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, 1996

                           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: $6,558,025.

The  aggregate  market  value  of  the  voting  stock  (Common  Stock)  held  by
non-affiliates was approximately $5,278,000 based upon the closing sale price of
the Issuer's Common Stock on March 20, 1997.

As of March 20, 1997,  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, 1996 (the
"1996 Annual Report").  Portions of the Company's definitive Proxy Statement for
its Annual Meeting of Shareholders  to be held on June 4, 1997 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 is also  developing  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 2,048,000
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 is developing  additional  end-user  systems that are designed to
provide  advanced   information   security   utilizing  digital  signatures  and
encryption.  These systems will  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

OEM 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


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or updated.  The storage  capacities of the Company's  portable  memory  devices
range from 1,000 bits (150  alphanumeric  characters)  to  2,048,000  bits.  The
portable  data  carriers  are  priced  generally  between  $2 and $100 per unit,
depending on capacities and quantities purchased.

         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.

End-User Systems (Advanced Information Security Products)

         For the past  year,  Datakey  has been  developing  new  products  that
provide advanced security solutions to the problems of organizations, worldwide.
All of  Datakey's  new  products,  some of  which  Datakey  expects  to begin to
introduce by mid-1997, incorporate hardware tokens such as the key-shaped tokens
that the Company has been known for in the past.  The launch and success of such
products  is  dependent  on further  successful  development  efforts and market
acceptance, along with other risks. See "Outlook and Risks."

         SignaSURE CIP and SignaSURE CSP.  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
(Cryptoki Interface Provider) and SignaSURE CSP (Cryptographic Service Provider)
are designed to solve this problem,  allowing the Internet to be used safely for
electronic commerce.

         Both  SignaSURE CIP and SignaSURE CSP will allow 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. SignaSURE CSP provides the
same capability for applications that incorporate  Microsoft's  CryptoAPI.  Both
products  offer  "load,  plug  and  play"  convenience  for  strong  information
security.

         SignaSURE CIP and SignaSURE  CSP 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

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companion  reader/writer  that plugs into a computer's serial port, and software
which is loaded into the workstation and interfaces to the application  program.
The Company  expects to begin to sell the  SignaSURE  CIP and  SignaSURE  CSP in
mid-1997.

         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 is  designing 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 userdevelopers
who  utilize   SignaSURE  DTK  to  integrate  just  what  is  needed  for  their
application. The Company expects to begin to sell 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 CADcreated 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(TM)  operating systems, is compatible with
all CAD programs and file formats,  and moves design and drafting to a paperless
environment.

         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


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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.

         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 nonrepudiation. 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
half of 1997.

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

===================================================================================================================================
                                                                                       SignaSURE Product
-----------------------------------------------------------------------------------------------------------------------------------
Attribute                                                        CIP            CSP           DTK            EDM            ESS
-----------------------------------------------------------------------------------------------------------------------------------
<S>                                                              <C>            <C>           <C>            <C>            <C> 
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>

Research and Development

         During 1996,  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


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information security products, which are expected to be released for sale during
1997,  are designed to provide  encryption and digital  signatures  required for
electronically generated documents on computer networks.

         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.  As a result,  the  Company  must  continue  to  improve  its  present
information security products in order to remain competitive.

         In  1996,  1995  and  1994,  research  and  development  expenses  were
$2,263,000,  $704,000  and  $771,000,  respectively.  The Company  expects  that
research and development  expenses in 1997 will be significantly  higher than in
1996.

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  purchases  microprocessors  for its  advanced  information
security products (the SignaSURE line of products) from a single supplier.  This
supplier also provides a proprietary card and key (token) operating system which
will be discontinued  after the current supply of  microprocessors  is depleted.
The Company  believes the current supply is sufficient to meet the expected need
in 1997. Upon depletion of this supply, however, the Company will be required to
purchase new microprocessors  from this sole source or an alternative source and
provide  its own smart token  operating  system.  The Company has a  significant
development effort underway to produce its own proprietary smart token operating
system and expects it to be  available  by the time the  current  microprocessor
supply is exhausted.  Negotiations  and evaluations are also underway to qualify
and procure new  microprocessors  from the same source or an alternative source.
Although the Company has a schedule and plan in place to avoid any gap in supply
of the  microprocessors  and operating system,  there are no assurances that the
current  supply  will  not be  exhausted  earlier  than  expected,  that the new
operating  system will be  available on time and operate as intended or that new
microprocessors will be available when needed and operate satisfactorily.

