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SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549
 FORM 10-KSB ANNUAL REPORT
 ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 For the fiscal year
ended December 31, 2003
 Commission file No. 0-11447 DATAKEY, INC.  MINNESOTA
    
    41-1291472(State of incorporation or organization)
    
    (I.R.S. Employer Identification No.)
 407 West Travelers Trail, Minneapolis, Minnesota 55337
(Address of principal executive offices) Issuers telephone number, including area code: (952) 890-6850 Securities registered pursuant to Section 12(b) of the Act:            NONE
Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $.05 per shareSeries B Preferred Stock Purchase Rights Pursuant to Rights Agreement  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 fiscal year ending December 31, 2003: $4,113,000. The aggregate market value of the Issuers common stock held by non-affiliates
was approximately $8,104,307 based upon the closing sale price of the Issuers
common stock on March 16, 2004. As of March 16, 2004, there were 11,767,254 shares of the Issuers common stock
outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Companys definitive Proxy Statement for its Annual Meeting of
Shareholders to be held on May 26, 2004 are incorporated by reference pursuant
to Rule 12b-23 into Items 9, 10, 11, 12 and 14 of Part III. Transitional Small Business Disclosure Format (check one) YES [   ]  NO [ X ]




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TABLE OF CONTENTS  PART IITEM 1. DESCRIPTION OF BUSINESSITEM 2. DESCRIPTION OF PROPERTYITEM 3. LEGAL PROCEEDINGSITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSPART IIITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASE OF SECURITIESITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONITEM 7. FINANCIAL STATEMENTSITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSUREITEM 8A. CONTROLS AND PROCEDURESPART IIIITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANTITEM 10. EXECUTIVE COMPENSATIONITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATED STOCKHOLDER MATTERSITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONSITEM 13. EXHIBITS AND REPORTS ON FORM 8-KITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICESSIGNATURESEXHIBIT INDEXIndependent Auditors ReportBalance SheetsStatements of OperationsStatements of Stockholders EquityStatements of Cash FlowsNotes to Financial StatementsEmployment Agreement - Christopher A SchwartzbauerAmendment Employment Agreement - Alan G SchulerConsent of Independent AccountantsPower of AttorneyCertification of Chief Executive OfficerCertification of Chief Financial OfficerCertification of Chief Executive OfficerCertification of Chief Financial Officer    Table of Contents  
 PART I Forward-Looking Statements We make many statements in this Annual Report on Form 10-KSB under the captions
Description of Business, Managements Discussion and Analysis or Plan of
Operation,  Factors That Could Affect Future Results and elsewhere that
are forward-looking and are not based on historical facts. These statements
relate to our future plans, objectives, expectations and intentions. We may
identify these statements by the use of words such as believe, expect, will,
anticipate, intend, plan and similar expressions. These forward-looking
statements generally relate to our belief that users of network services will
increase their usage of smart cards; government agencies and financial service
organizations worldwide will continue to implement PKI-based security
infrastructures; and our strategic relationships will provide market leverage
and higher value solutions to new and existing customers. In addition, these
forward-looking statements reflect our specific expectations that research and
development, engineering and technical support expenses in 2004 will increase;
the demand for PKI enabled products will increase; our broader sales and
marketing efforts in 2004 will establish a market for Datakey Axis and increase
revenue growth over the next several years; our gross margins will improve in
2004; and our cash and cash equivalents together with expected revenues from
operations should be sufficient to meet anticipated working capital
requirements into the first quarter of 2005 (assuming the outstanding
convertible debt due in October 2004 is converted to capital stock or the
maturity date is extended). Our actual results could differ materially from
those anticipated in these forward-looking statements as a result of various
factors, including those we discuss under the caption Factors That Could
Affect Future Results and elsewhere in this report. These forward-looking
statements speak only as of the date of this report, and we caution you not to
rely on these statements without considering the risks and uncertainties
associated with these statements and our business that are addressed in this
report. Additional factors that could cause actual results to differ materially
from those expressed in these forward-looking statements include, among others,
the following:  
    
    we may be unable to secure other sources of working capital
financing should the holders of our secured convertible promissory
notes require the repayment of their notes on the October 17, 2004
maturity date;
    
    the timing and demand in the market for our Datakey Axis single sign-on product introduced in 2003;
    
    the loss of, and failure to replace, any significant customers;
    
    product developments, introductions and the pricing of products
competitive to our enterprise-wide access and identity management
products;
    
    the timing of substantial customer orders;
    
    the availability of qualified personnel;
    
    the performance of suppliers and subcontractors; and
    
    market demand, as well as industry and general economic or business conditions. In light of these risks and uncertainties, there can be no assurance that the
forward-looking statements contained in this report will prove to be accurate.
Unless required by law, we undertake no obligation to publicly update or revise
any forward-looking statements, or any facts, events, or circumstances after
the date hereof that may bear upon forward-looking statements. Information regarding market and industry statistics contained in the Business
section is included based on information available to us that we believe is
accurate. It is generally based on academic and other publications that are not
produced for purposes of economic analysis. We have not reviewed or included
data from all sources and cannot assure you of the accuracy of the data we have
included. 
 ITEM 1. DESCRIPTION OF BUSINESS General We were incorporated in Minnesota in 1976 under the name The Systems Group,
Inc. In 1980, we changed our name to Datakey, Inc. Our office is located at
407 West Travelers Trail, Minneapolis, Minnesota 55337-2558. Our telephone
number is (952) 890-6850 and our website is www.datakey.com. The information on
our website is not incorporated into and is not intended to be a part of this
report. We make available free of charge on or through our website our annual
report on Form 10-KSB, quarterly reports on Form 10-QSB, current reports on
Form 8-K and amendments to those reports filed or furnished pursuant to Section
13(a) or 15(d) of the Exchange Act as soon as reasonably practicable 2




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after we
electronically file such material with, or furnish it to, the U.S. Securities
and Exchange Commission. Unless the context otherwise indicates, all references to
the Registrant or Company in this Form 10-KSB relate to Datakey, Inc. We have registered DATAKEY® as a trademark with the U.S. Patent and
Trademark Office. We also use the trademarks Rapid Deploy Technology and
Model 330J Java Card. All other trademarks used in this report are the
property of their respective owners. We commenced business as a manufacturer of rugged memory keys and tokens to
reliably store and transfer electronic data. For more than two decades, our
unique, easy-to-use Data Keys were integrated into a wide range of industrial
and commercial applications throughout the world to help businesses run their
equipment and control their operations with electronic information. One notable
application for our tokens was accessing a cryptographic telephone used to
protect private and sensitive communications between high-ranking government
officials. We delivered more than one million tokens to operate these
cryptographic telephones. Recognizing the growing need to secure access to computer networks and to
protect electronic data  our memory key technology was revised and
re-engineered to develop a prototype secure token for computer workstation
authentication in 1989. Based on this secure token, we pioneered the first
cryptographic smart card used for digital signatures in 1991. During the 1990s, we continued to refine and set the standards for
cryptographic smart card technology, drawing upon our existing memory key
technology to form the basis for our new smart card product line. Since the
divestiture of our traditional Electronics Products (memory key) business unit
in August 2001, we have focused our remaining resources on delivering smart
card technology for access and identity management. Today, we believe that we are uniquely positioned to deliver comprehensive
smart card and token-based authentication and identity management solutions
that are easy to use and secure. Our solutions make it easier to manage user
identities and authentication to computer network resources and application
software. We believe our smart card and token-based solutions provide the
following potential benefits:  
    
    simplified administration, simplified user experience;
    
    reduced costs while strengthening security; and
    
    strong solutions that work the first time, every time. We generate revenue from the sale of our authentication and identity management
software; smart cards, tokens and smart card readers; maintenance, support and
technical support fees from agreements with end users; and license fees on a
per seat basis from the sale of our smart card and token-based operating system
and CIP software to original equipment manufacturers for incorporation into
their products. Recent Developments On January 6, 2003, we announced that the DataCard Group signed a reseller
agreement, enabling them to integrate and sell our Model 330 cryptographic
smart cards, CIP client software and smart card readers as part of their secure
authentication solution for enterprise solutions that allow businesses to
efficiently manage and secure enterprise resources and facility access. On February 3, 2003, we announced the market introduction of our Model 330J
Java Card. This new card is designed to meet the highest levels of
multi-application card security and efficiency, is fully compatible with our
CIP client software and other industry-leading information security products,
and supports important U.S. government smart card initiatives. On February 20, 2003, we announced our comprehensive solution, Datakey Axis,
for simplifying access and identity management throughout large and medium-size
enterprises by consolidating credentials on one smart card and giving
administrators a single point to manage user identity and access throughout a
company. On March 3, 2003, Carl Boecher resigned as our Chief Executive Officer and
President, but remained an officer and director until February 29, 2004.
Timothy Russell, who was previously our Vice President and General Manager,
replaced Mr. Boecher as the President and Chief Executive Officer, and joined
our Board. 3




