone, with full power of substitution and re-substitution,
for him and in his name, place and stead, in any and all capacities, to sign
any or all amendments to this Annual Report on Form 10-KSB and to file the
same, with all exhibits thereto, and other documents in connection therewith,
with the Securities and Exchange Commission, granting unto said
attorneys-in-fact and agents, acting alone, full power and authority to do and
perform each and every act and thing requisite and necessary to be done in and
about the premises, as fully to all intents and purposes as he might or could
do in person, hereby ratifying and confirming said attorneys-in-fact and
agents, acting alone, or his substitute or substitutes, may lawfully do or
cause to be done by virtue thereof.

|                                            |  |                                                                                         |  |               
|------------------------------------------- |  | --------------------------------------------------------------------------------------- |  | --------------
|SIGNATURES                                  |  | TITLES                                                                                  |  | DATE          
|                                            |  |                                                                                         |  |               
|/s/ Timothy L. Russell
Timothy L. Russell   |  | Chief Executive Officer
(Principal Executive Officer)                                   |  | March 26, 2003
|                                            |  |                                                                                         |  |               
|/s/ Alan G. Shuler
Alan G. Shuler           |  | Vice President and Chief
Financial Officer (Principal
Financial and Accounting Officer) |  | March 26, 2003
|                                            |  |                                                                                         |  |               
|/s/ Thomas R. King
Thomas R. King           |  | Director and Secretary                                                                  |  | March 26, 2003
|                                            |  |                                                                                         |  |               
|/s/ Terrence W. Glarner
Terrence W. Glarner |  | Director                                                                                |  | March 26, 2003
|                                            |  |                                                                                         |  |               
|/s/ Carl P. Boecher
Carl P. Boecher         |  | Vice Chairman of the Board
of Directors                                                 |  | March 20, 2003
|                                            |  |                                                                                         |  |               
|/s/ Gary R. Holland
Gary R. Holland         |  | Chairman of the Board of
Directors                                                      |  | March 20, 2003
|                                            |  |                                                                                         |  |               
|/s/ Eugene W. Courtney
Eugene W. Courtney   |  | Director                                                                                |  | March 26, 2003

2747866-6

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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

In connection with this Annual Report of Datakey, Inc. Inc. (the
Company) on Form 10-KSB for the year ended December 31, 2002 as filed with
the Securities and Exchange Commission (the Report), I, Timothy L. Russell,
Chief Executive Officer of the Company, certify, pursuant to §302(a) of the
Sarbanes-Oxley Act of 2002 and related rules, that:



|1. |  | I have reviewed this annual report on Form 10-KSB of Datakey, Inc. for
the period ended December 31, 2002;                                                                                                                                                                                                                                                                     
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this annual report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to
make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by
this annual report;                                                       
|  
|3. |  | Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of
the Company as of, and for, the periods presented in this annual report;                                                                             
|  
|4. |  | The Companys other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d -14) for the Company and
have:                                                                                                                                                               
|  
|   |  | a) designed such disclosure controls and procedures to ensure that material
information relating to the Company, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;                                                                                   
|   |  | b) evaluated the effectiveness of the Companys disclosure controls and
procedures as of a date within 90 days prior to the filing date of the
annual report (the Evaluation Date);                                                                                                                                                                                          
|   |  | c) presented in this annual report our conclusions about the effectiveness
of the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;                                                                                                                                                                                                        
|  
|5. |  | The Companys other certifying officer and I have disclosed, based on our
most recent evaluation, to the Companys auditors and the audit committee
of the Companys board of directors:                                                                                                                                                                                       
|  
|   |  | a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Companys ability to record,
process, summarize and report financial data and have identified for the
Companys auditors any material weaknesses in internal controls; and                                                                                    
|   |  | b) any fraud, whether or not material, that involves management or other
employees which have a significant role in the Companys internal controls;
and                                                                                                                                                                                                                       
|  
|6. |  | The Companys other certifying officer and I have indicated in this
annual report whether there were significant changes in the internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation, including
any corrective actions with regard to significant deficiencies and
material weaknesses.

| |                      |  |            |  |                                                                  
| | -------------------- |  | ---------- |  | -----------------------------------------------------------------
| | Date: March 26, 2003 |  | Signature: |  | /s/ Timothy L. Russell
Timothy L. Russell
Chief Executive Officer

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CERTIFICATION OF CHIEF FINANCIAL OFFICER

In connection with this Annual Report of Datakey, Inc. Inc. (the
Company) on Form 10-KSB for the year ended December 31, 2002 as filed with
the Securities and Exchange Commission (the Report), I, Alan G. Shuler, Chief
Financial Officer of the Company, certify, pursuant to §302(a) of the
Sarbanes-Oxley Act of 2002 and related rules, that:



|1. |  | I have reviewed this annual report on Form 10-KSB of Datakey, Inc.
for the period ended December 31, 2002;                                                                                                                                                                                                                                                                     
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|  
|2. |  | Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this annual report;                                                       
|  
|3. |  | Based on my knowledge, the financial statements, and other
financial information included in this annual report, fairly present in
all material respects the financial condition, results of operations
and cash flows of the Company as of, and for, the periods presented in
this annual report;                                                                             
|  
|4. |  | The Companys other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d -14) for the Company and
have:                                                                                                                                                               
|  
|   |  | a) designed such disclosure controls and procedures to ensure that
material information relating to the Company, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this annual report is being
prepared;                                                                                   
|   |  | b) evaluated the effectiveness of the Companys disclosure controls and
procedures as of a date within 90 days prior to the filing date of the
annual report (the Evaluation Date);                                                                                                                                                                                          
|   |  | c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;                                                                                                                                                                                                        
|  
|5. |  | The Companys other certifying officer and I have disclosed, based
on our most recent evaluation, to the Companys auditors and the audit
committee of the Companys board of directors:                                                                                                                                                                                       
|  
|   |  | a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the Companys ability to record,
process, summarize and report financial data and have identified for the
Companys auditors any material weaknesses in internal controls; and                                                                                    
|   |  | b) any fraud, whether or not material, that involves management or other
employees which have a significant role in the Companys internal
controls; and                                                                                                                                                                                                                       
|  
|6. |  | The Companys other certifying officer and I have indicated in this
annual report whether there were significant changes in the internal
controls or in other factors that could significantly affect internal
controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.

| |                      |  |            |  |                                                          
| | -------------------- |  | ---------- |  | ---------------------------------------------------------
| | Date: March 26, 2003 |  | Signature: |  | /s/ Alan G. Shuler
Alan G. Shuler
Chief Financial Officer

-19-



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(MCGLADREY & PULLEN CERTIFIED PUBLIC ACCOUNTANTS)

INDEPENDENT AUDITORS REPORT

To the Stockholders
Datakey, Inc.
Burnsville, Minnesota

We have audited the accompanying balance sheets of Datakey, Inc. as of December
31, 2002 and 2001, and the related statements of operations, stockholders
equity and cash flows for the years then ended. These financial statements are
the responsibility of the Companys management. Our responsibility is to
express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Datakey, Inc. as of December
31, 2002 and 2001, and the results of its operations and its cash flows for the
years then ended, in conformity with accounting principles generally accepted
in the United States of America.



/s/  McGladrey & Pullen, LLP

Minneapolis, Minnesota
January 31, 2003



McGladrey & Pullen, LLP is an independent member firm of
RSM International, an affiliation of independent accounting
and consulting firms.

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DATAKEY, INC.