         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


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molded  on the  Company's  in-house  molding  equipment  or  suppliers'  molding
equipment using Company-owned tooling.

         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 OEM 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, commercial sales to OEM customers increased 33% to
$6,205,000  and in 1996 they decreased 9% to  $5,669,000.  The Company  believes
that commercial OEM sales may decrease again in 1997.

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

         Commercial  Market of OEM Products.  To date, most  applications in the
commercial  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 1996, 1995 and 1994, sales to domestic customers,
and the corresponding percentage of total revenue, were approximately $3,763,000
(57%), $4,319,000 (60%) and $2,953,000 (50%), 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 1996, 1995 and 1994, sales to international  customers,  and the
corresponding  percentage of total revenue, were approximately $1,906,000 (29%),
$1,907,000 (26%) and $1,716,000 (29%), respectively.


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         Government  Market.  The  Company  markets its  products to  government
agencies through its direct sales and marketing personnel. The Company's primary
activity in this  segment has been in the  marketing  of its  portable  data and
access  devices to  government  agencies for use in various  secure  information
systems and in the  development  of custom  designed  portable  data devices for
other government programs.  In 1996, 1995 and 1994, sales to government agencies
and  government  subcontractors,  and  the  corresponding  percentage  of  total
revenue, were approximately $889,000 (14%), $993,000 (14%) and $1,146,000 (20%),
respectively.

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  "Issues  and
Uncertainties"  in the  Management's  Discussion  and Analysis  contained in the
Company's 1996 Annual Report,  portions of which are included in Exhibit 13.1 of
this Report.

Backlog

         As of  March 7,  1997,  the  Company  had an  order  backlog,  totaling
approximately  $4,127,000,  including  approximately  $1,187,000  with scheduled
shipment  dates in 1998,  compared to  $2,813,000  a year ago, all of which were
scheduled for shipment in 1996.  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

         OEM Products. The Company's primary competition for its OEM products 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.

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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.

         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 updatable, 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.

         End-User  Systems.  Datakey currently offers  token-based  (smart card,
smart  key)  information  security  products  which are  primarily  utilized  in
encryption for electronic mail and other electronic document privacy 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
presently  undertaking a significant  product  development  effort to expand the
applications    and    ease-of-use   of   its   products   and   systems.    See
"Products--End-User Systems."

         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 and
company  intranets and 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  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. There
are no assurances,  however,  that the products will be readily  accepted in the
marketplace when they become available.


                                        9

<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 50 full-time  employees,  18 of whom are
involved in manufacturing,  4 in materials handling, 2 in quality assurance,  11
in engineering,  8 in marketing/sales and 7 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.

Outlook and Risks

         As provided for under the Private  Securities  Litigation Reform Act of
1995,  the Company  wishes to caution  investors  that the  following  important
factors,  among  others,  in some cases have  affected  and in the future  could
affect the  Company's  actual  results of  operations  and cause such results to
differ materially from those anticipated in  forward-looking  statements made in
this  document and in the  Company's  1996 Annual  Report by or on behalf of the
Company:

         Uncertainty  of Market  Acceptance  of New  Products.  The  Company  is
currently  developing  new data security  products,  some of which it expects to
introduce by mid-1997.  While Datakey  performs market research and beta testing
to determine  the  viability of its new products,  actual user  acceptance  will
ultimately  dictate  the  success  of the  marketing  and sales  efforts  of new
products such as SignaSURE EDM and ESS.  Although the Company  believes that the
decision to fund these new products is correct, there are no assurances that the
investments already made and additional investments planned for 1997 will result
in a financial return.

         New Product  Development and Product Delivery.  Substantial  additional
development work is required for the  introduction of the Company's  planned new
information   security   products.   The  Company  expects  extensive   software
development  and  staffing  expenses to  contribute  to an overall  research and
development expense figure for 1997 in excess of that for 1996 and substantially
in excess of  previous  years.  No  assurance  can be given  that the  Company's
timetable  for these  development  plans will be  achieved  or that  development
efforts will be  successful.  Delays in the release of new  products  will cause
operational inefficiencies, increased development costs and reduced revenues.

         Dependence  on Key  Personnel.  The  Company is highly  dependent  on a
limited  number of key  management  and technical  personnel,  including Carl P.
Boecher who has been President and Chief  Executive  Officer since December 1996
and was Vice  President  of  Marketing  and Sales from  January 1995 to December
1996, Alan G. Shuler who has been the Vice President and Chief Financial Officer
since June 1992 and Jim Foley,  who joined the  Company in January  1997 as Vice
President of Engineering. The loss of key personnel, especially while working to
add a new product line, could have an adverse effect on the Company's  business,
financial condition and results of operations.