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On April 3, 2003, we announced signing a license agreement with Precise
Biometrics for its Precise BioMatch Pro and Precise BioMatch C
technology that will allow us to integrate Precise Biometrics fingerprint
technology with our client software and smart card solutions. On July 1, 2003, we announced that Chris Schwartzbauer had joined us as our
Vice President of Sales and Business Development. Mr. Schwartzbauer is
responsible for worldwide sales including the development of an indirect sales
channel for the recently announced Datakey Axis product line. On August 11, 2003, Gary Holland resigned from our Board of Directors and his
position as Board Chairman citing a potential conflict of interest with his
other business activities. Gene Courtney, who has served on our Board for eight
years, was appointed Board Chairman and the Board now stands at five members
with three outside directors. On September 16, 2003, we announced that we delivered 25,000 smart ID badges to
the United States Patent and Trademark Office; of which many of these smart ID
badges are embedded with a smart card chip based on our cryptographic smart
card technology. In October 2003, in two separate transactions, we received $1.12 million from
the exercise of existing warrants and $2.0 million from the issuance of secured
convertible promissory notes with an aggregate face value of $2.0 million. As
part of this financing, holders of 1,600,000 warrants issued in February 2001
exercised all their warrants in connection with a re-pricing offer of $.70 per
share. In addition, holders who exercised February 2001 warrants to purchase an
aggregate of 1,295,933 shares were each granted one new warrant priced at $.77
per share for each warrant exercised. The secured convertible promissory notes
have a term of 12 months, and are secured by all of our assets and are
convertible into shares of our common stock at $1.25 per share. Holders of the
secured convertible promissory notes were also granted 4,000,000 warrants with
an exercise price of $.77 per share as part of the overall transaction. On November 11, 2003, we decided to withdraw our appeal and accept the pending
delisting of our common stock from the Nasdaq SmallCap Market. Following the
withdrawal of our appeal, the Nasdaq took action on November 12, 2003 to delist
our common stocks from the Nasdaq SmallCap Stock Market. Our shares were then
immediately eligible for quotation on the OTC Bulletin Board and began trading
on the OTC Bulletin Board as of the open of business on November 13, 2003. The
OTC Bulletin Board symbol assigned to Datakey is DKEY. On November 18, 2003, we announced that our client software and smart card
products were selected by the U.S. General Services Administration to secure
access to both their physical facilities and computing resources with a single
smart identification badge. On December 2, 2003, we announced that the US Department of Treasurys
Financial Management Service has incorporated our CIP client software and Model
330 smart card into their Secure Payment System. On January 14, 2004, we announced that readers of Microsoft Certified
Professional Magazine have named our Axis single sign-on product as the best
product for enforcing strong network authentication, according to results
published in the December 31, 2003 Products You Love issue. On February 23, 2004, we announced that David Feste had joined us as our Vice
President and Chief Financial Officer, replacing Alan Shuler, who will remain
an employee for a six month transition period. On February 24, 2004, we announced that we have received notification of
acceptance into the 2004 Microsoft Certified Partner Program, which will help
ensure that our products integrate fully within Microsoft operating
environments. Industry Background Computer networks enable people, businesses, governments and other entities to
communicate, conduct commerce, access and share information, entertain, provide
services and conduct countless other activities. Individuals and organizations
are now using computer networks for increasingly complex and sensitive tasks,
such as attracting new customers, accessing new markets and services, improving
customer service and satisfaction, and lowering support and distribution costs.
The use of computer networks is extending to a number of sensitive activities,
including business-to-business transactions, electronic data interchange, as
well as access to a variety of services and products available on the Internet. 4




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The growth in network computing and network services has created security
challenges for enterprises that rely on these networks and services. Industry
sources report that unauthorized access to computer systems and applications
accounted for 42% of security breaches in 2000, representing the largest
security problem for enterprises. In addition, their research shows that
passwords are the most common form of authentication  used by nearly 90% of
organizations for internal access and by nearly 75% of organizations for
external access. To meet these security challenges, enterprises must develop
strategies to control access to their computer network by implementing systems
that authenticate or identify users of the computer network and network
services through the use of stronger authentication methods. Such strategies
must provide for the following:  
    
    stronger authentication of users and systems on a computer network;
    
    stronger access control to the network services, such as to files and applications; and
    
    reasonable assurance of data integrity by controlling access to network resources and services. Historically, computer network access control issues have been addressed by a
variety of security products, including user authentication and personal
identity solutions. However, due to cost and complexity of some of these
authentication and personal identity solutions, such as the use of digital
signatures or public key infrastructures, many smaller to mid-sized enterprises
continue to rely on passwords to authenticate users. Password based
authentication for enterprises have tended to be problematic because people are
involved, which means simple passwords are generally chosen and passwords are
forgotten. Depending on the level of network resources requiring
authentication, industry sources estimate that the cost to the enterprise of
managing passwords is approximately $100 to $350 per employee. Investment in
the build-out of private, public and hybrid networks has been substantial in
recent years as applications for users have proliferated and network features
and functionalities have expanded. As a result, the complexity of network
administration, including identity management and user authentication, is
typically compounded by the variety of systems in place for each of its
services and applications. Today, an enterprise requires security solutions
that:  
    
    are easy to implement;
    
    convenient and easy to use for the user;
    
    preserve existing infrastructure and investment;
    
    reduce operating costs;
    
    simplify access to network applications and services for users;
    
    provide for increased network and application security;
    
    consolidate network and application authentication with broad access control coverage; and
    
    achieve an acceptable return on investment. The worldwide market for authentication devices and identity management
software is growing. Industry sources estimate that the worldwide market could
reach approximately $9.4 billion by 2005, up from $2.8 billion in 2000. Single
sign-on products, including our Datakey Axis product offering, will compete for
market share in a portion or subset of this $9.4 billion worldwide market,
which is estimated by industry sources to account for about a quarter, or
approximately $2.3 billion, of the total market for authentication smart cards,
tokens, and identity management software. Business Strategy We are focused on becoming a leading provider of simple and secure
authentication solutions. Simplifying a computer users experience, while
simultaneously increasing the security of the corporate computing environment
has proven to be quite difficult. Information security companies have marketed
a variety of technology solutions aimed at increasing security, but have at the
same time increased the burden on the computer user to remember one more thing
or perform additional steps during the login process. As a result, according
to industry sources, nearly 90% of organizations continue to use passwords to
control user access to computing systems and applications. As these
organizations move more and more processes to electronic systems, the number of
passwords a user must remember is growing. This trend results in a growing cost
to support users who forget their passwords and increased security risk due to
poor password polices and frequently written down passwords. This coupled with
increasing regulatory control of information access and privacy is leading many
organizations to search for a better way to manage and control access to
computing systems and applications. 5




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We introduced Datakey Axis, a smart card-based authentication and single
sign-on solution to address the current password management problem and to
provide a foundation for introducing stronger authentication methods. Datakey
Axis solves these problems while simultaneously simplifying the users
experience when logging into computer systems, applications and networks. With
an innovative client-only architecture and patent pending Rapid Deploy
Technology, organizations can quickly and easily implement the solution without
undertaking a major infrastructure change or requiring extensive end user
training. Datakey Axis essentially serves as an ATM card for usernames and
passwords. A user presents a password or personal identification number to the
smart card and the Axis software takes over all login and password management
(e.g. change) functions without requiring user action, a true single sign-on
experience. Our objective is to become the leading supplier of comprehensive smart
card-based solutions that simplify enterprise-wide access and identity
management. To achieve this objective, we are pursuing the following principal
strategies:  
    
    Expand our base of strategic partners, system integrators and OEMs.
We are committed to expanding our base of strategic partners, system
integrators and original equipment manufacturers to ensure that our
technology is broadly available and compatible with existing corporate
network and software infrastructures. We expect our other strategic
relationships to provide market leverage as the need for managing user
authentication develops in step with the increase in network
transactions and the consequent increased need for security.
    