BALANCE SHEETS
December 31, 2002 and 2001

|                                              |                                                                                                         |                      |           |           |           |   |           |           |           | 
|--------------------------------------------- | ------------------------------------------------------------------------------------------------------- | -------------------- | --------- | --------- | --------- | - | --------- | --------- | --------- | 
|ASSETS                                        |                                                                                                         | 2002                 |           | 2001     
|                                              |                                                                                                         |                      |           |          
|Current Assets                                |                                                                                                         |                      |           |           |           |   |           |          
|                                              | Cash and cash equivalents                                                                               |                      | $         | 2,562,611 |           |   | $         | 4,112,264 |          
|                                              | Trade receivables, less allowance for doubtful accounts of $55,000
in 2002 and $28,000 in 2001 (Note 6) |                      |           | 1,700,434 |           |   |           | 2,154,723 |          
|                                              | Inventories (Note 2)                                                                                    |                      |           | 996,532   |           |   |           | 926,028   |          
|                                              | Prepaid expenses and other                                                                              |                      |           | 65,259    |           |   |           | 84,433    |          
|                                              | Net assets of discontinued operations (Note 9)                                                          |                      |           |          |           |   |           | 82,077    |          
|                                              |                                                                                                         |                      |           |           |           |   |           |           |          
|                                              |                                                                                                         | Total current assets |           |           | 5,324,836 |   |           |           | 7,359,525 | 
|                                              |                                                                                                         |                      |           |           |           |   |           |          
|Other Assets                                  |                                                                                                         |                      |           |           |           |   |           |          
|                                              | Licenses, less accumulated amortization (Note 10)                                                       |                      |           | 236,817   |           |   |           | 191,839   |          
|                                              |                                                                                                         |                      |           |           |           |   |           |          
|Equipment and Leasehold Improvements, at cost |                                                                                                         |                      |           |           |           |   |           |          
|                                              | Production tooling                                                                                      |                      |           | 23,650    |           |   |           | 209,752   |          
|                                              | Equipment                                                                                               |                      |           | 735,916   |           |   |           | 671,221   |          
|                                              | Furniture and fixtures                                                                                  |                      |           | 166,520   |           |   |           | 166,520   |          
|                                              | Leasehold improvements                                                                                  |                      |           | 310,912   |           |   |           | 146,812   |          
|                                              |                                                                                                         |                      |           |           |           |   |           |           |          
|                                              |                                                                                                         |                      | 1,236,998 |           |           |   | 1,194,305 |          
|                                              | Less accumulated depreciation                                                                           |                      |           | 927,844   |           |   |           | 803,548   |          
|                                              |                                                                                                         |                      |           |           |           |   |           |          
|                                              |                                                                                                         |                      | 309,154   |           |           |   | 390,757   |          
|                                              |                                                                                                         |                      |           |           |           |   |           |          
|                                              |                                                                                                         | $                    | 5,870,807 |           |           | $ | 7,942,121 |          
|                                              |                                                                                                         |                      |           |           |           |   |           |          

See Notes to Financial Statements.

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|                                                  |                                                                                                                                                      |              |                           |             |         |           |           |             |         |           | 
|------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------- | ------------ | ------------------------- | ----------- | ------- | --------- | --------- | ----------- | ------- | --------- | 
|LIABILITIES AND STOCKHOLDERS' EQUITY              |                                                                                                                                                      | 2002         |                           | 2001       
|                                                  |                                                                                                                                                      |              |                           |            
|Current Liabilities                               |                                                                                                                                                      |              |                           |             |         |           |           |            
|                                                  | Accounts payable                                                                                                                                     |              | $                         | 574,266     |         |           | $         | 566,345     |        
|                                                  | Accrued expenses:                                                                                                                                    |              |                           |             |         |           |           |             |        
|                                                  |                                                                                                                                                      | Compensation |                           |             | 287,718 |           |           |             | 313,098 |          
|                                                  |                                                                                                                                                      | Other        |                           |             | 154,267 |           |           |             | 118,119 |          
|                                                  | Deferred revenue                                                                                                                                     |              |                           | 355,338     |         |           |           | 474,897     |        
|                                                  |                                                                                                                                                      |              |                           |             |         |           |           |             |        
|                                                  |                                                                                                                                                      |              | Total current liabilities |             |         | 1,371,589 |           |             |         | 1,472,459 | 
|                                                  |                                                                                                                                                      |              |                           |             |         |           |           |            
|                                                 
|Commitments and Contingencies (Notes 7, 9 and 10) |                                                                                                                                                      |              |                           |             |         |           |           |            
|                                                 
|                                                 
|Stockholders Equity (Notes 4 and 5)              |                                                                                                                                                      |              |                           |             |         |           |           |            
|                                                  | Convertible preferred stock, voting, liquidation value $2.50 per share;
authorized 400,000 shares; issued and outstanding 150,000 shares             |              |                           | 375,000     |         |           |           | 375,000     |        
|                                                  | Common stock, par value $0.05 per share; authorized 20,000,000
shares; issued and outstanding 10,082,750 shares in 2002 and
9,974,012 shares in 2001 |              |                           | 504,138     |         |           |           | 498,701     |        
|                                                  | Additional paid-in capital                                                                                                                           |              |                           | 18,921,150  |         |           |           | 18,580,288  |        
|                                                  | Accumulated deficit                                                                                                                                  |              |                           | (15,301,070 | )       |           |           | (12,984,327 | )      
|                                                  |                                                                                                                                                      |              |                           |             |         |           |           |            
|                                                  |                                                                                                                                                      |              | 4,499,218                 |             |         |           | 6,469,662 |            
|                                                  |                                                                                                                                                      |              |                           |             |         |           |           |            
|                                                  |                                                                                                                                                      | $            | 5,870,807                 |             |         | $         | 7,942,121 |            
|                                                  |                                                                                                                                                      |              |                           |             |         |           |           |            

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DATAKEY, INC.

STATEMENTS OF OPERATIONS
Years Ended December 31, 2002 and 2001

|                                  |                                                             |                                                     |           |            |            |      |           |           |            |  
|--------------------------------- | ----------------------------------------------------------- | --------------------------------------------------- | --------- | ---------- | ---------- | ---- | --------- | --------- | ---------- | -
|                                  |                                                             |                                                     |           | 2002       |            | 2001
|                                  |                                                             |                                                     |           |            |            |     
|Net sales (Note 6)                |                                                             | $                                                   | 7,257,109 |            |            | $    | 7,814,850 |          
|                                  |                                                             |                                                     |           |            |            |      |           |          
|Costs and expenses:               |                                                             |                                                     |           |            |            |      |           |          
|                                  | Cost of goods sold                                          |                                                     |           | 3,601,347  |            |      |           | 3,369,483 |           
|                                  | Research and development, engineering and technical support |                                                     |           | 2,314,391  |            |      |           | 2,325,037 |           
|                                  | Marketing and sales                                         |                                                     |           | 3,346,501  |            |      |           | 3,460,675 |           
|                                  | General and administrative                                  |                                                     |           | 707,296    |            |      |           | 744,335   |           
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Total costs and expenses                            |           |            | 9,969,535  |      |           |           | 9,899,530  |  
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Operating loss                                      |           |            | (2,712,426 | )    |           |           | (2,084,680 | )
|Interest income                   |                                                             |                                                     | 44,637    |            |            |      | 109,028   |          
|Interest expense                  |                                                             |                                                     |          |            |            |      | (30,096   | )        
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Loss from continuing operations before income taxes |           |            | (2,667,789 | )    |           |           | (2,005,748 | )
|Income tax expense (Note 3)       |                                                             |                                                     |          |            |            |      |          |          
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Net loss from continuing operations                 |           |            | (2,667,789 | )    |           |           | (2,005,748 | )
|                                  |                                                             |                                                     |           |            |            |      |           |          
|Discontinued operations (Note 9): |                                                             |                                                     |           |            |            |      |           |          
|                                  | Gain (loss) on disposal of discontinued segment             |                                                     |           | 351,046    |            |      |           | (487,045  | )         
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Gain (loss) from discontinued operations            |           |            | 351,046    |      |           |           | (487,045   | )
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Net loss                                            |           | $          | (2,316,743 | )    |           | $         | (2,492,793 | )
|                                  |                                                             |                                                     |           |            |            |      |           |          
|Loss per share:                   |                                                             |                                                     |           |            |            |      |           |          
|                                  | Basic and diluted loss from continuing operations           |                                                     | $         | (0.26      | )          |      | $         | (0.21     | )         
|                                  | Basic and diluted gain (loss) from discontinued operations  |                                                     |           | 0.03       |            |      |           | (0.05     | )         
|                                  |                                                             |                                                     |           |            |            |      |           |          
|                                  |                                                             | Basic and diluted loss per common share             |           | $          | (0.23      | )    |           | $         | (0.26      | )
|                                  |                                                             |                                                     |           |            |            |      |           |          
|Weighted-average common shares:   |                                                             |                                                     |           |            |            |      |           |          
|                                  | Basic and diluted                                           |                                                     |           | 10,074,871 |            |      |           | 9,714,002 |           
|                                  |                                                             |                                                     |           |            |            |      |           |          

See Notes to Financial Statements.

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DATAKEY, INC.

