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, 1997

                           Commission file No. 0-11447

                                  DATAKEY, INC.
                 (Name of small business issuer in its charter)

         MINNESOTA                                         41-1291472
(State of incorporation or organization)    (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:  (612) 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 (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 ____

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: $5,977,464.

The  aggregate  market  value  of  the  voting  stock  (Common  Stock)  held  by
non-affiliates was approximately $6,529,018 based upon the closing sale price of
the Issuer's Common Stock on March 13, 1998.

As of March 13, 1998,  there were 2,887,235  shares of the Issuer's Common Stock
outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE

         Part II of this Annual Report on Form 10-KSB  incorporates by reference
information  (to the extent  specific  sections are referred to herein) from the
Issuer's Annual Report to Shareholders for the year ended December 31, 1997 (the
"1997 Annual Report").  Portions of the Company's definitive Proxy Statement for
its Annual Meeting of Shareholders  to be held on June 2, 1998 are  incorporated
by reference pursuant to Rule 12b-23 into Items 9, 10 and 11 of Part III.

Transitional Small Business Disclosure Format (check one)  YES  [  ]   NO  [ X ]



<PAGE>

                                     PART I


ITEM 1.  DESCRIPTION OF BUSINESS

General

         Datakey,  Inc. (the "Company") was  incorporated  under the laws of the
State of Minnesota in 1976 under the name "The Systems Group, Inc." In 1980, the
Company  changed  its  name to  Datakey,  Inc.  The  Company  provides  product,
subsystem  and  system  solutions  to  record,  store  and  transmit  electronic
information.  Datakey also  manufactures and sells products and systems directed
to the  information  security market which will enable user  identification  and
authentication,  secure  data  exchange  and  information  validation.  It  also
provides OEM products,  consisting of proprietary  memory keys,  cards and other
custom-shaped  tokens  that  serve  as a  convenient  way  to  carry  electronic
information and are packaged to survive in portable environments.

         The  Company's  first  portable  information  system,  consisting of an
electronic key and support electronics,  was introduced in 1981 for applications
requiring convenient storage,  transportation and management of information. The
Company's current system utilizes semiconductor  technology to provide a storage
device more versatile than conventional  portable  information  products such as
keys,  badges and magnetic stripe cards.  The Company's  current product line of
portable  data  carriers  and  associated   interface  products  provide  up  to
16,384,000  bits of data storage which are used in a wide range of  applications
including communications security, computer security, facility security, vending
and process control.

         Each of the Company's personal portable information systems consists of
one or more  portable data  carriers,  access  devices and, for certain  models,
interface modules containing  microprocessors.  These components,  together with
the user's processor-based equipment,  function as an integrated system allowing
instantaneous  processing of  personalized  data carried  within a portable data
carrier.  Through the incorporation of advanced semiconductor memory technology,
the  Company's  portable  data  carrier  is able to store and carry  substantial
amounts of  information.  When the portable data carrier is used in  conjunction
with  the  other  components  of  the  Company's  system,   information  can  be
selectively  altered,  added to or  erased,  as  required,  to  effectively  and
reliably manage or control a particular activity or transaction.

         The Company has  introduced  an end-user  system level product which is
designed to provide  electronic  signatures  on computer  aided  drafting  (CAD)
drawings and additional  end-user  systems that are designed to provide advanced
information security utilizing digital signatures and encryption.  These systems
incorporate  hardware and software to provide a higher level of security than is
obtainable with current software only solutions.

Current Products and Products Under Development

Electronic Products

         Portable Data Carrier  Devices.  Portable data carriers are  electronic
memory devices which store information. They have a plastic exterior, are in the
forms of keys,  cards,  or custom  shaped tokens and  encapsulate  semiconductor
memory.  Certain  devices have been designed to store  information  which may be
retrieved, altered, erased or updated; while other devices have been designed to
store one-time  programmable  information which may be retrieved but not altered
or updated.  The storage  capacities of the Company's  portable  memory  devices
range from 1,024 bits (150  alphanumeric  characters)  to 16,384,000  bits.  The
portable  data  carriers  are  priced  generally  between  $2 and $100 per unit,
depending on capacities and quantities purchased.


<PAGE>

         Access  Device.  The access device is the element into which a portable
data  carrier is inserted to provide the  interconnection  between the  portable
data carrier and the electronic  interface circuitry or the host processor-based
equipment.  It is through this physical  interconnection that the data contained
in the portable data carrier's memory is transmitted to the electronic interface
or to the  host  interface.  Several  models  of the  access  device  have  been
developed to handle the Company's  different portable data carriers.  The access
devices are priced generally between $15 and $120 per unit,  depending on models
and quantities purchased.

         Interface.  The interface is the electronics control module between the
access device and a customer's  processor-based  equipment.  This module is used
with the  Company's  serial  communication  key and contains  all the  necessary
electronics  to  control  information  within  the  key  and to  coordinate  the
information  requests  of the host  equipment.  This  communication  process  is
managed by the system's  firmware,  which is a software  program existing within
the interface.  For some  applications,  this firmware  structures,  secures and
verifies the  information  within the portable  device,  and may allow  separate
groups or files of data to reside in a single portable device and be secure from
access except by equipment  authorized  to manage a particular  group or file of
data. The interface is priced between $70 and $120 per unit, depending on models
and quantities purchased.

Integrated System Solutions

         For the past two years,  Datakey has been  developing new products that
provide advanced security solutions to the problems of organizations, worldwide.
The  first  release  of  these  token-based  information  security  systems  was
introduced  in  September  1997  and  additional  versions  are  expected  to be
introduced in the first half of 1998. The launch and success of such products is
dependent on further successful development efforts and market acceptance, along
with other risks. See "Forward Looking Statements."

         SignaSURE  CIP.   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 insufficient for private networks
with  connections  outside  of the  corporation.  The  Company's  SignaSURE  CIP
(Cryptographic  Interface Provider) is designed to solve this problem,  allowing
the Internet to be used safely for electronic commerce.

         SignaSURE CIP allows users and  value-added  resellers 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. SignaSURE CIP provides
token upgrades for Cryptoki or PKCS-11 standard  information  security interface
applications and for applications that incorporate Microsoft's CryptoAPI.  These
products  offer  "load,  plug  and  play"  convenience  for  strong  information
security.

         SignaSURE CIP products  include a  user-unique  smart card or smart key
that holds the  critical  information  to perform  the  cryptographic  functions
necessary for information privacy and data integrity, a companion  reader/writer
that plugs into a computer's  serial port, PCMCIA port or floppy disk drive, and
software which is loaded into the  workstation and interfaces to the application
program.  The Company introduced,  in September 1997, a version of SignaSURE CIP
that utilizes the standard PKCS #11 (Cryptoki) Interface and plans to release in
early 1998 a version that utilizes Microsoft's CryptoAPI.


<PAGE>

         SignaSURE  DTK. As  public-key  information  security  grows due to the
technology's  adoption by well-known  software  companies  such as Microsoft and
Netscape,   smaller  software   developers  are  also  implementing   public-key
information security into their specialized applications. Because no easy method
was  available  for smaller  application  developers  to implement a token-based
public key  infrastructure,  the Company developed its SignaSURE DTK (Developers
Tool Kit) so that  developers  could  easily and  cost-effectively  launch their
applications with the much stronger, token-based information security.