    Make Datakey Axis the authentication and digital identity solution
of choice for network and application access.We believe that users of
network services will increase their usage of the smart card if it is
easy-to-use, has appealing applications and protects their personal
credentials. We will continue to develop our authentication and digital
identity management system to address the challenges of card issuance,
card and digital credential management and the complexity of the users
authentication experience.
    
    Support and grow our PKI-centric business.We believe that
government agencies and financial services organizations worldwide will
continue to implement PKI-based security infrastructures, which may
include smart card and token-based authentication systems.
    
    Leverage our existing customer base.We intend to leverage our
existing PKI-based customer base. We will attempt
to migrate these customers to our new product offering, Datakey Axis.
We also intend to market our product offerings to new customers by
referencing our existing customer base. Business Development Our business development efforts are focused on establishing and managing
collaborative relationships with strategic industry participants. We have
developed strategic relationships with partners in an effort to incorporate our
products into third-party products, and develop joint proposals and
presentations for products and services and reseller arrangements. Strategic
relationships assist us in expanding our sales, marketing and technical
capabilities and increase the distribution and market acceptance of our
products. Our strategic partners include the following:  
    
    Rainbow Technologies.We have licensed our client software and
smart card operating system as the basis for their iKey 2000
product line.
    
    DataCard Group. DataCard is an industry leading provider of smart
card printing and personalization equipment, software and services. We
have established a reseller relationship in North America to allow
DataCard dealers to offer Datakey Axis as a complement to DataCards
identification badge systems.
    
    Entrust.We have a long standing technology alliance with this
industry leading supplier of solutions that secure digital identities
and information. Our CIP software and 330 series smart card is
compatible with and certified for use with Entrust PKI security
solutions. Entrust PKI solutions have been installed by many government
agencies and financial services customers around the world.
    
    Precise Biometrics. We have incorporated Precise Biometrics
on-card finger recognition technology into our client software and
smart cards providing increased security and convenience for
organizations requiring a biometric replacement for smart card personal
identification numbers. We believe this relationship will provide
opportunities to offer higher value solutions to new and existing
customers. 6




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
    
    ASSA ABLOY. We have established a reseller relationship with this
worldwide leader in electronic physical access systems and technology.
We have integrated our smart card technology into their physical access
proximity card products creating an integrated enterprise access card
enabling physical, workstation, network and application access with a
single smart identification badge. We believe this relationship will
provide substantial exposure to organizations currently using access
card technology creating opportunities to sell Datakey Axis. Our
Solution - Interoperable Smart Card Solutions for Access and Identity Management We focus on delivering complete smart card and token-based security solutions
that simplify access and identity management throughout the enterprise. We
believe our solutions make it easier to administer digital identities and to
manage access to corporate resources. In turn, its more convenient and secure
for users to login to an enterprises resources by consolidating all
credentials onto onesmart card or token and automating access through a single
smart card or token sign-on. Our access and identity management software
solutions along with our smart cards and tokens enable enterprises to simplify
and increase the security of user authentication. A strict adherence to industry standards allows our technology to plug and
play with most authentication/security software. Customers and partners alike
rely on our interoperable technology as the foundation for securing a wide
range of their existing applications and environments. Product Applications Customers use our smart cards, tokens and software for a diverse range of
applications:  
    
    Smart Identification Card- Our smart cards, when combined with
building access control technologies, function as both an employees
physical identification as well as digital identification. The same
smart card that is used for network and computer security can be
personalized and printed with a personal photograph to function as an
employees identification badge, and fitted with a magnetic stripe or
RF proximity technology for door access systems.
    
    Password Management/Consolidation of Credentials- Our smart cards
offer a medium for storing all of a users access credentials,
including passwords, digital certificates, VPN/dial-up credentials or
biometric templates. Instead of having to remember multiple passwords
or maintain many certificates to access corporate applications and
protected web sites, the user only has to remember one PIN to activate
their smart card.
    
    Network Authentication- Our smart card technology is used to
enable secure network logon. Windows 2000, XP and later versions of
Windows support smart card logon. In addition, public key
infrastructure or PKI products can be deployed together with our smart
cards to enable secure network authentication and logon based on PKI.
Datakey smart card technology also works with dynamic password products
to enable an enterprise to use one-time authentication codes for
network access or application authentication. Datakey smart cards
integrate seamlessly with one-time password and authentication server
products.
    
    Single Sign-On- Our smart card solution enables single sign-on to
an enterprises applications and resources. When the user logs into the
network by inserting his or her smart card, he or she only enters his
or her PIN one time for authentication. In doing so, the user gains
access not only to the network, but also to company applications
(accounting system, CRM, e-mail, etc.).
    
    Secure E-Mail- Microsoft Outlook, Lotus Notes and Netscape
Messenger support our smart cards for digitally signing and encrypting
e-mail messages. A user generates/stores his or her digital certificate
and public/private key pair on his or her smart card, and through the
built-in support in Outlook, Notes and Messenger, each has the
capability of digitally signing his or her e-mail message or encrypting
an e-mail message when he or she possesses a valid certificate from
another user.
    
    Computer Security- Our smart card technology protects access to an
employees desktop/laptop computer, as well as protects the data that
resides on that computer. Our smart cards can be used for pre-boot
authentication, file/folder encryption and computer lock-down
functions.
    
    Secure Virtual Private Network or VPN Access -VPN technology gives
remote or traveling users the ability to connect to the corporate
network through a secure, encrypted network address. Many enterprises
are using our smart cards as part of their VPN solution to enable
greater security for user authentication. A users credentials, whether
password-based or a digital certificate, are stored on our smart card
for greater flexibility, portability and security. These credentials
travel with the user anywhere they carry their smart card. 7




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
    
    Digital Signature Applications- Our smart cards have been
integrated with a range of applications for digitally signing
electronic documents created under a variety of application programs. Our Products and Service Offerings Datakey Axis.Introduced in 2003, Datakey Axis is a smart card-based solution
that simplifies access control and identity management throughout the
enterprise. Axis makes it much more convenient and secure for users to login to
an enterprises resources by consolidating all credentials/user identities onto
one smart card and automating access through a single sign-on. With this
product, we are primarily targeting enterprises that do not currently intend to
install an information security system based on PKI. Axis Rapid Deploy Technology automates policy, credential and desktop
management through a single, powerful desktop-based management center. It makes
it easier to configure and deploy smart cards for access to a complete range of
corporate resources, without requiring any changes to the existing
infrastructure. In July 2003, we applied for a patent with the U.S. Patent and
Trademark Office for our Rapid Deploy Technology under the title,
Administrative System for Smart Card Technology. Success of this new product will depend upon our ability to demonstrate that
(i) it simplifies the management of multiple passwords for the administrator,
(ii) the smart cards convenience outweighs the cost, and (iii) passwords in
combination with smart cards are far more secure than passwords alone. We
believe large and medium-sized enterprises will benefit from rapid return on
investment with Datakey Axis through an increase in productivity and a
reduction in administrator workload. Datakey Cryptographic Interface Provider or 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 often
insufficient for public networks with connections, such as extranets and the
Internet, outside of the organization. Our CIP software allows enterprise users
to upgrade their software-only systems to token-based information security and
gain the benefit of secure Internet operation. Token-based information
security implements a two-level security scheme, something that is owned (a
hardware token) and something that is known (a password to activate the token),
for a much stronger level of security than password-based software solutions.
CIP provides token add-ons to Cryptoki (PKCS-11) standard information security
interface applications and for applications that incorporate Microsofts
CryptoAPI (CAPI). CIP offers load, plug and play convenience for strong
information security. CIP includes three elements:  
    
    a user-unique smart card or smart key token that holds critical
information and performs the cryptographic functions necessary for
information security;
    
    a companion reader that plugs into a computers serial port, PCMCIA port or USB port; and
    
    software that is installed in the workstation and interfaces to the application program. Datakey CIP Thin.A server-based version of the client based CIP for thin
client applications. CIP Thin contains all the features and functionality of
CIP, but is installed on the server instead of on each individual workstation. Datakey CMS or Card Management System.CMS is a web-based smart card and
digital credential management solution for enterprises; used to issue, manage
and support our cryptographic smart cards throughout the organization for
identity-based applications. CMS gives enterprise customers a powerful, secure
system that reduces the cost of deploying and supporting smart cards and
digital identity credentials. Through innovative, policy-based enrollment
features, CMS significantly reduces the time an enterprise must spend issuing
and managing smart cards for geographically distributed users. CMS makes it
easier to perform a wide range of critical digital credential management
activities; everything from requesting or renewing a users digital credentials
to revoking or re-issuing these credentials. Datakey Smart Cards.We offer several smart cards for use with our Axis, CIP
and CMS solutions. These cards support public and symmetric key encryption and
have received certification under appropriate U.S. and Canadian standards.
These smart cards include Models 330 and 330J, which is Java card compliant. OEM Private Label Product and Licensing.We provide our family of products to
third party original equipment manufacturers for sale under their own private
label. In addition to selling products, we license our smart card operating
system and CIP software to third party original 8