STATEMENTS OF STOCKHOLDERS EQUITY
Years Ended December 31, 2002 and 2001

|                           |                                                                                   |  |                 |   |              |   |            |   |             |  |            |           |         |   |         |        |  |   |            |           |  |   |             |            |   |   |           |            |  
|-------------------------- | --------------------------------------------------------------------------------- |  | --------------- | - | ------------ | - | ---------- | - | ----------- |  | ---------- | --------- | ------- | - | ------- | ------ |  | - | ---------- | --------- |  | - | ----------- | ---------- | - | - | --------- | ---------- | -
|                           |                                                                                   |  | Convertible     |   |              |   |            |   |             |  |            |           |         |   |         |        |  |   |            |           |  |   |            
|                           |                                                                                   |  | Preferred Stock |   | Common Stock |   | Additional |   |             |  |            |           |         |   |        
|                           |                                                                                   |  |                 |   |              |   | Paid-In    |   | Accumulated |  |            |           |        
|                           |                                                                                   |  | Shares          |   | Amount       |   | Shares     |   | Amount      |  | Capital    |           | Deficit |   | Total  
|                           |                                                                                   |  |                 |   |              |   |            |   |             |  |            |           |         |   |        
|Balance, December 31, 2000 |                                                                                   |  | 150,000         |   |              | $ | 375,000    |   |             |  | 8,269,173  |           |         | $ | 413,459 |        |  | $ | 13,906,744 |           |  | $ | (10,491,534 | )          |   | $ | 4,203,669 |           
|                           | Issuance of common stock (net of offering expenses of $297,066)                   |  |                 |  |              |   |            |  |             |  |            | 1,601,633 |         |   |         | 80,082 |  |   |            | 4,414,505 |  |   |             |           |   |   |           | 4,494,587  |  
|                           | Exercise of stock options                                                         |  |                 |  |              |   |            |  |             |  |            | 87,840    |         |   |         | 4,392  |  |   |            | 210,916   |  |   |             |           |   |   |           | 215,308    |  
|                           | Issuance of common stock in accordance with employee stock
purchase plan (Note 5) |  |                 |  |              |   |            |  |             |  |            | 15,366    |         |   |         | 768    |  |   |            | 40,874    |  |   |             |           |   |   |           | 41,642     |  
|                           | Compensation expense from stock options                                           |  |                 |  |              |   |            |  |             |  |            |          |         |   |         |       |  |   |            | 7,249     |  |   |             |           |   |   |           | 7,249      |  
|                           | Net loss                                                                          |  |                 |  |              |   |            |  |             |  |            |          |         |   |         |       |  |   |            |          |  |   |             | (2,492,793 | ) |   |           | (2,492,793 | )
|                           |                                                                                   |  |                 |   |              |   |            |   |             |  |            |           |         |   |         |        |  |   |            |           |  |   |             |            |   |   |           |           
|Balance, December 31, 2001 |                                                                                   |  | 150,000         |   |              |   | 375,000    |   |             |  | 9,974,012  |           |         |   | 498,701 |        |  |   | 18,580,288 |           |  |   | (12,984,327 | )          |   |   | 6,469,662 |           
|                           | Exercise of stock options                                                         |  |                 |  |              |   |            |  |             |  |            | 6,667     |         |   |         | 333    |  |   |            | 9,667     |  |   |             |           |   |   |           | 10,000     |  
|                           | Exercise of warrants                                                              |  |                 |  |              |   |            |  |             |  |            | 80,268    |         |   |         | 4,014  |  |   |            | 272,109   |  |   |             |           |   |   |           | 276,123    |  
|                           | Issuance of common stock in accordance with employee stock
purchase plan (Note 5) |  |                 |  |              |   |            |  |             |  |            | 21,803    |         |   |         | 1,090  |  |   |            | 59,086    |  |   |             |           |   |   |           | 60,176     |  
|                           | Net loss                                                                          |  |                 |  |              |   |            |  |             |  |            |          |         |   |         |       |  |   |            |          |  |   |             | (2,316,743 | ) |   |           | (2,316,743 | )
|                           |                                                                                   |  |                 |   |              |   |            |   |             |  |            |           |         |   |         |        |  |   |            |           |  |   |             |            |   |   |           |           
|Balance, December 31, 2002 |                                                                                   |  | 150,000         |   |              | $ | 375,000    |   |             |  | 10,082,750 |           |         | $ | 504,138 |        |  | $ | 18,921,150 |           |  | $ | (15,301,070 | )          |   | $ | 4,499,218 |           
|                           |                                                                                   |  |                 |   |              |   |            |   |             |  |            |           |         |   |         |        |  |   |            |           |  |   |             |            |   |   |           |           

See Notes to Financial Statements.

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DATAKEY, INC.

STATEMENTS OF CASH FLOWS
Years Ended December 31, 2002 and 2001

|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |            |            |           |            |  
|----------------------------------------- | --------------------------------------------------------------------------- | ------------------------------------------------------- | ----------------- | --------------------------------------------------- | ------- | -------- | ---------- | ---------- | ---------- | --------- | ---------- | -
|                                          |                                                                             |                                                         |                   |                                                     |         | 2002     |            | 2001      
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           
|Cash Flows From Operating Activities      |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          | Net loss                                                                    |                                                         | $                 | (2,316,743                                          | )       |          | $          | (2,492,793 | )         
|                                          | Adjustments to reconcile net loss to net cash used in operating activities: |                                                         |                   |                                                     |         |          |            |            |           
|                                          |                                                                             | Depreciation                                            |                   |                                                     | 170,528 |          |            |            | 233,403    |          
|                                          |                                                                             | Amortization                                            |                   |                                                     | 182,847 |          |            |            | 415,934    |          
|                                          |                                                                             | Utilization of reserve for loss of discontinued segment |                   |                                                     |        |          |            |            | (1,281,000 | )        
|                                          |                                                                             | Loss on disposal of equipment                           |                   |                                                     | 682     |          |            |            | 144,146    |          
|                                          |                                                                             | Noncash compensation from stock options                 |                   |                                                     |        |          |            |            | 7,249      |          
|                                          |                                                                             | Changes in assets and liabilities:                      |                   |                                                     |         |          |            |            |            |          
|                                          |                                                                             |                                                         | Trade receivables |                                                     |         | 536,366  |            |            |            | (749,499  | )         
|                                          |                                                                             |                                                         | Inventories       |                                                     |         | (70,504  | )          |            |            | 1,035,306 |           
|                                          |                                                                             |                                                         | Prepaid expenses  |                                                     |         | 19,174   |            |            |            | 28,743    |           
|                                          |                                                                             |                                                         | Accounts payable  |                                                     |         | 7,921    |            |            |            | (177,808  | )         
|                                          |                                                                             |                                                         | Deferred revenue  |                                                     |         | (119,559 | )          |            |            | 411,100   |           
|                                          |                                                                             |                                                         | Other             |                                                     |         | 10,768   |            |            |            | 7,048     |           
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |            |           
|                                          |                                                                             |                                                         |                   | Net cash used in operating activities               |         |          | (1,578,520 | )          |            |           | (2,418,171 | )
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           
|Cash Flows From Investing Activities      |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          | Purchases of equipment                                                      |                                                         |                   | (89,607                                             | )       |          |            | (271,390   | )         
|                                          | Proceeds on sale of segment                                                 |                                                         |                   |                                                    |         |          |            | 550,000    |           
|                                          | Proceeds on sale of equipment                                               |                                                         |                   |                                                    |         |          |            | 3,730      |           
|                                          | Purchased licenses                                                          |                                                         |                   | (227,825                                            | )       |          |            | (36,000    | )         
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          |                                                                             |                                                         |                   | Net cash provided by (used in) investing activities |         |          | (317,432   | )          |            |           | 246,340    |  
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           
|Cash Flows From Financing Activities      |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          | Net proceeds from issuance of common stock                                  |                                                         |                   | 346,299                                             |         |          |            | 4,751,537  |           
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          |                                                                             |                                                         |                   | Increase (decrease) in cash and cash equivalents    |         |          | (1,549,653 | )          |            |           | 2,579,706  |  
|Cash and Cash Equivalents                 |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          | Beginning                                                                   |                                                         |                   | 4,112,264                                           |         |          |            | 1,532,558  |           
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |            |           
|                                          | Ending                                                                      |                                                         | $                 | 2,562,611                                           |         |          | $          | 4,112,264  |           
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           
|Supplemental Disclosures of Noncash Items |                                                                             |                                                         |                   |                                                     |         |          |            |           
|                                          | Cash paid for interest                                                      |                                                         | $                 |                                                    |         |          | $          | 30,096     |           
|                                          |                                                                             |                                                         |                   |                                                     |         |          |            |           

See Notes to Financial Statements.

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Business and Significant Accounting Policies

Nature of business:Datakey, Inc. provides products and systems directed to the
information security market, which enables user identification and
authentication, secure data exchange and information validation. The Company
discontinued a segment (Note 9) which provided electronic products, consisting
of proprietary memory keys, cards and other custom-shaped tokens, that served
as a convenient way to carry electronic information and were packaged to
survive in portable environments. The Company has a wholly owned subsidiary
which is inactive.

A summary of significant accounting policies follows:

Use of estimates:The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.

Cash and cash equivalents:For purposes of reporting in the statements of cash
flows, the Company includes all cash accounts and all highly liquid debt
instruments purchased with an original maturity of three months or less as cash
and cash equivalents on the accompanying balance sheets.