         SignaSURE DTK is a turnkey  package that the Company  designed to allow
software  developers  to  integrate  Datakey  hardware  tokens and a  public-key
infrastructure  into  their   applications.   DTK  includes  up  to  three  main
components:  hardware  cryptographic tokens,  interface and integration software
and security  infrastructure  products.  DTK is available in four configurations
ranging from just a token with a reader/writer and integration  software, to the
full public-key  infrastructure  configuration  that issues and manages hardware
tokens and digital certificates. This product flexibility allows user-developers
who  utilize   SignaSURE  DTK  to  integrate  just  what  is  needed  for  their
application. The Company began selling the SignaSURE DTK in mid-1997.

         SignaSURE EDM. Design and drafting was  revolutionized  several decades
ago with the  introduction of computer  aided-design  (CAD)  software.  However,
engineers still must print their CAD-created designs, approve the documents with
hand-written  signatures,  and archive these  hand-signed  originals to maintain
change  control and ensure  design  traceability.  The  Company's  SignaSURE EDM
(Electronic  Document  Manager),  which  Datakey  began  to sell  in late  1996,
provides a way to sign an electronic  document to ensure its authenticity,  thus
eliminating  the need  for  hand-signed  originals  and all of the  storage  and
archiving requirements for paper-based engineering drawings and documents.

         SignaSURE  EDM adds digital  signatures  to CAD and other  documents to
ensure document authenticity,  configuration control and conformance to ISO 9000
document   management   requirements.   SignaSURE   EDM  provides  for  copying,
distributing and archiving of electronically generated documents with a level of
authenticity  formerly  obtainable only with  hand-signed  paper  documents.  It
answers  questions of document  authorship,  integrity and culpability  quickly,
easily and  unambiguously.  With SignaSURE EDM, documents in electronic form can
be transmitted  over local area networks,  intranets and the Internet with their
authenticity assured.

         SignaSURE  EDM  includes a smart card or smart key that  generates  the
user's digital signature, a companion reader/writer that plugs into a computer's
serial  port,  and a  software  program  which is loaded  into the  workstation.
SignaSURE EDM operates on all Windows operating systems,  is compatible with all
CAD  programs  and file  formats,  and moves  design and drafting to a paperless
environment.  A new SignaSURE version of EDM with a more "windows like" look and
feel is scheduled for release in the second quarter of 1998.

         SignaSURE ESS. Many of today's  organizations  have made the transition
from  large  mainframe   systems  to  more  flexible,   but  much  less  secure,
client-server networks and intranets. Client-server networks and intranets allow
digital  information  to reside  on  networks,  rather  than at the  desktop  so
authorized users can access the same  information.  Authorized users can include
company employees,  suppliers and customers who can be connected to the network,
or  located  remotely  from the  enterprise.  With the  advent of the  Internet,
information  transmission over any distance can be accomplished quickly and cost
effectively,  but not securely.  Datakey  believes its SignaSURE ESS (Enterprise
Security  Suite)  offers a solution to manage a network,  intranet  and Internet
computing  structure to allow authorized users ready access to information,  but
deny it to the  unauthorized.  Information can then be transmitted  securely and
stored  safely on both  private  and public  networks  without  privacy and data
integrity concerns.


<PAGE>

         SignaSURE ESS is an integrated end-to-end data security system that the
Company  believes will assure secure network  access,  confidential  information
exchange,   integrity   of  data  and   transaction   non-repudiation.   Secure,
personalized  smart tokens are employed  within a public key  infrastructure  to
provide a higher level of information security than is provided by software-only
solutions.  Security  functions are integrated into  applications like Microsoft
Office(TM), thereby providing seamless security operation to the user. SignaSURE
ESS will operate over the Internet,  and wide and local area  networks  enabling
secure  information  exchange  for all  users,  whether  local or  remote to the
enterprise.

         SignaSURE  ESS  includes  a  user-personalized  smart card or smart key
hardware  token and  companion  reader/writer  for  workstation  or laptop  that
perform the functions necessary for information  privacy and data integrity.  It
also incorporates client software that manages secure information and interfaces
to  applications,  and  server-based,  enterprise  infrastructure  hardware  and
software that  initialize  SignaSURE ESS and  continually  ensures all users are
authorized.  The Company  expects to begin  selling  SignaSURE ESS in the second
quarter of 1998.

         The following chart shows the Company's SignaSURE products:
<TABLE>
<S>         <C>                         <C>         <C>        <C>         <C>        <C>

                                                            SignaSURE Product
----------- --------------------------- -----------------------------------------------------------
Attribute                                  CIP         CSP        DTK         EDM         ESS
----------- --------------------------- ----------- ---------- ----------- ---------- -------------
Customer    Organizational End-User         x           x                                  x
            Engineer/Architect End-User                                        x
            Software Developer                                     x
----------- --------------------------- ----------- ---------- ----------- ---------- -------------
System Type Integrated Solution                                                x           x
            Add-on Subsystem                x           x
            Component                                              x
----------- --------------------------- ----------- ---------- ----------- ---------- -------------
Application Information Security            x           x                                  x
            Paperless Automation                                               x
            Token Integration               x           x          x
----------- --------------------------- ----------- ---------- ----------- ---------- -------------
Hardware    Datakey Smart Token             x           x          x           x           x
            Datakey Reader/Writer           x           x          x           x           x
----------- --------------------------- ----------- ---------- ----------- ---------- -------------
Software    Security Solution                                                  x           x
            Token Interface                 x           x          x
----------- --------------------------- ----------- ---------- ----------- ---------- -------------
</TABLE>

Year 2000

         The Company's  products are designed on an operating  system which uses
four digits in designating the year. As a result, these products can distinguish
the year  2000  from the year  1900;  therefore,  the year  2000  will not cause
problems.


Research and Development

         During 1997,  the Company  continued the  development  of portable data
carriers  to expand  its line of  standard  products  as well as newly  designed
custom  products.  The Company also  substantially  increased its development of
token-based information security products.

         As the need for  computer  security  products  continues  to grow,  the
Company has been expending  significant  effort into  development of token-based
computer   information   security  systems.  The  Company's  SignaSURE  line  of
information  security  products,  which were initially  released for sale during
1997,  are designed to provide  encryption and digital  signatures  required for
electronically generated documents on computer networks.


<PAGE>

         The  technology  involved in  information  systems in 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.

         In  1997,  1996  and  1995,  research  and  development  expenses  were
$3,186,000,  $2,263,000  and $704,000,  respectively.  The Company  expects that
research and development expenses in 1998 will be about 45% less than in 1997.

Manufacturing

         The   Company's    in-house    manufacturing    capabilities    include
microelectronic  assembly,  plastic injection  molding,  automated surface mount
assembly, and general electronic assembly. The Company also utilizes independent
subcontractors from time to time to perform certain manufacturing functions. The
Company  provides a 90-day  warranty on domestic  sales,  a 180-day  warranty on
sales to its  international  distributors  to cover the longer shelf life of the
Company's products, and a 180-day warranty on sales to the government.

         In an effort to more efficiently  produce  products,  to reduce product
costs,  and to increase its  manufacturing  flexibility,  the Company intends to
continue to improve certain manufacturing processes and add capital equipment to
its manufacturing  operations.  While the Company believes that these steps will
provide a greater level of control over, and flexibility  in, its  manufacturing
processes,  there  are no  assurances  that the  Company's  ability  to  produce
products and to meet required delivery  schedules will be sufficiently  improved
to meet the demands  created by increased  sales and more complex  manufacturing
processes.

Sources of Supply

         The Company  purchased  microprocessors  for its  advanced  information
security  products (the SignaSURE  line of products)  from a single  supplier in
1997. This supplier also provided a proprietary  card and key (token)  operating
system which will be discontinued after the current supply of microprocessors is
depleted.  The Company has also  developed its own  proprietary  card  operating
system which is "masked" into a new  microprocessor.  The new  microprocessor is
being  purchased  from a different  single  supplier,  will be placed into smart
cards and smart keys and introduced to the  marketplace  when the current supply
of microprocessors is depleted.