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equipment manufacturer for
incorporation into their products. Licenses are sold on a per seat basis with revenue recognized at time
of delivery to the customer, provided that we have no significant cost or
obligation beyond the original authorization to the silicon supplier. Services.We offer customers a variety of services, which range from advanced
customer support to supporting system integrators addressing large-scale
deployments of our products. We have offered customization services to adapt
our software products for specific customer requirements. In addition,
depending on the support and maintenance package purchased, we also offer
support and maintenance services for our software products and smart cards that
typically include telephone support, on-site support, installation and software
updates, bug fixes and upgrades. Sales We market and sell our products and technologies through a network of
distribution partners, such as systems integrators, value-added resellers and
original equipment manufacturers, as well as our own sales organization. Our
network of system integrators and resellers typically incorporate products from
a variety of suppliers to address end user requirements. Sales consisting of hardware, software and technical support fees for 2003 and
2002 were approximately $4,113,000 and $7,257,000, respectively. Export sales
to international customers, including Canada, for 2003 and 2002 were
approximately $2,181,000 and $4,168,000 or 53% and 57% of total sales,
respectively. Direct and indirect sales to U.S. government agencies were
approximately $1,586,000 and $1,756,000, or 39% and 24% of total sales in 2003
and 2002, respectively. We currently have approximately 20 active selling partners in North America.
Major selling partners in the North America include: Qunara, DataCard,
BearingPoint and Northrop Grumman. As of March 1, 2004, we had seven sales
representatives and two sales engineers on staff in the United States who are
responsible for soliciting prospective customers and providing primarily
pre-sales technical advice with respect to our product offerings. Outside of North America, we have relationships with independent
commission-based sales representatives and resellers. European sales are
handled through a relationship with HMK Computer Technologies Gmbh, which has
offices in Germany and the Netherlands. Other major selling partners outside
North America include: Ubizen, PointGroup, SoftLab, T-Soft and Rainbow
Technologies (Asia). Our relationship with any particular distribution partner is typically set
forth in a written distribution contract. The terms applicable to channel
distribution vary depending upon the type of distribution partner being
utilized. For instance, we typically use distributors and resellers to market
and distribute our hardware and client software products and we engage systems
integrators if it is likely that the customer will require more complex
installation routines. We have a large installed base of customers currently using our CIP software
systems and smart cards/tokens. The majority of our customers are governments
and financial services organizations throughout North America and Europe who
have implemented PKI-based security infrastructures. Our installed base of CIP
and CMS software systems includes, but not limited to, the following
organizations: Bank of International Settlement, Bausparkasse Schwaebisch Hall,
Canadian Department of National Defence, Clearstream Banking, Federal Deposit
Insurance Corporation, Federal Reserve Bank, Office of the Superintendent of
Financial Institutions (Canada), Rabobank, SWIFT, several agencies within the
Swiss Government, an agency of the State of New York, U.S. Department of State,
U.S. Department of Treasury and the U.S. Patent and Trademark Office. We provide technical and pre-sale support for existing and potential customers,
respectively, from our office located in Minneapolis, Minnesota. This office
also provides technical support to our integration and reselling partners, who,
in turn, provide first level support to their customers.
In addition, we provide telephone and online support services to answer
inquiries related to implementation, integration and operation of our products
and technologies. We are increasing the resources we dedicate to technical
service and support in line with the increased distribution of our products,
including a technical service web site with controlled access through the
Internet. We offer a maintenance program for the software products covering
updates and minor software releases. Our standard practice is to provide a
warranty on all our products for 90 days after shipment for hardware products
and the physical media on which our software may be contained. 9




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Manufacturing and Sources of Supply We do not maintain an internal manufacturing capability. We outsource the
manufacturing process for our smart cards, smart card readers, and USB tokens,
as well as the reproduction of our software. We place purchase orders with
these manufacturers and suppliers, the terms of which are negotiated on an
order-by-order basis or by a supply agreement. The microprocessor we use has our proprietary operating system masked into it
and is sourced from a single source, Philips Electronics. We contract with
third parties to incorporate the microprocessor into plastic cards and tokens.
There are alternate sources of supply available for the microprocessor, the
plastic cards and the tokens. We have not qualified other suppliers at this
time, but we believe we could do so without incurring significant cost or
disrupting supply in the event we switched suppliers. We purchase smart card readers from SCM Microsystems, OmniKey and GemPlus and
our USB tokens from Rainbow Technologies. These items are readily available
from multiple sources of supply. We offer a Smart Key version of our smart card offering. Although this product
has not received broad acceptance, several customers have expressed interest in
it as an alternative to the card. When we receive orders for this product, we
will purchase our requirements from Datakey Electronics, an unrelated third
party. Backlog Our customers typically require prompt delivery of our products and as such,
our product revenue is generally booked and shipped in the same quarter. Our
backlog is not material at any point in time and is not indicative of future
revenue. The timing and volume of customer orders are difficult to forecast and
are typically made pursuant to standard purchase orders that can be
rescheduled, reduced or cancelled prior to shipment without significant
penalty. Competition 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 sophisticated multi-function, all-in-one security appliances.
Competitive products use 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. Our advanced information security products are based upon a smart card, smart
key or USB token and utilize passwords, encryption and digital signatures. They
also include extensive software to make the system user-friendly and seamless
with common desktop software packages. There are several companies, including
ActivCard, Aladdin, Imprivata, Passlogix, Protocom and RSA, operating in this
highly competitive and rapidly changing marketplace. Some of our competitors
have strong name recognition and much greater financial resources than we do.
However, we believe our product offerings can compete on the basis of their
unique design and ease of use. The technology involved in information security
systems is undergoing rapid expansion and advancement that could result in the
development of new products and systems, which may make present information
security products obsolete. There are no assurances, however, that our existing
and future products will, in the long term, be accepted in the marketplace. Research and Development, Engineering and Technical Support In 2003 and 2002, research and development, engineering and technical support
expenses were approximately $2,054,000 and $2,314,000, respectively. We expect
our research and development, engineering and technical support expenses in
2004 to increase above 2003 levels as we continue to spend on product
development activities for the Datakey Axis product line, for technical support
on all of our products and to keep up with rapidly changing technology. Technology and Intellectual Property We rely on a combination of patents, trade secrets, copyright and trademark
law, nondisclosure agreements and technical measures to protect our
intellectual property and proprietary rights. We have entered into
confidentiality and licensing agreements with our employees and 10