The Company maintains its cash in bank deposit accounts, which, at times, may
exceed federally insured limits. The Company has not experienced any losses in
such accounts.

Trade receivables:Trade receivables are carried at original invoice amount
less an estimate made for doubtful receivables based on a review of all
outstanding amounts on a quarterly basis. Management determines the allowance
for doubtful accounts by identifying troubled accounts and by using historical
experience applied to an aging of accounts. Trade receivables are written off
when deemed uncollectible. Recoveries of trade receivables previously written
off are recorded when received.

A trade receivable is considered to be past due if any portion of the
receivable balance is outstanding for more than 60 days.

Inventories:Inventories are stated at the lower of cost (first-in, first-out
method) or market.

Depreciation:Depreciation of equipment and leasehold improvements is computed
on the straight-line and accelerated methods over the following estimated
useful lives:

|                       |  |               |     | 
|---------------------- |  | ------------- | --- | 
|                       |  | Years        
|                       |  |              
|Production tooling     |  |               | 2-5 | 
|Equipment              |  |               | 3-7 | 
|Furniture and fixtures |  |               | 7   | 
|Leasehold improvements |  | Life of lease

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Business and Significant Accounting Policies (Continued)

Income taxes:Deferred taxes are provided on an asset and liability method
whereby deferred tax assets are recognized for deductible temporary differences
and operating loss or tax credit carryforwards, and deferred tax liabilities
are recognized for taxable temporary differences. Temporary differences are the
differences between the amounts of assets and liabilities recorded for income
tax and financial reporting purposes. Deferred tax assets are reduced by a
valuation allowance when management determines that it is more likely than not
that some portion or all of the deferred tax assets will not be realized.
Deferred tax assets and liabilities are adjusted for the effects of changes in
tax laws and rates on the date of enactment.

Revenue recognition and deferred revenue:The revenue from products and systems
sold by the information security business segment is recognized upon shipment
to the customer, as the Company has no future obligation for support, upgrades
or other services. If the customer purchases an extended maintenance contract,
revenue from the contract is deferred and recognized over the term of the
contract.

The revenue from products sold by the electronic products business segment is
recognized upon shipment, FOB shipping point. This segment, now discontinued,
fulfilled its last contract in 2002.

Shipping and handling charges to customers are included in net sales. Shipping
and handling costs incurred by the Company are included in cost of goods sold.

Software development costs:The Companys policy is to charge to expense those
costs of software development incurred until the point of technical feasibility
is attained, at which time such costs are capitalized.

Technical feasibility for the Companys current products was attained several
years ago, before the Company was able to ascertain the market acceptance of
the products. As a result, the Company charged these costs to operations, as
the net realizable value was not determinable at that time. Costs in recent
years have been comprised primarily of maintenance and customer support, which
have been charged to operations. Company plans for new product development
and/or significant product enhancements in the future may result in an
increased level of capitalized software costs.

Research and development, engineering and technical support:Research and
development costs, engineering and technical support are charged to expense as
incurred and consist primarily of engineering expenses related to product
development. Engineering and technical support consist primarily of maintenance
of the Companys products and systems. Research and development costs were
approximately $1,903,000 and $1,972,000 during 2002 and 2001, respectively.

Advertising:Expenditures for advertising costs are expensed as incurred.
Advertising and product promotion expense was approximately $106,000 and
$83,000 during 2002 and 2001, respectively.

Fair value of financial instruments:The Companys financial instruments
consist of cash and cash equivalents and short-term trade receivables and
payables for which current carrying amounts approximate fair value.

Loss per share:The Company computes basic and diluted net loss per share based
upon the weighted-average number of common shares outstanding during each year.
Potential common shares, such as options and warrants, were not included in the
computation of diluted loss per common share since their effect would be
anti-dilutive. Due to the losses from continuing operations in 2002 and 2001,
basic and diluted loss per share were the same for both years.

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Business and Significant Accounting Policies (Continued)

Recent accounting pronouncements:In April 2002, the FASB issued Statement No.
145, Rescission of FASB Statements No. 4, 44, and 64, Amendments of FASB
Statement No. 13, and Technical Corrections.The Company does not believe that
the adoption of the pronouncement will have a material effect on its financial
statements.

In June 2002, the FASB issued Statement No. 146, Accounting for Costs
Associated With Exit or Disposal Activities.This statement requires the
recognition of a liability for a cost associated with an exit or disposal
activity when the liability is incurred versus the date the Company commits to
an exit plan. In addition, this statement states the liability should be
initially measured at fair value. The statement is effective for exit or
disposal activities that are initiated after December 31, 2002. The Company
does not believe that the adoption of this pronouncement will have a material
effect on its financial statements.

In January 2003, the FASB issued Statement No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure.This statement provides alternative
methods of transition for a voluntary change to the fair value-based method of
accounting for stock-based employee compensation. In addition, this statement
also amends the disclosure requirements of Statement No. 123 to require more
prominent and frequent disclosures in the financial statements about the
effects of stock-based compensation. The transitional guidance and annual
disclosure provisions of the statement is effective for the December 31, 2002,
financial statements. The interim reporting disclosure requirements will be
effective for the Companys March 31, 2003, 10-QSB. Because the Company
continues to account for employee stock-based compensation under APB Opinion
No. 25, the transitional guidance of Statement No. 148 has no effect on the
financial statements at this time. However, the December 31, 2002, financial
statements have incorporated the enhanced disclosure requirements of Statement
No. 148, as presented below under the caption Stock-based compensation.

In January 2003, the Financial Accounting Standards Board issued Interpretation
No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees,
Including Indirect Guarantees of Indebtedness of Others. FASB Interpretation
No. 45 clarifies that a guarantor is required to recognize, at the inception of
a guarantee, a liability for the fair value of the obligation undertaken in
issuing certain guarantees. The December 31, 2002, financial statements have
incorporated the enhanced disclosure requirements of Interpretation No. 45, as
presented in Note 1 to the financial statements under the caption Product
warranty. The Company does not anticipate that this interpretation will have
other effects on the financial statements.

In January 2003, the Financial Accounting Standards Board issued Interpretation
No. 46, Consolidation of Variable Interest Entities. This interpretation
establishes standards for identifying a variable interest entity and for
determining under what circumstances a variable interest entity should be
consolidated with its primary beneficiary and where additional disclosures
about such entities should be made. Until now, a company generally has included
another entity in its consolidated financial statements only if it controlled
the entity through voting interests. Interpretation No. 46 changes that by
requiring a variable interest entity to be consolidated by a company if that
company is subject to a majority of the risk of loss from the variable interest
entitys activities or is entitled to receive a majority of the entitys
residual returns or both. The requirements of Interpretation No. 46 will apply
to the Company for its quarter ending September 30, 2003. The Company does not
believe that the adoption of this pronouncement will have a material effect on
its financial statements.

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Business and Significant Accounting Policies (Continued)

Stock-based compensation:The Company regularly grants options to its employees
under various plans as described below. As permitted under accounting
principles generally accepted in the United States of America, these grants are
accounted for following APB Opinion No. 25 and related interpretations.
Accordingly, compensation cost has been recognized for those grants whose
exercise price is less than the fair market value of the stock on the date of
grant. There was no compensation expense recorded for employee grants for the
year ended December 31, 2002. Compensation expense recorded for employee grants
for the year ended December 31, 2001, was $7,249.

The Company also grants options and warrants to nonemployees for goods and
services and in conjunction with certain agreements. These grants are accounted
for under FASB Statement No. 123 based on the grant date fair values.

Had compensation cost for all of the stock-based compensation grants and
warrants issued been determined based on the fair values at the grant date
consistent with the provisions of Statement No. 123, the Companys net loss and
net loss per basic and diluted common share would have been as indicated below.

|                                                                                                                   |  |                         |            |      |  |   |            |  
|------------------------------------------------------------------------------------------------------------------ |  | ----------------------- | ---------- | ---- |  | - | ---------- | -
|                                                                                                                   |  | Years Ended December 31
|                                                                                                                   |  |                        
|                                                                                                                   |  | 2002                    |            | 2001
|                                                                                                                   |  |                         |            |     
|Net loss, as reported                                                                                              |  | $                       | (2,316,743 | )    |  | $ | (2,492,793 | )
|Deduct total stock-based employee compensation expense
determined under the fair value-based method for all awards |  |                         | (747,322   | )    |  |   | (699,141   | )
|                                                                                                                   |  |                         |            |      |  |   |            |  
|Net loss, pro forma                                                                                                |  | $                       | (3,064,065 | )    |  |   | (3,191,934 | )
|                                                                                                                   |  |                         |            |      |  |   |            |  
|Basic and diluted loss per share, as reported                                                                      |  | $                       | (0.23      | )    |  | $ | (0.26      | )
|Basic and diluted loss per share, pro forma                                                                        |  |                         | (0.30      | )    |  |   | (0.33      | )

The above pro forma effects on net loss and net loss per basic and diluted
common share are not likely to be representative of the effects on reported net
loss or net loss per common share for future years because options vest over
several years and additional awards generally are made each year.