         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  interchanged  with  another.  Should the newly
arranged  source of supply become  inadequate or inferior to other  offerings in
the  future,  the  Company  will be  required  to incur a  significant  cost and
possibly experience a gap in supply to switch to a new supplier.

         The  Company  has  several  qualified  sources  from which to  purchase
printed  circuit  boards  and  electronic  components  for most of its  standard
portable  data  carriers.  The  components  for the  Company's  products are, in
general,  available from multiple suppliers.  Some of the plastic components are
molded  on the  Company's  in-house  molding  equipment  or  suppliers'  molding
equipment using Company-owned tooling.


<PAGE>

         The Company purchases  integrated circuits primarily through nationwide
multivendor  distributors.  If, for any reason, the Company would have to cancel
or reduce a particular integrated circuit order, it might thereafter have to pay
a higher price for the integrated  circuits.  Since general economic  conditions
have an  effect  on the  supply  and cost of  integrated  circuits,  there is no
guarantee  that  the  Company  will be able to  obtain  adequate  quantities  of
integrated  circuits to meet all of its production needs during periods of short
supply.

Significant Customer

         The Company  sells its  electronic  products to a number of  commercial
original  equipment   manufacturers   (OEMs)  and  other  customers,   including
governmental  entities.  At this time,  the Company is not  dependent on any one
customer  or few  customers,  the loss of which  would have a  material  adverse
effect on its business.

Marketing

         General.  While there appears to be a broad range of  applications  and
potential customers for portable data carriers,  no single application group has
evidenced  strong,  long-term  growth  potential.  The  diversity  of  potential
applications  has  made it  difficult  for the  Company  to  focus  its  limited
marketing  resources.   In  1995,  sales  to  OEM  customers  increased  23%  to
$7,219,000, in 1996 they decreased 9% to $6,559,000,  and in 1997 they decreased
11% to $5,868,000.  The Company  believes that commercial OEM sales may decrease
again in 1998.

         New end-user  products  being  developed for the  information  security
marketplace  were introduced in 1997 and, based upon current  expectations,  are
expected to result in material  revenue  during the second half of 1998. As with
any new product line, revenue will depend on customer acceptance,  the extent of
which is difficult to assess at this time.

         Market of OEM Products.  To date,  most  applications in the commercial
and  government  market  have  used  the Data Key for  electronic  security  and
equipment  control  applications.  The  Company  is  seeking  to  develop  other
long-term  business in this  market.  The Company  markets its  products to both
domestic and international customers using the following channels.

                  Domestic.   The  Company  markets  its  portable   information
products  domestically  through a  combination  of  direct  and  indirect  sales
personnel. In addition, it utilizes advertising,  trade shows and direct mail to
reach  its  buying  audience.  In 1997,  1996 and 1995,  OEM  sales to  domestic
customers, and the corresponding percentage of total revenue, were approximately
$4,068,000 (68%), $4,653,000 (71%) and $5,312,000 (74%), respectively.

                  International.  The Company  presently  markets  its  portable
information products  internationally  through an independent sales agent in the
United Kingdom and agents and/or distributors in Columbia,  Australia,  Belgium,
the  Netherlands  and Germany.  The Company has customers in other countries who
are  handled on a direct  basis from the  Company's  headquarters  in the United
States. The Company intends to expand into other  international  market areas in
the future.  In 1997, 1996 and 1995, OEM sales to international  customers,  and
the corresponding  percentage of total revenue,  were  approximately  $1,800,000
(30%), $1,906,000 (29%) and $1,907,000 (26%), respectively.


<PAGE>

End-User Products

         Datakey  plans to market  and sell its  advanced  information  security
products  (the  initial  offerings  in its  end-user  systems  line)  through  a
combination  of direct sales and  marketing  personnel,  dealers,  distributors,
value added resellers and system integrators/developers.

         The direct sales and marketing personnel will concentrate  primarily on
relationships with large security-conscious  organizations either through direct
or indirect contact,  establishing alliances with system  integrators/developers
and setting up  dealer/distributor  relationships  for its products.  The future
revenue of Datakey  end-user  systems is  dependent  on the success of a new and
untested  marketing  and  direct  sales  organization.   Also,  see  "Risks  and
Uncertainties"  in the  Management's  Discussion  and Analysis  contained in the
Company's 1997 Annual Report,  portions of which are included in Exhibit 13.1 of
this Report.

Backlog

         As of  March 9,  1998,  the  Company  had an  order  backlog,  totaling
approximately  $3,047,000,   including  approximately  $404,000  with  scheduled
shipment dates in 1999,  compared to $4,127,000 a year ago,  $1,187,000 of which
were  scheduled  for  shipment in 1998.  Although the orders  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.

Competition

         Electronic   Products.   The  Company's  primary  competition  for  its
electronic  products  sold to OEMs is  presently,  and is  expected  to  remain,
conventional  portable  information  systems,  such as keys and cards,  and more
advanced  portable  information  systems  including those in the familiar credit
card format,  such as "smart  cards,"  Personal  Computer  Memory Card  Industry
Association  (PCMCIA)  cards,  magnetic  stripe cards,  bar-code cards and laser
technology cards. The Company's products, when used as a portable data base, may
also compete with  centralized data base systems.  Many of the  manufacturers of
these  portable  information  devices and  systems  are large,  well-established
companies.

         A number of European and Japanese  firms continue to develop and refine
the smart card  technologies.  Some of these companies have  established  branch
offices in the United States to explore the United States  market.  To date, the
smart card has been used primarily in Europe,  where it has been  implemented in
prepaid telephone systems. In the United States, smart cards are currently being
used  mainly in field trial  environments.  Although  the Company  does not have
complete  information  about the status of these  trials,  the Company  believes
that, in time, the smart card will be successfully  developed and could become a
competitor,  especially in those markets which have a history of using a card or
a preference for card-type devices.

         Memory  cards,   such  as  PCMCIA  standard  cards,   are  functionally
equivalent  to the  Company's  portable  data  carriers  in  that  they  utilize
semiconductor  memory in  card-shaped  devices  made of  plastic.  Memory  cards
generally have larger memory  capacities than the devices  currently  offered by
the  Company  and  historically  incorporated  volatile,  battery-backed  memory
elements.  More  recently,   nonvolatile  (principally  "Flash  Memory")  memory
elements which do not require  battery backup have become more  prominent.  They
are  used  in  such  applications  as  laser  printer  fonts,   instrumentation,
electronic lettering machines and fax/modems,  and are also used as replacements
or "add ons" to diskettes  and hard drives for data storage in certain  desktop,
notebook and smaller portable computers.


<PAGE>

         Magnetic   stripe  cards  are  relatively   inexpensive  and  are  used
extensively  in the access  control  industry and in the banking and credit card
industries.  These markets are not priority  markets for the Company's  portable
information devices.  Magnetic stripe cards are not conveniently  updated,  have
limited  storage  capacity and generally have a useful life of one or two years.
As a result, the Company believes its products are technologically  superior and
may be more cost-effective for applications requiring more complex technologies.

         Another  technology  utilizes a strip of reflective  material  which is
laminated into a card.  Information is inscribed on this material through use of
a laser beam. Since these cards can contain several million bits of information,
the Company  believes  that this  technology  will be a  competitor  in portable
information markets where very large information storage capacities are required
and instantaneous management of information is not essential.