                                       10

<PAGE>



         Fluctuations  in Operating  Results.  Due to the  Company's  historical
dependence on sales to OEM customers who,  themselves,  must  successfully  sell
products containing  components produced by Datakey, the Company has experienced
year to year fluctuations in its revenue.  During the past three years,  Datakey
has marketed secure microprocessor-based tokens in the smart card format and its
patented  key  shaped  format,  along  with a file based  software  package  for
encrypting  and  digitally   signing   electronic   documents  in  the  emerging
information  data security  market.  The  information  data security market is a
rapidly developing and changing market, but to date the Company has not achieved
a high sales level on its current product  offerings.  In addition,  the Company
plans to spend  substantially  more for  research  and  development  of such new
products.  Therefore,  the Company  believes that its results of operations  may
fluctuate  as a result of the new  product mix and the timing of releases of new
products  and  product  upgrades.   As  a  result  of  its  product  development
expenditures, the Company expects to have significant losses in 1997.

         Competition  -  General.  Both the  Company's  OEM  Products  business,
consisting of portable  memory-based  systems,  subsystems  and  custom-designed
components  for  security-driven  markets,  and the  information  data  security
(end-user) market are highly  competitive.  The information data security market
is rapidly  developing.  There can be no assurance that the Company will be able
to effectively compete within such markets, and that others will not enter these
markets.  Competition in the sale of information  data security  products occurs
principally on the basis of price and  functionality.  Many of the manufacturers
of  portable  information  devices  and  systems  are  large,   well-established
companies.  Datakey's  information  security end-user products such as SignaSURE
EDM(TM) and SignaSURE ESS(TM) will integrate  hardware tokens with software that
provide a much higher level of security  than  software  implementations  alone.
There is a possibility that software-only solutions may overcome this deficiency
in the future.

         Price  Competition.   While  Datakey  believes  that  its  strategy  of
providing  token-based  product  solutions at a price that is  competitive  with
software-only  products is attainable,  there are no assurances that competitive
pressures will not force the Company to accept reduced margins to compete in the
future.  Large companies have  recognized the need for information  security and
could enter this market as competitors with much greater financial resources.  A
portion of its new end-user  products'  cost is royalties and license fees which
would need to be re-negotiated to maintain acceptable margins.

         Integrated  information  security products.  Although the Company's new
products  will  operate  seamlessly  with  popular  application  programs,   new
application  programs  that  integrate  information  security into their product
could erode the future market for these Datakey products.

         Marketing  and  sales.  The  future  revenue  of  Datakey  products  is
dependent  on the  success of a new and  untested  marketing  and  direct  sales
organization.

         Need for information  security.  Although corporate  utilization of the
Internet and internal intranets dictate a need for information  security,  there
are no assurances that other, more secure information transmission media may not
become  available  in the future  that would  preclude  the need for the type of
information security provided by the Company's products.


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,


                                       11

<PAGE>



and the balance for present and future office space. All of this space is rented
under a lease which extends  through June 1999.  The annual rent expense for the
space currently  occupied is $97,000,  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.


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 1996.


                                     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 1996
and 1995.

         On March 17, 1997, the Company had  approximately  1,350  shareholders,
including  approximately  1,000  beneficial  owners.  The Company has never paid
dividends and does not plan to in the foreseeable future.

                                   Sale Prices
                                                     High         Low
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

1995
   1st Quarter....................................   $4           $2 7/8
   2nd Quarter....................................   $4 1/8       $3 1/2
   3rd Quarter....................................   $4 1/4       $2 1/2
   4th Quarter....................................   $8 3/4       $3 3/8



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  1996 Annual  Report,  portions of which are included  herewith in
Exhibit 13.1 to this Report.

                                       12

<PAGE>





ITEM 7.           FINANCIAL STATEMENTS

         The  information  required by Item 7 is  incorporated by reference from
the Company's  1996 Annual  Report,  portions of which are included  herewith in
Exhibit 13.1 to this Report.


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

         None.

                                       13

<PAGE>



                                    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 1997  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 1997  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 1997 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 1997 Annual Meeting of Shareholders  under the
caption "Security Ownership of Management and Certain Beneficial Owners."

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 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, 1996.