Product warranty:The Company provides a limited 90-day warranty for the
replacement of defective products. The Companys standard warranty policy
requires the Company to repair or replace defective products at no cost to its
customers. The Company estimates the costs that may be incurred under its basic
limited warranty and records a liability in the amount of such costs at the
time product revenue is recognized. Factors that affect the Companys warranty
liability include the number of units sold, historical and anticipated rates of
warranty claims, and cost per claim. The Company periodically assesses the
adequacy of its recorded warranty liabilities and adjusts the amounts as
necessary. The Company utilizes historical trends and information received from
its customers to assist in determining the appropriate loss reserve levels.

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 1. Nature of Business and Significant Accounting Policies (Continued)

Changes in the Companys warranty liability are as follows:

|                   |                                                                                 |   |                         |         |      |   |        |      |  
|------------------ | ------------------------------------------------------------------------------- | - | ----------------------- | ------- | ---- | - | ------ | ---- | -
|                   |                                                                                 |   | Years Ended December 31
|                   |                                                                                 |   |                        
|                   |                                                                                 |   | 2002                    |         | 2001
|                   |                                                                                 |   |                         |         |     
|Balance, beginning |                                                                                 | $ | 26,894                  |         |      | $ | 27,872 |     
|                   | Reduction of accrual to estimated required amount based upon
current experience |   |                         | (20,000 | )    |   |        |     |  
|                   | Payments made                                                                   |   |                         | (2,719  | )    |   |        | (978 | )
|                   |                                                                                 |   |                         |         |      |   |        |     
|Balance, ending    |                                                                                 | $ | 4,175                   |         |      | $ | 26,894 |     
|                   |                                                                                 |   |                         |         |      |   |        |     

Note 2. Inventories

Inventories consist of the following components as of December 31, 2002 and
2001:

|                               |  |      |          |      |  |   |          |  
|------------------------------ |  | ---- | -------- | ---- |  | - | -------- | -
|                               |  | 2002 |          | 2001
|                               |  |      |          |     
|Raw materials                  |  | $    | 585,743  |      |  | $ | 764,249  |  
|Work in process                |  |      | 22,024   |      |  |   | 19,193   |  
|Finished goods                 |  |      | 553,417  |      |  |   | 327,873  |  
|Inventory obsolescence reserve |  |      | (164,652 | )    |  |   | (185,287 | )
|                               |  |      |          |      |  |   |          |  
|                               |  | $    | 996,532  |      |  | $ | 926,028  |  
|                               |  |      |          |      |  |   |          |  

Note 3. Income Taxes

The income tax benefit is different from that which would be computed by
applying the U.S. federal income tax rate (35 percent) to pretax loss as
follows:

|                                                           |  |             |          |      |  |   |          |  
|---------------------------------------------------------- |  | ----------- | -------- | ---- |  | - | -------- | -
|                                                           |  | December 31
|                                                           |  |            
|                                                           |  | 2002        |          | 2001
|                                                           |  |             |          |     
|Computed expected federal tax benefit at statutory rates |  | $           | (811,000 | )    |  | $ | (872,000 | )
|Effect of net operating loss with no current benefit       |  |             | 811,000  |      |  |   | 872,000  |  
|                                                           |  |             |          |      |  |   |          |  
|Actual tax benefit                                         |  | $           |         |      |  | $ |         |  
|                                                           |  |             |          |      |  |   |          |  

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 3. Income Taxes (Continued)

Deferred taxes consist of the
following components as of December 31, 2002 and 2001:

|                                |                                       |   |            |           |      |   |            |           | 
|------------------------------- | ------------------------------------- | - | ---------- | --------- | ---- | - | ---------- | --------- | 
|                                |                                       |   | 2002       |           | 2001
|                                |                                       |   |            |           |     
|Deferred tax assets:            |                                       |   |            |           |      |   |            |          
|                                | Net operating loss carryforwards      |   | $          | 7,247,000 |      |   | $          | 6,456,000 | 
|                                | Research and development tax credit   |   |            | 415,000   |      |   |            | 349,000   | 
|                                | Allowance for doubtful accounts       |   |            | 20,000    |      |   |            | 10,000    | 
|                                | Inventory                             |   |            | 59,000    |      |   |            | 58,000    | 
|                                | Accrued expenses and deferred revenue |   |            | 91,000    |      |   |            | 59,000    | 
|                                | Contributions carryforward            |   |            | 7,000     |      |   |            | 7,000     | 
|                                | Depreciation                          |   |            | 31,000    |      |   |            | 20,000    | 
|                                |                                       |   |            |           |      |   |            |           | 
|Total gross deferred tax assets |                                       |   | 7,870,000  |           |      |   | 6,959,000  |          
|Valuation allowance             |                                       |   | (7,870,000 | )         |      |   | (6,959,000 | )        
|                                |                                       |   |            |           |      |   |            |          
|Net deferred taxes              |                                       | $ |           |           |      | $ |           |          
|                                |                                       |   |            |           |      |   |            |          

Realization of deferred tax assets is dependent upon the generation of
sufficient future taxable income. Management has determined that significant
uncertainty exists regarding the realizability of the net deferred tax assets
and, accordingly, has provided a valuation allowance against them.

At December 31, 2002, the Companys net operating loss and tax credit
carryforwards expire as follows:

|     |  |                |            |              |  |              |         | 
|---- |  | -------------- | ---------- | ------------ |  | ------------ | ------- | 
|     |  |                |            |              |  | Research and
|     |  |                |            |              |  | Development 
|     |  | Operating Loss |            | Tax Credit  
|     |  | Carryforward   |            | Carryforward
|     |  |                |            |             
|2011 |  | $              | 1,850,000  |              |  | $            |        | 
|2012 |  |                | 3,540,000  |              |  |              | 113,000 | 
|2018 |  |                | 2,560,000  |              |  |              | 59,000  | 
|2019 |  |                | 2,450,000  |              |  |              | 67,000  | 
|2020 |  |                | 3,114,000  |              |  |              | 40,000  | 
|2021 |  |                | 4,422,000  |              |  |              | 70,000  | 
|2022 |  |                | 2,193,000  |              |  |              | 66,000  | 
|     |  |                |            |              |  |              |         | 
|     |  | $              | 20,129,000 |              |  | $            | 415,000 | 
|     |  |                |            |              |  |              |         | 

The use of the federal net operating losses will be limited to $5.5 million per
year under the provisions of the Internal Revenue Code, Section 382, which
relates to a 50 percent change in control over a three-year period. Further
changes of control may result in additional limitations of the remaining
carryforward. Utilization of the carryforwards is dependent upon the Company
attaining profitable operations in the future.

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 4. Stockholders Equity

Convertible preferred stock:The preferred stock is convertible at the rate of
one share of common stock for each share of preferred stock, subject to certain
anti-dilution adjustments. Conversion is mandatory in the event of certain
future public offerings of corporate stock. The holders of the preferred stock
have certain piggyback and demand registration rights, voting rights and a
liquidation preference of $2.50 per share, and share in dividends paid on
common stock.

Series B Preferred Stock:The Board of Directors has designated 120,000 shares
of previously undesignated stock as Series B Preferred Stock. The shares have a
par value of $0.05 per share and a liquidation value equal to the greater of
$100 or 100 times the aggregate amount to be distributed per share to holders
of common stock. Shares of Series B Preferred Stock are not convertible into
shares of the Companys common stock. Each share of Series B Preferred Stock
will be entitled to a minimum preferential quarterly dividend payment of $1 per
share but will be entitled to an aggregate dividend of 100 times the dividend
declared per share of common stock. Each share of Series B Preferred Stock has
100 votes. In the event of any merger, consolidation or other transaction in
which common stock is exchanged, each share of Series B Preferred Stock will be
entitled to receive 100 times the amount received per share of common stock.
There are no shares of Series B Preferred Stock outstanding.