         The  Company's  ability to compete in the portable  information  market
will depend primarily on its ability to demonstrate superior product performance
at  cost-effective  prices and on the enhanced features of its system which make
it more effective than competing systems.

         Integrated  System  Solutions.  Datakey  currently  offers  token-based
(smart  card,  smart  key)  information  security  systems  which are  primarily
utilized in encryption  for  electronic  mail  privacy,  private and secure file
transfer and digital  signatures for  electronic  document  authentication.  The
Company also sells a digital  signature  based product,  known as SignaSURE EDM,
which  enables  users  to  electronically  sign  computer-aided  drafting  (CAD)
documents. The Company is continuing a significant product development effort to
expand the  applications  and  ease-of-use  of its  products  and  systems.  See
"Products--Integrated System 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 or smart key and  utilize  encryption  and  digital  signatures.  They also
include  extensive  software to make the system  user-friendly and seamless with
common desktop software  packages.  The Company feels this will provide a unique
combination of advanced security features at a reasonable  selling price.  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 and units for pilot  programs  have been  progressing
very  well.  There are no  assurances,  however,  that the  existing  and future
products will, in the long term, be accepted in the marketplace.


<PAGE>

Patents and Trademarks

         The  Company  has been  granted  several  patents by the United  States
Patent and Trademark  Office relative to the Data Key, its key interface and its
overall portable information device technology. The Company has sought and will,
when  appropriate,  continue  to  seek  patent  protection  in  several  foreign
countries.  The federal  registration  of the Datakey  trademark was approved in
1985. The Company also has patents in application or in the filing  process.  In
an industry  characterized by rapid  technological  change, the Company believes
that the knowledge,  experience and creativity of its employees will prove to be
more important than patent protection.

Employees

         The Company  presently employs 55 full-time  employees,  14 of whom are
involved in manufacturing,  5 in materials handling, 3 in quality assurance,  14
in engineering, 11 in marketing/sales and 8 in general and administrative areas.
In addition,  the Company uses contract labor during peak  production  times and
for major  projects.  The  Company's  employees  are not subject to a collective
bargaining  agreement,  and the Company believes that its employee relations are
good.

Forward Looking Statements

Certain  statements  made in this Form 10-KSB,  which are  summarized  here, are
forward-looking  statements  that  involve  risk and  uncertainties,  and actual
results may be materially different.  Factors that could cause actual results to
differ include, but are not limited to those identified:

--   The  expectation  that  Datakey  in the first  half of 1998 will  introduce
     additional versions of its token-based  information security systems, a new
     version of SignaSURE  CIP, and a new version of SignaSURE EDM is subject to
     the risk of  unanticipated  problems or delays in  development  and depends
     upon  market  acceptance  and  demand,  as well  as  other  general  market
     conditions and  competitive  conditions  within this market,  including the
     introduction of products by competitors.

--   The expectation that Datakey will begin to sell SignaSURE ESS in the second
     quarter of 1998 depends upon successful development efforts and meeting the
     currently scheduled timetable for such development.

--   The expectation that the Company will continue to improve its manufacturing
     processes,  leading to more efficient production,  depends on the Company's
     ability to monitor  such  processes  and to add  capital  equipment  to its
     manufacturing operations.

--   The expectation that the Company will expand sales in international markets
     depends on the acceptance of its products in such markets,  the quality and
     performance of the Company's products as compared to competitive  products,
     the  effectiveness  of relatively  new marketing and sales  personnel,  and
     other general market and competitive conditions within such markets.

ITEM 2.  DESCRIPTION OF PROPERTY

         The Company's corporate offices and manufacturing facility,  located at
407 West Travelers Trail, Burnsville, Minnesota, consists of 18,488 square feet.
Approximately  one-half of the space is used for  manufacturing and warehousing,
and the balance for present and future office space. All of this space is rented
under a lease  which  extends  through  June 1999.  The  Company  also  utilizes
approximately 2,400 square feet in a nearby office under a sublease that expires
in May 1999.  The  annual  rent  expense  for the space  currently  occupied  is
$156,000,  plus a portion of the operating  expenses and real estate taxes.  The
Company  believes  its  space is  sufficient  for its  needs in the  foreseeable
future, and it believes its property is adequately insured.


<PAGE>

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 1997.

                                     PART II

ITEM 5.           MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

         The  Company's  common  stock is traded on the Nasdaq  National  Market
System 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 1997
and 1996.

         On March 13, 1998, the Company had  approximately  1,100  shareholders,
including  approximately  800  beneficial  owners.  The  Company  has never paid
dividends and does not plan to in the foreseeable future.
                                                        Sale Prices
                                                    High      Low
1997
   1st Quarter.................................     $4 7/8    $2 1/4
   2nd Quarter.................................     $4 7/8    $1 7/8
   3rd Quarter.................................     $4 1/4    $3
   4th Quarter.................................     $4 1/4    $3 1/8

1996
   1st Quarter.................................     $5 7/8    $3 3/4
   2nd Quarter.................................     $8 3/4    $3 7/8
   3rd Quarter.................................     $7 3/4    $4 1/4
   4th Quarter.................................     $5 3/8    $3

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

         The  information  required by Item 6 is  incorporated by reference from
the Company's  1997 Annual  Report,  a portion of which is included  herewith in
Exhibit 13.1 to this Report.


<PAGE>

ITEM 7.  FINANCIAL STATEMENTS

         The  following  financial   statements  of  the  Company  are  included
immediately following the signature page of this Report on the pages indicated:

                                                                          Page
      Independent Auditor's Report                                         F-1
      Consolidated Balance Sheets as of December 31, 1997 and 1996         F-2
      Consolidated  Statements of Operations  for Years Ended  
             December 31, 1997,  1996  and 1995                            F-4
      Consolidated  Statements  of  Stockholders'  Equity for Years 
             Ended  December 31,  1997, 1996 and 1995                      F-5
      Consolidated  Statements  of Cash Flows for Years Ended 
             December 31, 1997,  1996 and 1995                             F-7
      Notes to Consolidated Financial Statements                           F-9


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 1998  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 1998  Annual  Meeting of  Shareholders  under the caption  "Compliance  With
Section 16(a) of the Exchange Act."

ITEM 10. EXECUTIVE COMPENSATION

         The information required by Item 10 is incorporated by reference to the
Company's proxy statement for its 1998 Annual Meeting of Shareholders  under the
caption "Executive Compensation."

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         The information required by Item 11 is incorporated by reference to the
Company's proxy statement for its 1998 Annual Meeting of Shareholders  under the
caption "Security Ownership of Management and Certain Beneficial Owners."



<PAGE>


ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

         None.

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

                  No reports on Form 8-K were  filed by the  Company  during the
quarter ended December 31, 1997.

<PAGE>


                                   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, 1998                    DATAKEY, INC.