                                       14

<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 28, 1997                      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 28, 1997
Carl P. Boecher            Director (Principal Executive
                           Officer)

/s/ Alan G. Shuler         Vice President and Chief            March 28, 1997
Alan G. Shuler             Financial Officer (Principal
                           Financial and Accounting Officer)

/s/ Thomas R. King         Director and Secretary              March 28, 1997
Thomas R. King

/s/ Terrence W. Glarner    Director                            March 28, 1997
Terrence W. Glarner

/s/ Gary R. Holland        Chairman of the Board of            March 28, 1997
Gary R. Holland            Directors

/s/ Eugene W. Courtney     Director                            March 28, 1997
Eugene W. Courtney

/s/ John H. Underwood      Director                            March 28, 1997
John H. Underwood

                                       15

<PAGE>



                                  DATAKEY, INC.

                         EXHIBIT INDEX TO ANNUAL REPORT
                                 ON FORM 10-KSB
                   For the Fiscal Year Ended December 31, 1996


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     Agreement  between  National  Security  Agency  and the  Company  dated
         September  30, 1986,  as amended on October 16, 1986  (Incorporated  by
         reference to Exhibit  10.5 to Form 10-K for fiscal year ended  December
         31, 1986)

10.2     Amendments  dated May 8, 1987, May 29, 1987, June 30, 1987 and February
         17, 1988 to Agreement  between National Security Agency and the Company
         dated September 30, 1986  (Incorporated by reference to Exhibit 10.6 to
         Form 10-K for fiscal year ended December 31, 1987)

10.3     1987  Datakey,  Inc.  Stock Option Plan  (Incorporated  by reference to
         Exhibit 10.7 to Form 10-K for fiscal year ended December 31, 1987)**

10.4     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)**

10.5     Amendments dated July 1, 1995 and March 19, 1996 to 1987 Datakey,  Inc.
         Stock Option Plan**

10.6     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)

10.7     Agreement  between  Maryland  Procurement  Office and the Company dated
         September 24, 1988 as amended on September 26, 1988,  November 7, 1988,
         November 9, 1988 and  December 19, 1988  (Incorporated  by reference to
         Exhibit 10.9 to Form 10- K for fiscal year ended December 31, 1988)

10.8     Agreement  between  Maryland  Procurement  Office and the Company dated
         October  2,  1989 as  amended  on  November  8, 1989  (Incorporated  by
         reference to Exhibit 10.10 to Form 10-K for fiscal year ended  December
         31, 1989)

10.9     Agreement  between  Maryland  Procurement  Office and the Company dated
         September  28, 1990 as amended on October 29,  1990,  February 22, 1991
         and May 15, 1991  (Incorporated  by reference to Exhibit  10.10 to Form
         10-K for fiscal year ended December 31, 1991)

10.10    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)


                                       16

<PAGE>





10.11    Agreement   between  National   Institute  of  Standards  &  Technology
         Acquisition of Assistance  Division and the Company dated June 2, 1992,
         as amended on June 3, 1992  (Incorporated by reference to Exhibit 10.12
         to Form 10-KSB for fiscal year ended December 31, 1992)*

10.12    Agreement  between  Maryland  Procurement  Office and the Company dated
         July 29,  1992,* as  amended  on  October  13,  1992  (Incorporated  by
         reference  to  Exhibit  10.13 to Form  10-KSB  for  fiscal  year  ended
         December 31, 1992)

10.13    Agreement  between  Maryland  Procurement  Office and the Company dated
         November 16, 1993  (Incorporated  by reference to Exhibit 10.15 to Form
         10-KSB for fiscal year ended December 31, 1993)*

10.14    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)

10.15    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)

10.16    Employment  Agreement  between  James P.  Foley and the  Company  dated
         January 1, 1996  (Incorporated  by reference  to Exhibit  10.18 to Form
         10-KSB for fiscal year ended December 31, 1995)**

10.17    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)**

10.18    Amendment dated February 11, 1997 to Consulting  Agreement between Gary
         R. Holland and the Company dated November 1, 1995**

10.19    Employment  Agreement  between  Carl P.  Boecher and the Company  dated
         January 1, 1997**

10.20    Separation  Agreement  and Release  between John H.  Underwood  and the
         Company dated January 1, 1997**

10.21    Management Incentive Plan dated February 27, 1997**

10.22    Lease  Amendment  No. 5 dated  December  17, 1996 to Lease  between the
         Company and Kraus-Anderson, Inc. dated June 3, 1987

13.1     Portions of 1996 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 Auditor's 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)

  * Confidential treatment has been granted for certain portion of this exhibit.
** Designates a management contract or compensatory plan or arrangement.       

                                       17