Shareholder Rights Plan:On October 19, 2001, the Companys Board of Directors
adopted a Shareholder Rights Plan, which took effect on October 26, 2001. Under
the plan, rights were constructively distributed as a dividend at the rate of
one right for each share of common stock or convertible preferred stock of the
Company held by the shareholders of record as of the close of business on
November 9, 2001. The Board further authorized the issuance of one right
(subject to adjustment) with each share of common stock or convertible
preferred stock issued subsequent to November 9, 2001, but prior to the
expiration date. Each right entitles its holder to purchase one-hundredth of a
share of Series B Preferred Stock at an exercise price of $60, subject to
adjustment. The rights will only be exercisable if a person or group acquires,
has the right to acquire, or has commenced a tender offer for 15 percent or
more of the outstanding common stock. The rights are nonvoting, pay no
dividends, expire on November 9, 2011, and may be redeemed by the Company for
$0.001 per right at any time before the tenth day (subject to adjustment) after
a 15 percent position is acquired. The rights have no effect on earnings per
share until they become exercisable.

After the rights are exercisable, if the Company is acquired in a merger or
other business combination, or if 50 percent or more of the Companys assets
are sold, each right will entitle its holder (other than the acquiring person
or group) to purchase, at the then current exercise price, common stock of the
acquiring entity having a value of twice the exercise price.

Undesignated stock:The Company has 9,480,000 shares of undesignated capital
stock.

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 5. Stock Options and Warrants

As discussed in Note 1 to the financial statements, the Company accounts for
employee stock-based compensation under APB Opinion No. 25, Accounting for
Stock Issued to Employees,and related interpretations. The pro forma fair
value of each option grant as presented in Note 1 to the financial statements
is estimated on the date of grant using the Black-Scholes option pricing model
with the following weighted-average assumptions used for grants in 2002 and
2001:

|                                                               |  |                         |            |      |  |   |            | 
|-------------------------------------------------------------- |  | ----------------------- | ---------- | ---- |  | - | ---------- | 
|                                                               |  | Years Ended December 31
|                                                               |  |                        
|                                                               |  | 2002                    |            | 2001
|                                                               |  |                         |            |     
|Expected dividend yield                                        |  |                         |           |      |  |   |           | 
|Expected stock price volatility                                |  |                         | 99.17%     |      |  |   | 101.45%    | 
|Risk-free interest rate                                        |  |                         | 2.54%      |      |  |   | 5.01%      | 
|Expected life of options                                       |  |                         | 5.00 years |      |  |   | 4.50 years | 
|Weighted-average fair value of options granted during the year |  | $                       | 2.42       |      |  | $ | 2.03       | 

The Company has reserved 1,800,000 common shares for issuance as qualified and
nonqualified stock options for its key employees and directors. The Company has
also reserved 100,000 common shares for issuance as nonqualified options to
various distributors, dealers and consultants. Option prices are generally at
the fair market value of the stock at the time an option is granted. Options
become exercisable as determined at the date of grant by a committee of the
Board of Directors. Options expire 10 years after the date of grant, unless an
earlier expiration date is set at the time of grant.

Additional information relating to all outstanding options as of December 31,
2002 and 2001, is as follows:

|                                         |                   |  |           |         |       |   |           |      |       |  |           |          |           |   |      |      | 
|---------------------------------------- | ----------------- |  | --------- | ------- | ----- | - | --------- | ---- | ----- |  | --------- | -------- | --------- | - | ---- | ---- | 
|                                         |                   |  | 2002      |         | 2001 
|                                         |                   |  |           |         |      
|                                         |                   |  |           |         |       |   | Weighted- |      |       |  |           |          | Weighted-
|                                         |                   |  |           |         |       |   | Average   |      |       |  |           |          | Average  
|                                         |                   |  |           |         |       |   | Exercise  |      |       |  |           |          | Exercise 
|                                         |                   |  | Shares    |         | Price |   | Shares    |      | Price
|                                         |                   |  |           |         |       |   |           |      |      
|Options outstanding at beginning of year |                   |  | 1,146,053 |         |       | $ | 3.66      |      |       |  | 1,059,423 |          |           | $ | 3.84 |     
|                                         | Options exercised |  |           | (6,667  | )     |   |           | 1.50 |       |  |           | (87,840  | )         |   |      | 2.31 | 
|                                         | Options forfeited |  |           | (73,833 | )     |   |           | 4.47 |       |  |           | (185,933 | )         |   |      | 3.46 | 
|                                         | Options granted   |  |           | 372,962 |       |   |           | 3.22 |       |  |           | 360,403  |           |   |      | 2.81 | 
|                                         |                   |  |           |         |       |   |           |      |       |  |           |          |           |   |      |     
|Options outstanding at end of year       |                   |  | 1,438,515 |         |       | $ | 3.51      |      |       |  | 1,146,053 |          |           | $ | 3.66 |     
|                                         |                   |  |           |         |       |   |           |      |       |  |           |          |           |   |      |     

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 5. Stock Options and Warrants (Continued)

The following table summarizes information about stock options outstanding at
December 31, 2002:

|                |  |                     |           |                     |  |           |      |                 |  |           |      |  |  |  |         |  |  |   |      | 
|--------------- |  | ------------------- | --------- | ------------------- |  | --------- | ---- | --------------- |  | --------- | ---- |  |  |  | ------- |  |  | - | ---- | 
|                |  | Options Outstanding |           | Options Exercisable
|                |  |                     |           |                    
|                |  |                     |           |                     |  | Weighted- |      |                 |  |           |      |  |  |  |         |  |  |  
|                |  |                     |           |                     |  | Average   |      |                 |  |           |      |  |  |  |         |  |  |  
|                |  | Number              |           | Remaining           |  | Weighted- |      | Number          |  | Weighted-
|                |  | Outstanding         |           | Contractual         |  | Average   |      | Exercisable     |  | Average  
|Range of        |  | at December 31,     |           | Life                |  | Exercise  |      | at December 31, |  | Exercise 
|Exercise Prices |  | 2002                |           | (Years)             |  | Price     |      | 2002            |  | Price    
|                |  |                     |           |                     |  |           |      |                 |  |          
|$0.01           |  |                     | 7,354     |                     |  |           | 7.84 |                 |  | $         | 0.01 |  |  |  | 7,354   |  |  | $ | 0.01 | 
|$1.42 - $2.40   |  |                     | 304,458   |                     |  |           | 8.19 |                 |  |           | 1.78 |  |  |  | 161,525 |  |  |   | 1.84 | 
|$2.50 - $3.625  |  |                     | 539,861   |                     |  |           | 6.37 |                 |  |           | 3.07 |  |  |  | 298,906 |  |  |   | 3.15 | 
|$3.74 - $5.25   |  |                     | 447,342   |                     |  |           | 7.84 |                 |  |           | 4.18 |  |  |  | 174,942 |  |  |   | 4.48 | 
|$5.38 - $7.563  |  |                     | 79,500    |                     |  |           | 7.26 |                 |  |           | 6.23 |  |  |  | 56,334  |  |  |   | 6.29 | 
|$8.00 - $8.38   |  |                     | 60,000    |                     |  |           | 7.29 |                 |  |           | 8.11 |  |  |  | 41,668  |  |  |   | 8.10 | 
|                |  |                     |           |                     |  |           |      |                 |  |           |      |  |  |  |         |  |  |   |      | 
|$0.01 - $8.38   |  |                     | 1,438,515 |                     |  |           | 7.31 |                 |  | $         | 3.51 |  |  |  | 740,729 |  |  | $ | 3.67 | 
|                |  |                     |           |                     |  |           |      |                 |  |           |      |  |  |  |         |  |  |   |      | 

At December 31, 2001, there were 542,154 options exercisable at a
weighted-average exercise price of $3.81.

Employee stock purchase plan:Under its 1998 employee stock purchase plan,
which became effective for the plan year beginning January 1, 1999, the Company
is authorized to issue up to 100,000 shares of common stock to its full-time
employees, nearly all of whom are eligible to participate. Employees can choose
each year to have up to 10 percent of their earnings withheld to purchase the
Companys stock at a price that is 85 percent of the lower of its
beginning-of-year or end-of-year fair market value. During 2002 and 2001,
21,803 and 15,366 shares, respectively, were issued under the plan.