                                          BY:      /s/ Carl P. Boecher
                                           Carl P. Boecher
                                           Chief Executive Officer and Director
                                           (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 Carl
P.  Boecher  and Alan G.  Shuler as his true and  lawful  attorneys-in-fact  and
agents,  each acting alone, with full power of substitution and  resubstitution,
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/ Carl P. Boecher       Chief Executive Officer and           March 26, 1998
Carl P. Boecher           Director (Principal Executive
                          Officer)

/s/ Alan G. Shuler        Vice President and Chief              March 26, 1998
Alan G. Shuler            Financial Officer (Principal
                          Financial and Accounting Officer)

/s/ Thomas R. King        Director and Secretary                March 26, 1998
Thomas R. King

/s/ Terrence W. Glarner   Director                              March 26, 1998
Terrence W. Glarner
 
/s/ Gary R. Holland       Chairman of the Board of              March 26, 1998
Gary R. Holland           Directors

/s/ Eugene W. Courtney    Director                              March 26, 1998
Eugene W. Courtney

/s/ John H. Underwood     Director                              March 26, 1998
John H. Underwood
<PAGE>

                          INDEPENDENT AUDITOR'S REPORT



To the Stockholders
Datakey, Inc.
Burnsville, Minnesota



We have audited the accompanying  consolidated  balance sheets of Datakey,  Inc.
and  Subsidiary as of December 31, 1997 and 1996,  and the related  consolidated
statements of operations,  stockholders'  equity, and cash flows for each of the
three years in the period ended December 31, 1997. These consolidated  financial
statements   are  the   responsibility   of  the   Company's   management.   Our
responsibility  is  to  express  an  opinion  on  these  consolidated  financial
statements based on our audits.

We  conducted  our  audits  in  accordance  with  generally   accepted  auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable  assurance about whether the  consolidated  financial  statements are
free of material  misstatement.  An audit includes  examining,  on a test basis,
evidence  supporting the amounts and disclosures in the  consolidated  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 consolidated  financial statements referred to above present
fairly, in all material respects,  the financial  position of Datakey,  Inc. and
Subsidiary as of December 31, 1997 and 1996, and the results of their operations
and their cash flows for each of the three  years in the period  ended  December
31, 1997, in conformity with generally accepted accounting principles.



                                                   /S/ McGladrey & Pullen, LLP
                                                   McGLADREY & PULLEN, LLP



Minneapolis, Minnesota
February 3, 1998


<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS
December 31, 1997 and 1996
<TABLE>
<CAPTION>

ASSETS (Note 9)                                                       1997         1996
                                                                  ----------   ----------
<S>                                                               <C>          <C>       
Current Assets
     Cash and cash equivalents                                    $1,305,392   $  140,030
     Investment in held-to-maturity securities (Note 2)                 --      5,993,228
     Trade receivables, less allowance for doubtful accounts of
         $30,000 in 1997 and $45,000 in 1996 (Note 7)                634,267      634,538
     Inventories (Note 3)                                          1,082,737    1,128,907
     Prepaid expenses and other                                       53,360       46,962
                                                                  ----------   ----------
                   Total current assets                            3,075,756    7,943,665
                                                                  ----------   ----------

Other Assets
     Deferred taxes (Note 4)                                            --        325,000
     Licenses and patents, less amortization--1997 $181,801;
         1996 $105,531 (Note 8)                                    1,104,302      228,986
                                                                  ----------   ----------
                                                                   1,104,302      553,986
                                                                  ----------   ----------

Equipment and Leasehold Improvements, at cost
     Production tooling                                            1,215,012    1,179,021
     Equipment                                                     2,956,269    2,561,659
     Furniture and fixtures                                          298,771      267,482
     Leasehold improvements                                          281,956      234,452
                                                                  ----------   ----------
                                                                   4,752,008    4,242,614

     Less accumulated depreciation                                 3,278,760    2,840,909
                                                                  ----------   ----------
                                                                   1,473,248    1,401,705
                                                                  ----------   ----------
                                                                  $5,653,306   $9,899,356
                                                                  ==========   ==========
</TABLE>

See Notes to Consolidated Financial Statements.

<PAGE>
<TABLE>
<CAPTION>


LIABILITIES AND STOCKHOLDERS' EQUITY                               1997            1996
                                                               -----------    -----------
<S>                                                            <C>            <C>        
Current Liabilities
     Accounts payable                                          $   184,103    $   559,280
     Accrued expenses:
         Compensation                                              410,055        538,664
         Other                                                      91,774        108,885
     License obligation (Note 8)                                   439,000           --
                                                               -----------    -----------
            Total current liabilities                            1,124,932      1,206,829
                                                               -----------    -----------

Commitments and Contingencies (Notes 5, 8, and 9)

Stockholders' Equity (Notes 5 and 6)
     Convertible preferred stock, voting, stated 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
         10,000,000 shares; issued and outstanding 2,887,235
         shares in 1997 and 2,882,069 shares in 1996               144,361        144,103
     Additional paid-in capital                                  4,089,283      4,070,815
Retained earnings (deficit)                                        (80,270)     4,102,609
                                                               -----------    -----------
                                                                 4,528,374      8,692,527
                                                               -----------    -----------
                                                               $ 5,653,306    $ 9,899,356
                                                               ===========    ===========

</TABLE>


<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1997, 1996, and 1995
<TABLE>
<CAPTION>

                                                            1997            1996            1995
<S>                                                    <C>             <C>             <C>         
Net sales (Note 7)                                     $  5,977,464    $  6,558,025    $  7,219,308
                                                       ------------    ------------    ------------
Costs and expenses:
     Cost of goods sold                                   4,389,367       4,282,062       4,821,516
     Research and development                             3,185,894       2,262,920         703,816
     Marketing and sales                                  1,716,343       1,311,663       1,123,781
     General and administrative                             713,308       1,156,270         669,954
                                                       ------------    ------------    ------------
                   Total costs and expenses              10,004,912       9,012,915       7,319,067
                                                       ------------    ------------    ------------

                   Operating loss                        (4,027,448)     (2,454,890)        (99,759)

Interest income                                             169,569         360,558         381,385
                                                       ------------    ------------    ------------
                   Income (loss) before income taxes     (3,857,879)     (2,094,332)        281,626

Income tax expense (benefit) (Note 4)                       325,000        (388,000)        106,000
                                                       ------------    ------------    ------------
                   Net income (loss)                   $ (4,182,879)   $ (1,706,332)   $    175,626
                                                       ============    ============    ============

Basic and diluted income (loss) per share              $      (1.45)   $      (0.60)   $       0.06
                                                       ============    ============    ============
</TABLE>

See Notes to Consolidated Financial Statements.



<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED  STATEMENTS OF STOCKHOLDERS'  EQUITY 
Years Ended December 31, 1997, 1996, and 1995
<TABLE>
<CAPTION>
                                                                                          Additional     Retained
                                    Convertible Preferred Stock       Common Stock          Paid-In      Earnings
                                         Shares     Amount          Shares     Amount       Capital      (Deficit)         Total
                                         -------   ---------      ---------   ---------   -----------   -----------    ------------
<S>                                      <C>       <C>            <C>         <C>         <C>           <C>             <C>         
Balance, December 31, 1994               150,000   $ 375,000      2,829,570   $ 141,479   $ 3,865,631   $ 5,633,315    $ 10,015,425
     Issuance of common stock 
        under stock options (Note 6)        --          --            5,666         283        20,256          --            20,539
     Net income                             --          --             --          --            --         175,626         175,626
                                         -------   ---------      ---------   ---------   -----------   -----------    ------------
Balance, December 31, 1995               150,000     375,000      2,835,236     141,762     3,885,887     5,808,941      10,211,590
     Issuance of common stock 
        under stock options (Note 6)        --          --           46,833       2,341       184,928          --           187,269
     Net loss                               --          --             --          --            --      (1,706,332)     (1,706,332)
                                         -------   ---------      ---------   ---------   -----------   -----------    ------------
Balance, December 31, 1996               150,000     375,000      2,882,069     144,103     4,070,815     4,102,609       8,692,527
     Issuance of common stock 
        under stock options (Note 6)        --          --            5,166         258        18,468          --            18,726
     Net loss                               --          --             --          --            --      (4,182,879)     (4,182,879)
                                         -------   ---------      ---------   ---------   -----------   -----------    ------------
Balance, December 31, 1997               150,000   $ 375,000      2,887,235   $ 144,361   $ 4,089,283   $   (80,270)   $  4,528,374
                                         =======   =========      =========   =========   ===========   ===========    ============
                                                                                                                        
</TABLE>

See Notes to Consolidated Financial Statements.