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distributors,
as well as with our customers and potential customers seeking proprietary
information. We also limit access to and distribution of our software,
documentation and other proprietary information. We do not have any active patents in the United States, or elsewhere. However,
we have applied for a patent with the U.S. Patent and Trademark Office for our
Rapid Deploy Technology under the title, Administrative System for Smart Card
Technology. There can be no assurance that we will be issued a patent with
respect to this application. Employees As of March 1, 2004, the Company employs 32 full-time employees, three in
procurement and materials handling, nine in technical support and engineering,
14 in marketing/sales and six in general and administrative areas. Our
employees are not subject to a collective bargaining agreement, and we believe
employee relations are good. Governance Code of Ethics and Business Conduct.We have adopted a Code of Ethics and
Business Conduct or the Code, which must be signed by and applies to all or
our officers, employees and directors. Each employee, officer and director has
an obligation to behave according to ethical standards set forth in our Code,
and the letter and spirit of applicable laws, rules and regulations. A copy of
the Code will be available on our website at www.datakey.com, or is available
free of charge upon request. We intend to post on our website any amendments
to, or waivers from, the Code as soon as practical after the date of any such
amendment or waiver. 
 ITEM 2. DESCRIPTION OF PROPERTY We currently lease approximately 25,000 square feet of office and warehouse
space in a suburb of Minneapolis, Minnesota. Approximately 13,000 square feet
of the space we lease is currently subleased to Datakey Electronics, an
unrelated third party. The current lease and our sublease expire on June 30,
2004. Of the space not subleased, approximately one-third of the space is used
for shipping and warehousing, and the balance for present and future office
space. The rent expense, net of sublease payments, from January 1, 2004 through
June 30, 2004 is approximately $42,000, plus operating expenses and real estate
taxes. We are attempting to negotiate a new long-term lease or an extension to our
existing lease for our current corporate offices and shipping/warehouse
facility located near Minneapolis, Minnesota, as well as negotiating with other
landlords for alternative sites within the same geographic area. There can be
no assurance that we will be successful in negotiating favorable lease renewal
or extension terms with our current landlord, nor with landlords for
alternative sites. We do not expect the relocation of our operations to a new
leased facility to be disruptive to our business. In addition, we believe that
between 12,000 and 15,000 square feet of combined office and shipping/warehouse
space should be adequate to meet our foreseeable requirements. 
 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 2003. 
 PART II 
 ITEM 5. MARKET FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND SMALL BUSINESS ISSUER PURCHASE OF SECURITIES Our common stock was traded on the Nasdaq SmallCap Market until November 12,
2003, and on OTC Bulletin Board as of the opening of business on November 13,
2003. Shares of our common stock are quoted under the symbol DKEY. The
quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not represent actual transactions. The following table presents, for the
periods indicated, the range of high and low closing sales prices as reported
by the Nasdaq Stock Market through November 12, 2003, and the OTC Bulletin
Board system since that date. 11




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High
    
    Low20031st Quarter
    
    $
    1.92
    
    
    $
    0.702nd Quarter
    
    $
    1.60
    
    
    $
    0.583rd Quarter
    
    $
    1.20
    
    
    $
    0.594th Quarter
    
    $
    1.18
    
    
    $
    0.5720021st Quarter
    
    $
    6.99
    
    
    $
    3.652nd Quarter
    
    $
    5.05
    
    
    $
    2.503rd Quarter
    
    $
    3.60
    
    
    $
    2.014th Quarter
    
    $
    2.50
    
    
    $
    1.35
 On March 16, 2004, the closing sale price for our common stock as reported on
the OTC Bulletin Board system was $0.73. As of March 16, 2004, we had 211
shareholders of record for our common stock and approximately 3,500 beneficial
owners. We have never paid cash dividends on our common stock. Any payment of cash
dividends in the future will depend upon our earnings, financial condition,
capital requirements, and other factors deemed relevant by our board of
directors. It is unlikely that any dividends on our common stock will be paid
in the foreseeable future. Between October 1 and October 29, 2003, we sold an aggregate of 1,600,000
shares of common stock for $1,120,000 upon the exercise of warrants by
investors who had acquired the warrants in connection with a private placement
completed on February 20, 2001. In addition, at the time of exercise, we also
issued to certain investors upon the exercise of their warrants, five-year
warrants to purchase an aggregate 1,295,933 shares of common stock at $0.77 per
share. For these issuances, we relied on Rule 506 of Regulation D for an
exemption from registration requirements. On October 23, 2003, we completed a $2,000,000 financing, pursuant to which we
issued to accredited investors promissory notes convertible into 1,600,000
shares of common stock at $1.25 per share and five-year warrants to purchase an
aggregate of 4,000,000 shares of common at $0.77 per share. In connection with
the financing, we also issued to a finder a five-year warrant to purchase
10,000 shares of common stock at $0.77 per share. For the issuances relating to
the financing, we relied on Rule 506 of Regulation D for an exemption from
registration requirements. 
 ITEM 6. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion and analysis of our financial condition and results of
operations should be read together with our financial statements and related
notes appearing elsewhere in this report. This discussion and analysis contains
forward-looking statements that involve risks, uncertainties and assumptions.
The actual results may differ materially from those anticipated in these
forward-looking statements as a result of many factors, including but not
limited to those set forth under Factors That Could Affect Future Results and
elsewhere in this report. Overview We develop, manufacture and market products and services based on our
technologies for the information and security market. For information security
solutions based on PKI, our product and service offerings include Datakey CIP
and CMS; and for information security solutions based on passwords, our product
and service offering is Datakey Axis and its management center software. Both
product lines may use either or both our 330 smart card and iKey USB token. We
are currently developing improvements to our Axis and CIP product offerings,
which are expected to add greater functionality of features and extend its
compatibility with non-Windows based operating systems. We operate within a
single business segment, the information security market. Our revenue is
reported as a single component, which is comprised of four elements, including
(1) net sales of hardware products developed and manufactured by third parties,
(2) software products developed or licensed by us and reproduced by third
parties, (3) product support and maintenance service fees we have earned from
end users of our products, and (4) license fees paid by original equipment
manufacturers on the use of our smart card and
token-based operating system that they incorporate in to their products. 12




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Revenue from the sale of smart card and token-based products and systems based
on our technologies; maintenance, support and technical support fees from
agreements with end users, and from custom system integration consulting; and
license fees on a per seat basis from the sale of our smart card and token
operating system and CIP software to original equipment manufacturers for
incorporation into their products will fluctuate from quarter to quarter and
from year to year depending on, among other factors, demand by end users and
original equipment manufacturers for the products and services we offer, and
new product and service introductions. The table below summarizes changes in selected operating indicators, showing
certain income, cost and expense items as a percentage of total revenue from
continuing operations for each of the past two years. Inflation has not been a
significant factor in our operations to date. Percentage of Total RevenueYear Ended December 31
    
    2003
    
    2002Revenue
    
    
    100
    %
    
    
    100
    %Cost and Expenses:Cost of goods sold
    
    
    54
    
    
    
    50Research and development, engineering and
technical support
    
    
    50
    
    
    
    31Marketing and sales
    
    
    74
    
    
    
    46General and administrative
    
    
    17
    
    
    
    10Total cost and expenses
    
    
    195
    
    
    
    137Operating loss
    
    
    (95
    )
    
    
    (37
    )Interest income (expense)
    
    
    (4
    )
    
    
    0Loss before income taxes
    
    
    (99
    )
    
    
    (37
    )Income taxes
    
    
    
    
    
    
    Net loss from continuing operations
    
    
    (99
    )%
    
    
    (37
    )%
 Critical Accounting Policies and Estimates The following discussion and analysis of our financial condition and results of
operations are based upon our financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
The preparation of our financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues and
expenses, and related disclosure of contingent assets and liabilities. On an
on-going basis, we evaluate our estimates, including those related to bad
debts, inventories, income taxes, and contingencies and litigation. We base our
estimates on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ
from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our financial
statements. Revenue Recognition: We recognize revenue in accordance with the Securities and
Exchange Commissions Staff Accounting Bulletin No. 101, or SAB 101, Revenue
Recognition in Financial Statements. SAB 101 requires that four basic
criteria must be met before revenue can be recognized: (1) persuasive evidence
of an agreement exists; (2) delivery has occurred or services rendered; (3) the
fee is fixed and determinable; and (4) collectibility is reasonably assured.
Revenue from products and systems sold is recognized upon shipment to the
customer as we have no future obligation for support, upgrades or other
services. Revenue from maintenance and support obligations under a
product and system sale agreement that are not separately valued from the
product and system sold are valued based on those maintenance and support
agreements that are separately valued, and recognized over the term of the
contract. Revenue from maintenance and support agreements, as well as any
technical consulting fees, is deferred and recognized over the term of the
agreement or when the services have been rendered and are complete. Revenue
from license fees is recognized at time of delivery to our customer, an
original equipment manufacturer. Software Development Costs: We expense all of our software development costs as
incurred, due to uncertainties about the market acceptance of our products and
significant risks of rapid and continual changes in available technology that
could result in our software products becoming obsolete. We may capitalize such
costs in the future as market acceptance of our products becomes determinable. 13