Warrants:The Company has issued warrants to purchase shares of common stock at
prices between $1.25 and $6.60 per share. All warrants are currently
exercisable. The following tables summarize information about warrants
outstanding at December 31, 2002 and 2001:

|                                          |                    |  |           |         |       |   |           |      |       |  |           |           |           |   |      |      | 
|----------------------------------------- | ------------------ |  | --------- | ------- | ----- | - | --------- | ---- | ----- |  | --------- | --------- | --------- | - | ---- | ---- | 
|                                          |                    |  | 2002      |         | 2001 
|                                          |                    |  |           |         |      
|                                          |                    |  |           |         |       |   | Weighted- |      |       |  |           |           | Weighted-
|                                          |                    |  |           |         |       |   | Average   |      |       |  |           |           | Average  
|                                          |                    |  |           |         |       |   | Exercise  |      |       |  |           |           | Exercise 
|                                          |                    |  | Shares    |         | Price |   | Shares    |      | Price
|                                          |                    |  |           |         |       |   |           |      |      
|Warrants outstanding at beginning of year |                    |  | 3,075,511 |         |       | $ | 3.44      |      |       |  | 1,395,243 |           |           | $ | 3.93 |     
|                                          | Warrants exercised |  |           | (80,268 | )     |   |           | 3.44 |       |  |           |          |           |   |      |     | 
|                                          | Warrants granted   |  |           |        |       |   |           |     |       |  |           | 1,680,268 |           |   |      | 3.04 | 
|                                          |                    |  |           |         |       |   |           |      |       |  |           |           |           |   |      |     
|Warrants outstanding at end of year       |                    |  | 2,995,243 |         |       | $ | 3.44      |      |       |  | 3,075,511 |           |           | $ | 3.44 |     
|                                          |                    |  |           |         |       |   |           |      |       |  |           |           |           |   |      |     

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 5. Stock Options and Warrants (Continued)

Warrants outstanding at December 31, 2002, expire as follows:

|     |  |   |           | 
|---- |  | - | --------- | 
|2003 |  | $ | 97,353    | 
|2004 |  |   | 10,000    | 
|2005 |  |   | 880,000   | 
|2006 |  |   | 1,600,000 | 
|2008 |  |   | 37,890    | 
|2009 |  |   | 370,000   | 
|     |  |   |           | 
|     |  | $ | 2,995,243 | 
|     |  |   |           | 

Note 6. Major Customers and International Sales

Major customers:Direct and indirect sales to U.S. government agencies from
continuing operations were approximately $1,756,000 and $1,250,000, or 24 and
16 percent of total sales, in 2002 and 2001, respectively. Accounts receivable
from U.S. government agencies were approximately $669,000 and $844,000 at
December 31, 2002 and 2001, respectively. In addition, sales to agencies of the
Canadian government were approximately $2,127,000, or 29 percent of net sales
from continuing operations, during the year ended December 31, 2002. Accounts
receivable from these customers were approximately $66,000 at December 31,
2002. Sales to these customers were approximately $4,152,000, or 53 percent of
total sales, during the year ended December 31, 2001. Accounts receivable from
these customers were approximately $511,000 at December 31, 2001. Sales to
another customer (not a government agency) were approximately $1,159,000, or 16
percent of net sales from continuing operations, during the year ended December
31, 2002. Accounts receivable from this customer were approximately $182,000
at December 31, 2002.

International sales:Export sales to international customers, including Canada,
from continuing operations, for 2002 and 2001 were approximately $4,168,000 and
$5,206,000, or 57 and 67 percent of total sales, respectively. Accounts
receivable from international customers were approximately $721,000 and
$982,000 at December 31, 2002 and 2001, respectively. Sales to customers in
Canada accounted for approximately $2,401,000, or 33 percent of sales, and
sales to customers in Germany accounted for approximately $768,000, or 11
percent of sales, in 2002. No other individual country accounted for more than
10 percent of sales in 2002. Sales to customers in Canada, including agencies
of the Canadian government, accounted for approximately $4,450,000, or 57
percent of sales in 2001. No other individual country accounted for more than
10 percent of sales in 2001.

Note 7. Commitments and Contingencies

The Company leases its office and warehouse facilities under a noncancelable
operating lease, which expires in June 2004. In addition, certain items of
equipment are leased under noncancelable operating leases through February
2007.

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##### Table of Contents



DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 7. Commitments and Contingencies (Continued)

Future lease commitments are as follows:

|     |  |   |         | 
|---- |  | - | ------- | 
|2003 |  | $ | 278,000 | 
|2004 |  |   | 138,000 | 
|2005 |  |   | 13,000  | 
|2006 |  |   | 6,000   | 
|2007 |  |   | 1,000   | 
|     |  |   |         | 
|     |  | $ | 436,000 | 
|     |  |   |         | 

Rent expense totaled approximately $343,000 and $240,000 in 2002 and 2001,
respectively.

In connection with the transaction described in Note 9, the Company is
subleasing a portion of its office space. The Company will receive monthly
rentals of $8,834 through June 2004. Sublease income during 2002 and 2001 was
approximately $106,000 and $46,000, respectively.

Employee benefits:The Company maintains a voluntary 401(k) plan in effect for
its employees. The Company offers a match of 25 percent of the employees
contributions, up to 6 percent. The Companys match was approximately $39,000
and $45,000 in 2002 and 2001, respectively. In addition, a discretionary
contribution may be authorized by the Board of Directors. There were no
discretionary contributions authorized in 2002 and 2001.

Note 8. Operating Segments

The Company had two reportable segments: ISS Information Security Solutions
(ISS) and Electronic Products (EP). The ISS Information Security Solutions
segment produces and markets products for the information security market,
which enable user identification and authentication, secure data exchange and
information validation. EP produced proprietary memory keys, cards and other
custom-shaped tokens that serve as a convenient way to carry electronic
information.

The accounting policies of the segments are the same as those described in the
summary of significant accounting policies. There are no inter-segment
transactions. The Company evaluates performance based on operating earnings of
the respective segments. The following tables present information by segment.
As further discussed in Note 9, the revenues and expenses of EP are reflected
in the statements of operations on a net basis as loss from operations of
discontinued segment.

|                              |  |      |            |    |  |             |         |       |  |   |        |  |  |   |            |  
|----------------------------- |  | ---- | ---------- | -- |  | ----------- | ------- | ----- |  | - | ------ |  |  | - | ---------- | -
|                              |  | 2002
|                              |  |     
|                              |  | ISS  |            | EP |  | Unallocated |         | Total
|                              |  |      |            |    |  |             |         |      
|Revenue                       |  | $    | 7,257,000  |    |  | $           | 870,000 |       |  | $ |       |  |  | $ | 8,127,000  |  
|Depreciation and amortization |  |      | 313,000    |    |  |             | 40,000  |       |  |   |       |  |  |   | 353,000    |  
|Segment profit (loss)         |  |      | (2,712,000 | )  |  |             | 351,000 |       |  |   | 45,000 |  |  |   | (2,316,000 | )

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DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 8. Operating Segments (Continued)

|                              |  |      |            |    |  |             |           |       |  |   |        |  |  |   |            |  
|----------------------------- |  | ---- | ---------- | -- |  | ----------- | --------- | ----- |  | - | ------ |  |  | - | ---------- | -
|                              |  | 2001
|                              |  |     
|                              |  | ISS  |            | EP |  | Unallocated |           | Total
|                              |  |      |            |    |  |             |           |      
|Revenue                       |  | $    | 7,815,000  |    |  | $           | 2,425,000 |       |  | $ |       |  |  | $ | 10,240,000 |  
|Depreciation and amortization |  |      | 479,000    |    |  |             | 170,000   |       |  |   |       |  |  |   | 649,000    |  
|Segment profit (loss)         |  |      | (2,085,000 | )  |  |             | (487,000  | )     |  |   | 79,000 |  |  |   | (2,493,000 | )

Note 9. Discontinued Operations

In February 2001, the Companys Board of Directors approved managements plan
to discontinue the operations of the EP segment. The Companys plan anticipated
the phasedown of operations through December 31, 2001, and the 2000 financial
statements were prepared as if the operation would be phased down. In August
2001, certain assets of the EP segment were sold to an unrelated party for
$550,000. One customer contract was retained by the Company with final delivery
taking place in 2002.

In 2000, an estimated loss of $1,281,000 on the phasedown of the EP segment was
recognized and included the write-off of inventory, patents and equipment
anticipated to remain at the date of closedown and expenses associated with the
phasedown, net of estimated operating income through closedown. The loss from
disposal of the discontinued segment in 2001 of $487,045 was the amount in
excess of the loss estimated at December 2000, net of sales proceeds of
$550,000. The Company fulfilled its final sales contract during 2002, and the
gain on disposal of the discontinued segment was the profit realized on the
contract in excess of the amounts previously estimated. The disposal of the
segment is being accounted for as discontinued operations and, accordingly, its
net assets have been segregated from continuing operations in the accompanying
balance sheets, and the results of its operations have been excluded from
continuing operations for all periods presented. There are no assets or
liabilities remaining from the EP segment as of December 31, 2002. Net assets
of $82,077 at December 31, 2001, represent accounts receivable which were
collected in 2002.

The EP segment had total revenues of $870,052 and $2,425,299 in 2002 and 2001,
respectively.