<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED  STATEMENTS OF CASH FLOWS 
Years Ended December 31, 1997, 1996, and 1995
<TABLE>
<CAPTION>

                                                                      1997           1996           1995
                                                                  -----------    -----------    -----------
<S>                                                               <C>            <C>            <C>        
Cash Flows From Operating Activities
     Net income (loss)                                            $(4,182,879)   $(1,706,332)   $   175,626
     Adjustments to reconcile net income (loss) to net
         cash provided by (used in) operating activities:
         Depreciation                                                 515,593        475,475        461,378
         Amortization                                                 127,723        134,041        133,253
         Change in accrued interest on investment
            securities                                                163,287         16,962        (44,399)
         Deferred taxes                                               325,000       (374,000)       114,000
         Changes in assets and liabilities:
            Trade receivables                                             271        420,537        135,818
            Inventories                                                46,170         94,031        126,047
            Accounts payable                                         (375,177)        49,597       (249,193)
            Other                                                    (152,118)       400,734         85,049
                                                                  -----------    -----------    -----------
                   Net cash provided by (used in)
                       operating activities                        (3,532,130)      (488,955)       937,579
                                                                  -----------    -----------    -----------

Cash Flows From Investing Activities
     Purchase of equipment                                           (587,136)      (351,795)      (262,892)
     Purchase of held-to-maturity securities                             --       (5,829,941)    (6,073,735)
     Proceeds from maturity of held-to-maturity
         securities                                                 5,829,941      6,073,735      5,974,726
     License and patent costs                                        (234,789)      (163,513)       (55,526)
                                                                  -----------    -----------    -----------
                   Net cash provided by (used in)
                       investing activities                         5,008,016       (271,514)      (417,427)
                                                                  -----------    -----------    -----------
</TABLE>

                                                    (Continued)

<PAGE>
DATAKEY, INC. AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued) Years Ended December 31, 1997,
1996, and 1995
<TABLE>
<CAPTION>

                                                                       1997           1996           1995
                                                                  -----------    -----------    -----------
<S>                                                                    <C>           <C>             <C>   
Cash Flows From Financing Activities
     Net proceeds from issuance of common stock                        18,726        187,269         20,539
     Payment on license obligation                                   (329,250)          --             --
     Payments on noncompete obligation                                   --             --          (82,500)
                                                                  -----------    -----------    -----------
                   Net cash provided by (used in)
                       financing activities                          (310,524)       187,269        (61,961)
                                                                  -----------    -----------    -----------

                   Increase (decrease) in cash and
                       cash equivalents                             1,165,362       (573,200)       458,191

Cash and Cash Equivalents
     Beginning                                                        140,030        713,230        255,039
                                                                  -----------    -----------    -----------
     Ending                                                       $ 1,305,392    $   140,030    $   713,230
                                                                  ===========    ===========    ===========

Supplemental Disclosures of Cash Flow Information
     Net cash refunds of income taxes                             $      --      $    75,112    $    63,038
                                                                  ===========    ===========    ===========

Supplemental Schedule of Noncash Investing and
     Financing Activity
     License obligation to licensor (Note 8)                      $   768,250    $      --      $      --
                                                                  ===========    ===========    ===========
</TABLE>

See Notes to Consolidated Financial Statements.






<PAGE>


Note 1.  Nature of Business and Significant Accounting Policies

Nature of business:  Datakey,  Inc. is an  international  supplier of electronic
products and services. The Company designs,  manufactures, and markets products,
subsystems,  and systems  solutions to record,  store,  and transmit  electronic
information.  The Company is  developing  products  and systems  directed to the
information   security  market  which  will  enable  user   identification   and
authentication,  secure data exchange, and information  validation.  The Company
also provides OEM products,  consisting of proprietary  memory keys,  cards, and
other  custom-shaped  tokens, that serve as a convenient way to carry electronic
information and are packaged to survive in portable environments.  The Company's
practice is to grant credit on an unsecured  basis to customers who meet certain
financial criteria.

A summary of significant accounting policies follows:

Principles of consolidation:  The consolidated  financial statements include the
accounts of Datakey,  Inc.  and its  wholly-owned  subsidiary.  All  significant
intercompany accounts and transactions have been eliminated in consolidation.

Use of estimates:  The  preparation of financial  statements in conformity  with
generally accepted  accounting  principles 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  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 consolidated 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.

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 market value.

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

Licenses and patents: Licenses and patents are stated at cost. Patents are being
amortized using the straight-line  method over their economic useful lives which
has been  estimated  to be five years.  The cost of the license  agreements  are
amortized to cost of goods sold as the products incorporating the licensed units
are sold (Note 8).

The Company periodically  reviews the utilization of its licenses,  patents, and
long-lived  assets for  impairment.  To date,  management has determined that no
impairment in the value of these assets has occurred.

<PAGE>


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

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                               5-7

Furniture and fixtures                    7

Leasehold improvements                 Life of lease


Warranty costs:  The Company provides for estimated normal warranty costs at the
time of product  sales to the  customers  and for other  costs  associated  with
specific items at the time their existence and amounts are determinable.

Income taxes: Deferred taxes are provided on a 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:  The Company  records  sales  revenue upon shipment to the
customer.

Research and development:  Research and development costs are charged to expense
as incurred.

Advertising:  Expenditures for advertising costs are expensed as
incurred.

Earnings (loss) per share: The Financial  Accounting  Standards Board has issued
Statement  No. 128,  Earnings Per Share,  which  supersedes  APB Opinion No. 15.
Statement  No.  128  requires  the  presentation  of  earnings  per share by all
entities  that have common stock or  potential  common  stock,  such as options,
warrants, and convertible securities, outstanding that trade in a public market.
Those entities that have only common stock  outstanding  are required to present
basic  earnings  per share  amounts.  Basic per share  amounts  are  computed by
dividing net income  (loss) (the  numerator) by the  weighted-average  number of
common shares outstanding (the denominator).  All other entities are required to
present basic and diluted per share  amounts.  Diluted per share amounts  assume
the conversion,  exercise, or issuance of all potential common stock instruments
unless the effect is to reduce the loss or increase  the income per common share
from continuing operations.

The Company  initially applied Statement No. 128 for the year ended December 31,
1997, and, as required by the statement,  has restated all per share information
for the prior years to conform to the statement.


<PAGE>

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

Following is  information  about the  computation of the earnings per share data
for the years ended December 31, 1997, 1996, and 1995:

                                          Numerator     Denominator   Net Income
                                                                       (Loss)
                                                                      Per Share

Year ended December 31, 1997:
Basic and diluted loss per share, loss
available to common stockholders          $(4,182,879)     2,886,924   $  (1.45)
                                          ============     =========   =========

Year ended December 31, 1996:
Basic and diluted loss per share, loss
available to common stockholders          $(1,706,332)     2,861,498   $  (0.60)
                                          ============     =========   =========

Year ended December 31, 1995:
Basic income per share, income available
to common stockholders                    $   175,626      2,829,885   $   0.06
                                                                       =========
Effect of dilutive securities:
Convertible preferred stock                     --           150,000
Stock options                                   --            65,289
                                          ------------     ---------

Dilutive income per share, income
available to common stockholders plus
assumed exercise of options               $   175,626      3,045,174   $   0.06
                                          ============     =========   =========

The Company had  outstanding  options to purchase  701,333 and 517,167 shares of
common  stock at an average  price of $3.84 and $4.37 per share during the years
ended  December  31, 1997 and 1996,  respectively.  The Company also has 150,000
shares  of  convertible  preferred  stock  outstanding.  Those  options  and the
preferred  stock were not included in the  computation of diluted loss per share
in 1997 and 1996 as they would be antidilutive.