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Valuation of Licenses: We utilize technology in our products, which is licensed
from third parties. License payments we make to third parties are stated at
cost on our balance sheets. The cost of these licenses is amortized to cost of
goods sold as the product incorporating the licensed units is sold or over the
term of the underlying license agreement. We review this asset category for
impairment and record impairment expense if warranted, based on the number of
licensed units sold. We recognized impairment expense of $91,000 and $49,000 in
2003 and 2002, respectively, and included this expense in cost of goods sold Valuation of Deferred Income Taxes.The carrying value of our net deferred tax
assets is based on our ability to generate sufficient taxable income in the
United States. We are generating operating losses and, therefore, are not a
taxpayer, nor are we able to demonstrate when we may be a taxpayer based on
future profitability. As a result, we have established reserves $9,375,000 and
$7,870,000, at December 31, 2003 and 2002, respectively, to reduce the carrying
value of our deferred tax assets to zero. Reserves for Doubtful Accounts and Obsolete/Excess Inventory.Based on our
judgment, we review our accounts receivable and inventory to establish reserves
that adjust the carrying value to the estimated net realizable value. Factors
we consider in establishing these reserves include economic conditions,
customer financial strength, product mix, sales levels and customer acceptance
of our products. As a result, we established reserves for doubtful accounts
receivable of $31,000 and $55,000 at December 31, 2003 and 2002, respectively,
and reserves for slow moving and obsolete inventories of $119,000 and $165,000
at December 31, 2003 and 2002, respectively. Results of Operations Comparison of 2003 with 2002 Total revenue:Net sales of our products and services were $4,113,000 in 2003
compared to $7,257,000 in 2002. The $3,144,000 decline in net sales was
primarily attributable to our inability to expand our customer base of
enterprises adopting or that have adopted PKI for information security, our
dependence of doing business with agencies of the U.S government and the
budgetary concerns of those agencies, the long sales lead times required for
our PKI product offerings, lost sales opportunities to those customers who are
unwilling to do business with us due to our size and lack of access to
additional sources of financing, and the loss of business to competitors with
substantially greater financial and marketing resources. We make no assurances
that potential customers will be more likely to do business with us, even with
greater financial resources, nor can we make assurances that our CIP and CMS
product offerings will ever find greater acceptance among those enterprises
adopting or that adopted PKI for information security. Our ability to increase
total revenues in the future will depend to a large extent on the acceptance of
and demand for Datakey Axis, which we introduced in 2003. With these factors in
mind, we currently expect total revenues in 2004 to increase significantly over
2003 levels because (i) we expect that demand for our PKI enabled products will
increase and (ii) we anticipate our broader sales and marketing efforts in 2004
to establish a market for Datakey Axis. Gross margins: Our gross profit margin decreased to 46% of revenue in 2003 from
50% of revenue in 2002 principally due to a product sales mix consisting of a
greater percentage smart card, token and card reader sales, which carry
significantly lower margins than our software products. We expect gross
margins to improve in 2004 as total revenues increase and as revenues from our
new product, Datakey Axis, start to comprise a larger percentage of total
revenue. Research and development, engineering and technical support: We incurred
research and development, engineering and technical support expense of
$2,054,000, or 50% of revenue, in 2003, compared to $2,314,000, or 31% of
revenue, in 2002. The decrease of $260,000 in research and development,
engineering and technical support expense is primarily due to a reduction in
payroll costs associated with a head count reduction of five technical support
and engineering personnel. Marketing and sales: We incurred marketing and sales expense of $3,058,000, or
74% of revenue, in 2003, compared to $3,347,000, or 46% of revenue, in 2002.
The decrease of $289,000 in marketing and sales expense in
2003 is primarily attributable to lower commissions paid on the lower level of
sales in 2003 partially offset by higher payroll costs associated with head
count additions in the second half of 2003. 14




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General and
administrative:We incurred general and administrative expense of
$692,000, or 17% of revenue, in 2003, compared to $707,000, or 10% of revenue,
in 2002. The decrease of 15,000 in general and administrative expense in 2003
is primarily attributable to a reduction in payroll costs and outside consulting
fees for investor
relations, largely offset by increased one-time severance costs resulting from the
departure of an officer and increased outside legal expenses. Interest income (expense):We incurred net interest expense of $148,000, or 4%
of revenue, in 2003, compared to net interest income of $45,000 in 2002. Our
net interest expense increased by $193,000 in 2003 due to additional expenses
of $164,000 attributable to the $2,000,000 convertible promissory notes
payable, which were issued on October 17, 2003, and lower interest income on
cash invested. Net loss from continuing operations:We incurred a net loss from continuing
operations of $4,079,000 in 2003, compared to a net loss of $2,668,000 in 2002.
The increase of $1,411,000 in net loss from continuing operations is a result
of significantly lower sales and gross margins partially offset by lower
expense levels. Net loss:We incurred a net loss of $4,079,000 in 2003, compared to a net loss
of $2,317,000 in 2002. For all of 2003 and 2002, we operated in a single
business segment. However, in 2002, we recognized a one-time gain of $351,000
on the disposal of a discontinued segment, which was attributable to finalizing
the sale of a business segment in 2001 that we reported as discontinued
operations. Liquidity and Capital Resources We have financed our operations to date primarily through private and public
sales of equity securities, the issuance of convertible promissory notes and
revenues from the sale of our products and services. Working capital, which is defined as current assets less current liabilities,
decreased by $2,425,000 from $3,953,000 at December 31, 2002 to $1,528,000 at
December 31, 2003. The single largest component of working capital is cash,
which increased by $139,000 from $2,563,000 at December 31 2002 to $2,702,000
at December 31, 2003. The increase in cash was primarily due to $3,075,000 of
cash provided by net cash proceeds from the issuance of common stock upon the
exercise of outstanding stock warrants and the issuance of $2,000,000 in
convertible promissory notes payable, offset by $2,568,000 of cash used to fund
operations and $367,000 used for the acquisition of capital assets. Even though
our cash increased in 2003, working capital decreased by $2,425,000 largely
because the convertible promissory notes payable and related accrued interest
expense were classified as current liabilities due to the contractual maturity
date for the repayment of these liabilities is October 17, 2004. We believe that our cash and cash equivalents, together with expected revenues
from operations, will be sufficient to meet our anticipated working capital
requirements into the first quarter of 2005. However, we will require
additional funds to support our working capital requirements in the fourth
quarter of 2004 should the convertible promissory note holders opt not to
convert the notes into our common stock or not to extend the maturity of the
notes beyond the scheduled maturity date of October 17, 2004. Should the
convertible promissory note holders decide not convert their notes into our
common stock during 2004, we will need to raise additional funds through public
or private equity financings or from other sources in order to ultimately repay
the notes and fund working capital in the future. Even if the convertible
promissory note holders convert their notes into our common stock, we may
require additional financing in 2005 to fund operations. We cannot be certain
that additional financing will be available on terms favorable to us, or at
all, or that any additional financing will not be dilutive. Contractual Cash Obligations The Company presently has no long-term debt outstanding and its only
contractual cash obligations are those from operating lease obligations and the
convertible promissory notes payable. Lease obligations total $162,000
over the next four years and debt and related accrued interest associated with
the convertible promissory notes could total $2,200,000 on October 17, 2004.
Approximately $95,000 of our total lease obligations of $162,000 relate to our
office and warehouse lease, which expires on June 30, 2004, and is payable
during the first half of 2004. Factors That Could Affect Future Results Certain statements made in this Annual Report on Form 10-KSB are
forward-looking statements based on our current expectations, assumptions,
estimates and projections about our business and our industry. These
forward-looking statements involve risks and uncertainties. Our business,
financial condition and results of operations could differ materially from
those anticipated in these forward-looking statements as a result of certain
factors, as more fully described below and elsewhere in this Form 10-KSB. You
should consider carefully the risks 15