Note 10. Licenses

Licenses are stated at cost. The costs of the license agreements are amortized
to cost of goods sold as the products incorporating the licensed units are sold
or over the life of the agreement. Under these agreements, the Company
generally agrees to purchase a minimum quantity of software units over a
specified period of time.

|                    |                          |   |             |          |      |   |         |          |  
|------------------- | ------------------------ | - | ----------- | -------- | ---- | - | ------- | -------- | -
|                    |                          |   | December 31
|                    |                          |   |            
|                    |                          |   | 2002        |          | 2001
|                    |                          |   |             |          |     
|Licenses:           |                          |   |             |          |      |   |         |         
|                    | Gross carrying amount    |   | $           | 546,000  |      |   | $       | 641,000  |  
|                    | Accumulated amortization |   |             | (309,183 | )    |   |         | (449,161 | )
|                    |                          |   |             |          |      |   |         |         
|Net carrying amount |                          | $ | 236,817     |          |      | $ | 191,839 |         
|                    |                          |   |             |          |      |   |         |         

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##### Table of Contents



DATAKEY, INC.

NOTES TO FINANCIAL STATEMENTS

Note 10. Licenses (Continued)

Aggregate amortization expense in 2002 was $182,847 and in 2001 was $343,122.
The Company expects that the remainder of the December 31, 2002, carrying
amount of the license agreements will be charged to amortization in 2003 based
upon the expected sales of its products which incorporate the licenses. In
2002, the Company entered into a license agreement under which it purchased
15,000 licenses for $195,000 and agreed to a minimum future purchase of 70,000
licenses for $910,000 by March 2004. The Company presently expects to acquire
and utilize the minimum number of licenses under the agreement by March 2004.

The Company reviews its license costs for impairment and records impairment
charges if sales of products incorporating the licenses are less than expected.
As a result, the Company recognized impairment expense of $48,667 in 2002 and
$45,000 in 2001 to reduce the carrying amount of certain license costs to the
amount required based on sales levels. These impairment charges are included in
the caption cost of goods sold in the accompanying income statement.

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DATAKEY, INC.

EXHIBIT INDEX TO ANNUAL REPORT
ON FORM 10-KSB
For the Fiscal Year Ended December 31, 2002

|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                                                                                                                                                                         
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|3.1*        |  | Restated Articles of Incorporation, as amended                                                                                                                                                                                                                                                                                                                                                      
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|3.2*        |  | Restated Bylaws                                                                                                                                                                                                                                                                                                                                                                                     
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|4.1         |  | Rights Agreement dated October 26, 2001 between the Company
and Wells Fargo Bank, as Rights Agent, including Statement of
Designation of Series B Preferred Stock, Summary of Rights to
Purchase Shares of Series B Preferred Stock and Form of Rights
Certificate included as exhibits (incorporated by reference to
Exhibit to the Companys Registration Statement on Form 8-A,
Reg. No. 0-11447)
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.1        |  | 1987 Datakey, Inc. Stock Option Plan (Incorporated by
reference to Exhibit 10.7 to Form 10-K for fiscal year ended
December 31, 1987)**                                                                                                                                                                                                                                                             
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.2        |  | Amendment dated March 15, 1991 to 1987 Datakey, Inc. Stock
Option Plan (Incorporated by reference to Exhibit 10.5 to Form
10-K for fiscal year ended December 31, 1991)**                                                                                                                                                                                                                           
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.3        |  | Amendments dated July 1, 1995 and March 19, 1996 to 1987
Datakey, Inc. Stock Option Plan (Incorporated by reference to
Exhibit 10.5 to Form 10-KSB for fiscal year ended December 31,
1996)**                                                                                                                                                                                                       
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.4        |  | Lease between the Company and Kraus-Anderson, Inc. dated June
3, 1987, as amended on February 10, 1988, December 23, 1988,
February 13, 1992 and April 1, 1992 (Incorporated by reference
to Exhibit 10.12 to Form 10-K for fiscal year ended December
31, 1991)                                                                                                                                    
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.5        |  | Manufacturing Agreement between Duncan Industries and the
Company dated August 27, 1993 (Incorporated by reference to
Exhibit 10.16 to Form 10-KSB for fiscal year ended December
31, 1993)                                                                                                                                                                                                         
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.6        |  | Employment Agreement between Alan G. Shuler and the Company
dated January 1, 1999 (Incorporated by reference to Exhibit
10.2 to Form 10-QSB for fiscal quarter ended April 3, 1999)**                                                                                                                                                                                                               
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.7        |  | 1997 Management Incentive Plan, as amended March 10, 1997
(Incorporated by reference to Exhibit 10 to Form 10-QSB for
fiscal quarter ended June 28, 1997)**                                                                                                                                                                                                                                         
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.8        |  | Lease Amendment No. 5 dated December 17, 1996 to Lease between
the Company and Kraus-Anderson, Inc. dated June 3, 1987
(Incorporated by reference to Exhibit 10.22 to Form 10-KSB for
fiscal year ended December 31, 1996)                                                                                                                                                                          
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.9        |  | 1997 Stock Option Plan (Incorporated by reference to Exhibit
10.15 to Form 10-KSB for fiscal year ended December 31,
1997)**                                                                                                                                                                                                                                                                        
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.10       |  | Forms of Incentive and Nonqualified Stock Option Agreements
under 1997 Stock Option Plan (Incorporated by reference to
Exhibit 10.16 to Form 10-KSB for fiscal year ended December
31, 1997)**                                                                                                                                                                                                      
|            |  |                                                                                                                                                                                                                                                                                                                                                                                                     
|10.11       |  | Lease Extension and Expansion Agreement between the Company
and Kraus-Anderson, Incorporated dated April 19, 1999
(Incorporated by reference to Exhibit 10.14 to Form 10-KSB for
fiscal year ended December 31, 1999)                                                                                                                                                                               

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##### Table of Contents



|            |  |                                                                                                                                                                                                                                                         
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description                                                                                                                                                                                                                                             
|            |  |                                                                                                                                                                                                                                                         
|10.12       |  | Employment Agreement between Timothy Russell and the Company
dated August 16, 1999 (Incorporated by reference to Exhibit
10.15 to Form 10-KSB for fiscal year ended December 31,
1999)**                                                                
|            |  |                                                                                                                                                                                                                                                         
|10.13       |  | Employment Agreement between Colleen M. Kulhanek and the
Company dated April 1, 2000 (Incorporated by reference to
Exhibit 10.1 to Form 10-QSB for fiscal quarter ended April 1,
2000)**                                                                
|            |  |                                                                                                                                                                                                                                                         
|10.14       |  | 2001 Executive Incentive Plan (Incorporated by reference to
Exhibit 10.17 to Form 10-KSB for the year ended December 31,
2000)**                                                                                                                        
|            |  |                                                                                                                                                                                                                                                         
|10.15       |  | Loan Agreement dated January 23, 2001 between the Company and
Ray Lipkin and Unsecured Promissory Note dated January 26,
2001 in the amount of $500,000 (Incorporated by reference to
Exhibit 10.18 to Form 10-KSB for the year ended December 31,
2000)
|            |  |                                                                                                                                                                                                                                                         
|10.16       |  | Asset Acquisition Agreement dated August 3, 2001 between
Datakey, Inc. and Datakey Electronics, Inc. (Incorporated by
reference to Exhibit 2.1 of Form 8-K dated August 3, 2001)                                                                        
|            |  |                                                                                                                                                                                                                                                         
|10.17       |  | 2002 Executive Incentive Plan (Incorporated by reference to
Exhibit 10.18 to Form 10-KSB for the year ended December 31,
2002)                                                                                                                          
|            |  |                                                                                                                                                                                                                                                         
|10.18*      |  | 2003 Executive Incentive Plan**                                                                                                                                                                                                                         
|            |  |                                                                                                                                                                                                                                                         
|10.19*      |  | Employment Agreement between Carl P. Boecher and the Company
effective March 1, 2003**                                                                                                                                                                  
|            |  |                                                                                                                                                                                                                                                         
|23.1*       |  | Consent of Independent Accountant                                                                                                                                                                                                                       
|            |  |                                                                                                                                                                                                                                                         
|24.1*       |  | Power of attorney for Timothy L. Russell, Alan G. Shuler, Carl
P. Boecher, Thomas R. King, Terrence W. Glarner, Gary R.
Holland, Eugene W. Courtney (included on the signature page of
this Form 10-KSB)                                                
|            |  |                                                                                                                                                                                                                                                         
|99.1*       |  | Certification of Chief Executive Officer Pursuant to Section
906 of the Sarbanes Oxley Act of 2002                                                                                                                                                      
|            |  |                                                                                                                                                                                                                                                         
|99.2*       |  | Certification of Chief Financial Officer Pursuant to Section
906 of the Sarbanes Oxley Act of 2002                                                                                                                                                      



|*  |  | Filed herewith.                                                      
|-- |  | ---------------------------------------------------------------------
|  
|** |  | Designates a management contract or compensatory plan or arrangement.

2747866-6

E-2