Of the 452,334  options  outstanding  at December  31,  1995, a total of 125,000
options to purchase common stock at an average price of $5.60 per share were not
included in the  computation  of diluted  income per share  because the exercise
price of those options exceeded the average market price of the common shares in
1995.



Note 2.  Investment in Held-to-Maturity Securities

The  following  is a summary of the  Company's  investment  in  held-to-maturity
securities as of December 31, 1996:

                                               Gross       Gross
                              Amortized      Unrealized  Unrealized
                                Cost           Gains       Losses    Fair Value

U. S. government securities   $5,993,228   $      465   $    6,445   $5,987,248

All securities matured in 1997.


<PAGE>

Note 3.  Inventories

Inventories  consist of the  following  components  as of December  31, 1997 and
1996:



                                    1997         1996
                                 ----------   ----------
Raw materials                    $  766,955   $  754,629
Work in process                      63,007       87,453
Finished goods                      252,775      286,825
                                 ----------   ----------
                                 $1,082,737   $1,128,907
                                 ==========   ==========


Note 4.  Income Taxes

The income tax expense (benefit) consists of the following:

                                               December 31
                                     1997         1996         1995
                                  ---------    ---------    ---------
Currently payable (refundable):
  Federal                         $    --      $ (15,000)   $  (9,000)
  State                                --          1,000        1,000
Deferred                            325,000     (374,000)     114,000
                                  ---------    ---------    ---------
                                  $ 325,000    $(388,000)   $ 106,000
                                  =========    =========    =========

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

<TABLE>
<CAPTION>
                                                                  December 31
                                                      1997           1996           1995
                                                  -----------    -----------    -----------
<S>                                               <C>            <C>            <C>        
Computed "expected" federal tax expense
  (benefit) at statutory rates                    $(1,350,000)   $  (733,000)   $    99,000
Effect of graduated tax rates                          --             21,000         (3,000)
Effect of net operating loss carryforward, with
  no current benefit                                1,350,000        338,000           --
State income taxes, net of federal benefit             --              1,000          1,000
Change in valuation allowance                         325,000           --             --
Other                                                  --            (15,000)         9,000
                                                  -----------    -----------    -----------
Actual tax expense (benefit)                      $   325,000    $  (388,000)   $   106,000
                                                  ===========    ===========    ===========

</TABLE>


<PAGE>


Note 4. Income Taxes (Continued)

Net deferred tax assets (liabilities)  consist of the following components as of
December 31, 1997 and 1996:

                                             1997           1996
                                        -----------    -----------
Deferred tax assets:
  Allowance for doubtful accounts       $    11,000    $    16,000
  Inventory                                 239,000         86,000
  Warranty reserve                           18,000         18,000
  Compensation and benefits                  89,000        134,000
  Net operating loss carryforward         1,940,000        698,000
  Research and development tax credit        68,000           --
                                        -----------    -----------
Total gross deferred tax assets           2,365,000        952,000
  Valuation allowance                    (2,206,000)      (455,000)
                                        -----------    -----------
Net deferred tax assets                     159,000        497,000

Deferred tax liability:
  Depreciation                             (159,000)      (172,000)
                                        -----------    -----------
Net deferred tax asset                  $      --      $   325,000
                                        ===========    ===========

Realization  of  deferred  tax  assets  is  dependent  upon  the  generation  of
sufficient  future  taxable  income.  At  December  31,  1996,  the  Company had
established  a valuation  allowance  against a portion of the net  deferred  tax
assets in recognition of the risk that part of the loss  carryforward may not be
realized.  During 1997, management determined that sufficient uncertainty exists
regarding the  realizability of the deferred tax assets,  and  accordingly,  the
Company  increased the valuation  allowance to entirely reserve the net deferred
tax asset of the Company.

At  December  31,  1997,  the  Company's  net  operating  loss  carryforward  is
approximately $5,390,000 and expires as follows:



2011                  $       1,850,000
2012                          3,540,000


Note 5.  Preferred Stock

The preferred  shares are  convertible  at the rate of one share of common stock
for each share of preferred stock, subject to certain antidilution  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,  have a liquidation  preference of $2.50 per share,
and share in dividends paid on common stock.



<PAGE>


Note 6.  Stock Options

The Company has reserved  800,000 common shares for issuance under qualified and
nonqualified stock options for its key employees and directors.  The Company has
also reserved  50,000 common shares for issuance under  nonqualified  options to
various  distributors,  dealers,  and  consultants.  Option  prices are the fair
market  value of the stock at the time the option was  granted.  Options  become
exercisable  as  determined  at the date of grant by a committee of the Board of
Directors.  Options  expire ten years after the date of grant  unless an earlier
expiration date is set at the time of grant.

The Company has adopted the disclosure-only provisions of Statement of Financial
Accounting   Standards  No.  123,   Accounting  for  Stock-Based   Compensation.
Accordingly,  no  compensation  cost has been  recognized  for the stock  option
plans.  Had  compensation  cost  for  the  Company's  stock  option  plans  been
determined  based on the fair value at the grant date for awards in 1997,  1996,
and 1995  consistent  with the  provisions  of SFAS No. 123, the  Company's  net
income  (loss) and basic and diluted  income (loss) per share would have changed
to the pro forma amounts indicated below:



                                               Years Ended December 31
                                            1997            1996         1995

Net income (loss), as reported         $ (4,182,879)   $ (1,706,332)  $ 175,626

Net income (loss), pro forma             (4,391,620)     (1,844,604)    112,348

Basic and diluted income (loss), per
  share, as reported                          (1.45)          (0.60)       0.06

Basic and diluted income (loss), per
  share, pro forma                            (1.52)          (0.64)       0.04


The fair value of each option  grant is estimated on the date of grant using the
Black-Scholes   option-pricing   model  with  the   following   weighted-average
assumptions used for grants in 1997, 1996, and 1995:



                                             Years Ended December 31
                                             1997        1996        1995

Expected dividend yield                       --          --          --
Expected stock price volatility             53.26%      48.39%      32.76%
Risk-free interest rate                      6.17%       5.87%       6.71%
Expected life of options                   3.6 years   3 years     3 years
Weighted-average fair value of options
  granted during the year                  $ 1.39      $ 1.29      $ 1.15


The pro forma  effect on net loss or net income in 1997,  1996,  and 1995 is not
representative  of the pro forma effect in future years because it does not take
into consideration pro forma  compensation  expense related to grants made prior
to 1995.