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and uncertainties described below, which
are not the only ones facing our company. Additional risks
and uncertainties
also may impair our business operations. These forward-looking statements generally relate to our belief that users of
network services will increase their usage of smart cards; government agencies
and financial service organizations worldwide will continue to implement
PKI-based security infrastructures; and our strategic relationships will
provide market leverage and higher value solutions to new and existing
customers. In addition, these forward-looking statements reflect our specific
expectations that research and development, engineering and technical support
expenses in 2004 will increase; the demand for PKI enabled products will
increase; our broader sales and marketing efforts in 2004 will establish a
market for Datakey Axis and increase revenue growth over the next several
years; our gross margins will improve in 2004; and our cash and cash
equivalents together with expected revenues from operations should be
sufficient to meet anticipated working capital requirements into the first
quarter of 2005 (assuming the outstanding convertible debt due in October 2004
is converted to capital stock or the maturity date is extended). Our past losses and expected future losses cast doubt on our ability to operate
profitably. We incurred losses from operations of $4,079,227 and $2,316,743 in 2003 and
2002, respectively. Our ability to improve our operating performance is
primarily dependent on a significantly improved market for smart card-based
information security products for PKI applications and the successful
introduction of a new product, Datakey Axis, which offers information security
and convenience without requiring the use of PKI. There is no assurance that
the PKI market will improve or that our Datakey Axis product will receive
market acceptance. Our ability to achieve or sustain profitability thereafter
is uncertain. Raising the required capital to conduct our operations and develop our products
is time critical. We may require substantial capital resources in order to conduct our operations
and to further develop and market our products, including our new product
Datakey Axis. We believe that our available cash and expected revenue is
sufficient to finance operations through the first quarter of 2005, provided we
are able to extend the maturity of the convertible promissory notes for at
least an additional six months or obtain new financing to repay the convertible
promissory notes at the scheduled maturity date of October 17, 2004. We will
owe the convertible promissory note holders approximately $2.2 million,
including interest, on the scheduled maturity date of October 17, 2004. There
is no assurance that we will be able to obtain the necessary financing to repay
this loan at favorable or acceptable terms, if at all, nor is there any
assurance that the convertible promissory note holders will extend the maturity
date of this loan. If we are unsuccessful in extending the maturity date of the
note payable or in obtaining new financing to repay the note payable, our
ability to continue to operate in our current form would be in doubt. Even if
we are successful, any new financing or term extensions of the existing note
payable will likely result in significant additional dilution to current
shareholders. Our Common Stock is traded on the OTC Bulletin Board, which may affect its
market price and liquidity. In order to maintain the listing of our common stock on the Nasdaq Stock
Market, we had to continue to meet certain financial tests (including, but not
limited to, a minimum bid price of our common stock of $1.00). Except for a few
days, our common stock consistently traded below the $1.00 minimum level from
March 3, 2003 through November 12, 2003. In addition, the National Association
of Securities Dealers has a minimum listing requirement of $2.5 million of net
equity, unless either the market value of a companys securities exceeds $35
million or the company has net income of at least $500,000. As of June 30, 2003, we no longer met such minimum net equity requirement or
alternative requirements; and, on August 6, 2003, we received notice from
Nasdaq that it was reviewing our eligibility for continued listing on Nasdaq.
Despite the Companys diligent efforts to meet the requirements, our common
stock was delisted from the Nasdaq Stock Market on November 12, 2003. Our
common stock was then immediately eligible for quotation on the OTC Bulletin
Board and began trading on the OTC Bulletin Board as of the open of business on
November 13, 2003. Because our common stock now trades on the OTC Bulletin
Board, trading may be more difficult because of lower trading volumes,
transaction delays and reduced security analyst and news media coverage of
Datakey. These factors could contribute to lower prices and larger spreads in
the bid and ask prices for our common stock. The SEC has rules relating to penny stock. If our common stock becomes
characterized as penny stock as a result of being delisted by Nasdaq or
otherwise, broker-dealers dealing in our common stock will be subject to the
disclosure rules for transactions involving penny stocks. The additional
burdens imposed upon broker-dealers may discourage them from effecting transactions in penny stocks, which could
further have a material adverse effect on the trading market of our common
stock and further reduce the liquidity of our stock. 16




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##### Table of Contents



Success of our new product, Datakey Axis, depends on commercial acceptance and
demand. We believe our new Datakey Axis product, which we introduced in 2003, offers
significant advantages to our customers. Datakey Axis is substantially less
complex and costly than PKI technology based products, while continuing to
offer the security and convenience demanded within the market. The product has
only recently reached the market and we continue to work toward engaging
necessary resellers in North America and Europe. For these reasons and because
substantial funds are necessary to effectively market the product, there is no
assurance that this product will be accepted by our potential customers or that
it will generate a successful financial return. If the introduction of our
Datakey Axis product is unsuccessful, our ability to survive would not be
certain. The price of our Common Stock has significantly decreased January 2003. The market price of our common stock has decreased over the past year, from a
high of $1.92 on January 7, 2003 to a low of $0.57 on December 18, 2003. On
December 31, 2003, the last sale price quoted on the OTC Bulletin Board was
$0.69 per share. On March 16, 2004, the last sales price quoted on the OTC
Bulletin Board was $0.73 per share. The overall decrease over this period is
due in part to a decrease in the market for technology related stocks during
this time period, the delisting of our common stock by the Nasdaq Stock Market
on November 12, 2003 and our decreased revenues and working capital during
2003. Other factors that could adversely affect our stock price include:  
    
    availability of alternative future sources of financing;
    
    fluctuations in our operating results;
    
    announcements of technological collaborations, innovations or new products by us or our competitors;
    
    developments in patent or other proprietary rights owned by us or others;
    
    litigation;
    
    decisions by our strategic partners relating to the products incorporating our technologies; and
    
    general market conditions. We face the risks related to rapid technological change. In the information security market, we face continuing significant risks due to
the rapid and continual changes in available technology. Alternative
technologies may be developed that are superior to ours and may result in our
products becoming obsolete. We face significant price competition. Even if our technology can demonstrate a higher level of features and functions
than many of the current competitive products, there are no assurances that
competitive pressures will not force us to accept reduced margins to compete in
the future. Large companies with significantly greater resources have
recognized the need for information security and will likely enter this market
as competitors with much greater financial resources. Our success is highly dependent on our ability to retain our management team
and technical expertise. Our ability to succeed in the highly competitive information security business
depends upon the efforts and abilities of our management team, our sales
personnel, our software engineers and other technical personnel. Our inability
to retain such highly skilled persons, due either to our current economic
circumstances or the intense competition faced in the market for such persons,
would substantially limit our ability to further our efforts in this business. We may not be able to adequately enforce or protect our intellectual property
rights or to protect ourselves against infringement claims by others. Although we have filed an application with the U.S. Patent and Trademark Office
for a patent covering the technology underlying our Datakey Axis product, we
cannot assure you that a patent concerning this technology will be issued or
that any resulting patent will be of sufficient breadth to deter competitors
from attempting to replicate our technology. Whether or not we receive a patent
covering our Datakey Axis technology, our continued success will depend in part
on our ability to protect our manufacturing processes, preserve our trade
secrets and operate without infringing the proprietary rights of third parties.
We cannot assure you that the scope of any patent protection under the patent
that is under pending application or any other patents will exclude competitors
or provide competitive advantages to us. Furthermore, we cannot assure you that
others have not developed or will not develop
similar products or manufacturing processes, duplicate any of our products or
manufacturing processes or design around our patents or other intellectual
property. We also rely on unpatented trade secrets to protect our proprietary
technology, and we cannot assure you that others will not develop independently
or otherwise acquire substantially equivalent techniques, gain access to our
proprietary technology or disclose our technology, or that we can ultimately
protect meaningful rights to our unpatented proprietary technology. 17




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##### Table of Contents



Recent Accounting Pronouncements In December 2003 the staff of the Securities and Exchange Commission issued
Staff Accounting Bulletin No. 104, or SAB 104, which updated the guidance in
Staff Accounting Bulletin No. 101, or SAB 101, Revenue Recognition in
Financial Statements. SAB 104 also integrates the set of related SAB 101
Frequently Asked Questions and recognizes the role of the AICPAs Emerging
Issue Task Force, or EITF, consensus on Issue No. 00-21 Accounting for Revenue
Arrangements with Multiple Deliverables. The EITF concluded that revenue
arrangements with multiple elements should be divided into separate units of
accounting if the deliverables in the arrangement have value to the customer on
a standalone basis, if there is objective and reliable evidence of the fair
value of the undelivered elements, and as long as there are no rights of return
or additional performance guarantees by the Company. The provisions of EITF
Issue No. 00-21 are applicable to agreements entered into in fiscal periods
commencing after June 15, 2003. SAB 104 directs companies to identify separate
units of accounting based on EITF Issue 00-21 before applying the guidance of
SAB 104. We believe that neither our operating results nor our financial
condition will be materially affected by the provisions of EITF Issue
00-21, nor
by the guidance of SAB 104. However, we expect that with certain future sales
we may be required to separately allocate and defer revenue recognition on the
fair value of support and maintenance services provided as part of the bundled
price on the sale of some of our software products. 
 ITEM 7. FINANCIAL STATEMENTS The following financial statements of the Company are included herein following
the signature page of this Report on the pages set forth: Independent Auditors Report
    