<PAGE>
Note 6. Stock Options (Continued)

Additional  information  relating to all outstanding  options as of December 31,
1997, 1996, and 1995 is as follows:
<TABLE>
<CAPTION>
                                        1997                    1996                 1995
                                 ------------------    ------------------    -------------------
                                           Weighted-             Weighted-             Weighted-
                                            Average               Average               Average
                                           Exercise              Exercise              Exercise
                                 Shares     Price      Shares     Price      Shares     Price
                                 -------    -------    -------    -------    -------    --------
<S>                              <C>        <C>        <C>        <C>        <C>        <C>
Options outstanding at
  beginning of  year             517,167    $  4.37    452,334    $  4.16    179,000    $   5.17
Options exercised                 (5,166)      3.62    (46,833)      4.00     (5,666)       3.63
Options expired                  (80,668)      4.81    (27,334)      3.73    (33,000)       4.66
Options granted                  270,000       3.12    139,000       4.80    312,000        3.62
                                 -------    -------    -------    -------    -------    --------
Options outstanding at
  end of year                    701,333    $  3.84    517,167    $  4.37    452,334    $   4.16
                                 =======    =======    =======    =======    =======    ========
</TABLE>

The following table summarizes  information  about stock options  outstanding at
December 31, 1997:

<TABLE>
<CAPTION>
                                         Options Outstanding             Options Exercisable
                                      --------------------------    ----------------------------
                                        Weighted-
                                         Average
                        Number          Remaining      Weighted-       Number          Weighted-
   Range of           Outstanding      Contractual      Average       Exercisable       Average
   Exercise         at December 31,       Life         Exercise      at December 31,   Exercise
   Prices                1997            (Years)         Price            1997          Price
-------------       ---------------    -----------     ---------     ---------------   ---------
<S>                     <C>                <C>         <C>              <C>            <C>
$2.25 - $3.38           187,500            9.5         $   2.77         35,000         $  2.88
$3.50 - $5.00           383,833            8.5             3.69        214,333            3.65
$5.38 - $8.00           130,000            5.5             5.84        130,000            5.84
-------------       ---------------    -----------     ---------     ---------------   ---------
$2.25 - $8.00           701,333            8.2         $   3.84        379,333         $  4.33
=============       ===============    ===========     =========     ===============   =========

</TABLE>

Note 7.  Major Customers and International Sales

Major  customers:  Net sales  for  1997,  1996,  and 1995  include  sales to the
following major customers:

<TABLE>
<CAPTION>
                                   Amount of Net Sales           Trade Receivables Balance
                           ------------------------------------   -----------------------
                               1997         1996         1995         1997         1996
                           ----------   ----------   ----------   ----------   ----------
<S>                        <C>          <C>          <C>          <C>          <C>
U.S. government agencies   $1,198,000   $  889,000   $  993,000   $   70,000   $  103,000
Customer A                    616,000    1,161,000    2,158,000        1,000      104,000
Customer B                       --        376,000      563,000        --           --
Customer C                    638,000      471,000      530,000       95,000       14,000
                           ----------   ----------   ----------   ----------   ----------
                           $2,452,000   $2,897,000   $4,244,000   $  166,000   $  221,000
                           ==========   ==========   ==========   ==========   ==========
</TABLE>

International sales: Export sales to international customers for 1997, 1996, and
1995 were $1,800,000, $1,906,000, and $1,907,000, respectively.

<PAGE>
Note 8.  Commitments and Contingencies

License  agreement:  In  December  1996,  the  Company  entered  into a  license
agreement  with a software  company to allow the Company to bundle the  licensed
products into certain of the Company's products.  Under the agreement,  payments
to the software  company for the licensed  products are based upon the number of
units sold and the nature of the  software  bundled.  In  addition,  the Company
agreed to purchase a minimum  quantity of software units over a specified period
of time.  The value of the minimum  purchase is included in the initial  license
agreement.

At December 31, 1996, the Company had paid $109,750 as the first payment for the
license  agreement,  with an additional  $768,250 to be paid in seven  quarterly
installments  pending the successful  delivery of a beta version of the licensed
product from the software company in 1997. Upon delivery of the product in 1997,
the Company  recorded an  additional  liability of $768,250 and a  corresponding
asset for prepaid license fees.  Subsequently,  the software  company  announced
that  certain of the  licensed  software  would be  available  at no cost to the
general  public.  As a result of this  announcement,  the Company has  suspended
payments, with $439,000 remaining under the original agreement,  and the Company
is seeking to  renegotiate  the  agreement to reduce or eliminate  the remaining
liability.  Upon completion of any contract  amendment,  the prepaid license fee
and corresponding liability would be adjusted to reflect the new agreement.

Leases:   The  Company  leases  its  office  and  warehouse   facilities   under
noncancelable operating leases which expire in May and June 1999. Minimum annual
cash  commitments  under this lease are  approximately  $156,000 and $75,000 for
1998 and 1999,  respectively.  Total rent  expense  under these  leases  totaled
$136,000 in 1997 and $97,000 in 1996 and 1995.

Note 9.  Subsequent Event

In January 1998,  the Company  obtained a $1,000,000  line of credit from a bank
which  bears  interest  at 1.25  percent  above the prime rate and is secured by
substantially all assets of the Company.  The line of credit expires in May 1998
and is subject to annual renewal.




<PAGE>
                                  DATAKEY, INC.

                         EXHIBIT INDEX TO ANNUAL REPORT
                                 ON FORM 10-KSB
                   For the Fiscal Year Ended December 31, 1997

 Exhibit No.        Description

3.1      Restated  Articles  of  Incorporation,   as  amended  (Incorporated  by
         reference  to Exhibit 3.1 to Form 10-K for fiscal  year ended  December
         31, 1987)

3.2      Bylaws,  as Amended  (Incorporated  by reference to Exhibit 3.2 to Form
         10-K for fiscal year ended December 31, 1988)

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     License  Agreement  between CTS Corporation and the Company dated March
         9, 1988  (Incorporated  by  reference  to Exhibit 10.8 to Form 10-K for
         fiscal year ended December 31, 1987)
 
10.5     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)
 
10.6     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)
 
10.7     Employment  Agreement  between  Alan G.  Shuler and the  Company  dated
         January 1, 1995 (Incorporated by reference to Exhibit 10 to Form 10-QSB
         for fiscal year ended July 1, 1995)*

10.8     Consulting  Agreement  between  Gary R.  Holland and the Company  dated
         November 1, 1995  (Incorporated  by reference to Exhibit  10.19 to Form
         10-KSB for fiscal year ended December 31, 1995)*

10.9     Amendment dated February 11, 1997 to Consulting  Agreement between Gary
         R.  Holland and the Company  dated  November 1, 1995  (Incorporated  by
         reference  to  Exhibit  10.18 to Form  10-KSB  for  fiscal  year  ended
         December 31, 1996)*

10.10    Employment  Agreement  between  Carl P.  Boecher and the Company  dated
         January 1, 1997  (Incorporated  by reference  to Exhibit  10.19 to Form
         10-KSB for fiscal year ended December 31, 1996)*

10.11    Separation  Agreement  and Release  between John H.  Underwood  and the
         Company  dated  January 1, 1997  (Incorporated  by reference to Exhibit
         10.20 to Form 10-KSB for fiscal year ended December 31, 1996)*


<PAGE>

10.12    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)*

10.13    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)

10.14    Employment  Agreement between Michael L. Sorensen and the Company dated
         April 16, 1997*

10.15    1997 Stock Option Plan*

10.16    Forms of Incentive and Nonqualified  Stock Option Agreements under 1997
         Stock Option Plan*

13.1     Portions of 1997 Annual Report

21.1     Subsidiaries of the Company  (Incorporated by reference to Exhibit 21.1
         to Form 10-KSB for fiscal year ended December 31, 1994)

23.1     Independent Auditors' Consent

24.1     Power of attorney for Carl P. Boecher,  Alan G. Shuler, Thomas R. King,
         Terrence W. Glarner,  Gary R.  Holland,  Eugene W. Courtney and John H.
         Underwood (included on the signature page of this Form 10-KSB)

27       Financial Data Schedule (filed with electronic version only)

* Designates a management contract or compensatory plan or arrangement.