    
    F-1Balance Sheets as of December 31, 2003 and 2002
    
    
    F-2Statements of Operations for Years Ended December 31, 2003 and 2002
    
    
    F-3Statements of Stockholders Equity for Years Ended December 31, 2003 and 2002
    
    
    F-4Statements of Cash Flows for Years Ended December 31, 2003 and 2002
    
    
    F-5Notes to Financial Statements
    
    
    F-6
 
 ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 
 ITEM 8A. CONTROLS AND PROCEDURES As of the end of the period covered by this report, the Company conducted an
evaluation, under the supervision and with the participation of the principal
executive officer and principal financial officer, of the Companys disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934 (the Exchange Act)). Based on this
evaluation, the principal executive officer and principal financial officer
concluded that the Companys disclosure controls and procedures are effective
to ensure that information required to be disclosed by the Company in reports
that it files or submits under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in Securities and
Exchange Commission rules and forms. There was no change in the Companys
internal control over financial reporting during the Companys most recently
completed fiscal quarter that has materially affected, or is reasonably likely
to materially affect, the Companys internal control over financial reporting. 
 PART III 
 ITEM 9. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 9 is incorporated by reference to the proxy
statement for our 2004 Annual Meeting of Shareholders under the captions
Corporate Governance, Determination of Number and Election of Directors,
Executive Officers of the Company and Section 16(a) Beneficial Ownership
Compliance. Our 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. 18




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##### Table of Contents



ITEM 10. EXECUTIVE COMPENSATION The information required by Item 10 is incorporated by reference to the proxy
statement for our 2004 Annual Meeting of Shareholders under the caption
Executive Compensation. 
 ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by Item 11 with respect to security ownership of
certain individuals is incorporated by reference to the proxy statement for our
2004 Annual Meeting of Shareholders under the caption Security Ownership of
Management and Certain Beneficial Owners. 
 ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 12 is incorporated by reference to the proxy
statement for our 2004 Annual Meeting of Shareholders under the caption
Certain Relationships and Related Transactions. 
 ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. The following exhibits are included in this report: See Exhibit Index
immediately following the financial statements following the signature page of
this Form 10-KSB. (b) Reports on Form 8-K. We filed three reports on Form 8-K during the fourth quarter of 2003: (1) on
October 17, 2003, announcing the closing of a $3.12 million financing, (2) on
October 30, 2003, announcing third quarter 2003 financial results, and (3) on
November 12, 2003, announcing the delisting of our common stock from the NASDAQ
Stock Market. 
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES The information required by Item 14 is incorporated by reference to the proxy
statement for our 2004 Annual Meeting of Shareholders under the caption
Ratification of Appointment of Auditors. 19




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##### Table of Contents



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 29,2004
    
    Datakey, Inc.
 BY:
    
    /s/David A. FesteDavid A. FesteVice President and Chief Financial 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 registrant and
in the capacities indicated on March 29, 2004. SIGNATURE
    

TITLE/s/ Timothy L. Russell
    
    President and Chief Executive Officer (Principal ExecutiveOfficer) and DirectorTimothy L. Russell/s/ David A. Feste
    
    Vice President and Chief Financial Officer (Principal Financialand Accounting Officer)David A. Feste*
    
    Director and SecretaryThomas R. King*
    
    DirectorTerrence W. Glarner*
    
    Director and ChairmanEugene W. Courtney
 By:
    /s/ David A. FesteDavid A. Feste, Attorney-In-Fact
 *David A. Feste, pursuant to the Powers of Attorney executed by each of the
directors above whose name is marked by a *, by signing his name hereto, does
hereby sign and execute this Annual Report on Form 10-K on behalf of each of
the directors in the capacities in which the name of each appears above. 20




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##### Table of Contents



DATAKEY, INC. 
 EXHIBIT INDEX TO ANNUAL REPORT
ON FORM 10-KSB
For the Fiscal Year Ended December 31, 2003 Exhibit No.
    
    Description3.1
    
    Restated Articles of Incorporation, as amended (Incorporated
by reference to Exhibit 3.1 to Form 10-KSB for fiscal year
ended December 31, 2002)3.2
    
    Restated Bylaws (Incorporated by reference to Exhibit 3.2 to
Form 10-KSB for fiscal year ended December 31, 2002)4.1
    
    Rights Agreement dated October 26, 2001 between the Company
and Wells Fargo Bank, as Rights Agent, including Statement of
Designation of Series B Preferred Stock, Summary of Rights to
Purchase Shares of Series B Preferred Stock and Form of Rights
Certificate included as exhibits (incorporated by reference to
Exhibit to the Companys Registration Statement on Form 8-A,
Reg. No. 0-11447)10.1
    
    1987 Datakey, Inc. Stock Option Plan (Incorporated by
reference to Exhibit 10.7 to Form 10-K for fiscal year ended
December 31, 1987)**10.2
    
    Amendment dated March 15, 1991 to 1987 Datakey, Inc. Stock
Option Plan (Incorporated by reference to Exhibit 10.5 to Form
10-K for fiscal year ended December 31, 1991)**10.3
    
    Amendments dated July 1, 1995 and March 19, 1996 to 1987
Datakey, Inc. Stock Option Plan (Incorporated by reference to
Exhibit 10.5 to Form 10-KSB for fiscal year ended December 31,
1996)**10.4
    
    Lease between the Company and Kraus-Anderson, Inc. dated June
3, 1987, as amended on February 10, 1988, December 23, 1988,
February 13, 1992 and April 1, 1992 (Incorporated by reference
to Exhibit 10.12 to Form 10-K for fiscal year ended December
31, 1991)10.5
    
    Manufacturing Agreement between Duncan Industries and the
Company dated August 27, 1993 (Incorporated by reference to
Exhibit 10.16 to Form 10-KSB for fiscal year ended December
31, 1993)10.6
    
    Employment Agreement between Alan G. Shuler and the Company
dated January 1, 1999 (Incorporated by reference to Exhibit
10.2 to Form 10-QSB for fiscal quarter ended April 3, 1999)**10.7
    
    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)10.8
    
    1997 Stock Option Plan (Incorporated by reference to Exhibit
10.15 to Form 10-KSB for fiscal year ended December 31,
1997)**10.9
    
    Forms of Incentive and Nonqualified Stock Option Agreements
under 1997 Stock Option Plan (Incorporated by reference to
Exhibit 10.16 to Form 10-KSB for fiscal year ended December
31, 1997)**10.10
    
    Lease Extension and Expansion Agreement between the Company
and Kraus-Anderson, Incorporated dated April 19, 1999
(Incorporated by reference to Exhibit 10.14 to Form 10-KSB for
fiscal year ended December 31, 1999)10.11
    
    Employment Agreement between Timothy Russell and the Company
dated August 16, 1999 (Incorporated by reference to Exhibit
10.15 to Form 10-KSB for fiscal year ended December 31,
1999)**
 21




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##### Table of Contents



Exhibit No.
    
    Description10.12
    
    Employment Agreement between Colleen M. Kulhanek and the
Company dated April 1, 2000 (Incorporated by reference to
Exhibit 10.1 to Form 10-QSB for fiscal quarter ended April 1,
2000)**10.13
    
    Loan Agreement dated January 23, 2001 between the Company and
Ray Lipkin and Unsecured Promissory Note dated January 26,
2001 in the amount of $500,000 (Incorporated by reference to
Exhibit 10.18 to Form 10-KSB for the year ended December 31,
2000)10.14
    
    Asset Acquisition Agreement dated August 3, 2001 between
Datakey, Inc. and Datakey Electronics, Inc. (Incorporated by
reference to Exhibit 2.1 of Form 8-K dated August 3, 2001)10.15
    
    2002 Executive Incentive Plan (Incorporated by reference to
Exhibit 10.18 to Form 10-KSB for the year ended December 31,
2001)**10.16
    
    2003 Executive Incentive Plan Incorporated by reference to
Exhibit 10.18 to Form 10-KSB for fiscal year ended December
31, 2002)**10.17
    
    Employment Agreement between Carl P. Boecher and the Company
effective March 1, 2003 (Incorporated by reference to Exhibit
10.19 to Form 10-KSB for fiscal year ended December 31,
2002)**10.18*
    
    Employment Agreement dated June 30, 2003, between Christopher
A. Schwartzbauer and the Company**10.19*
    
    Amended Employment Agreement dated February 23, 2004, between
Alan G. Shuler and the Company**23.1*
    
    Consent of Independent Accountant24.1*
    
    Power of attorney for Timothy L. Russell, David A. Feste,
Thomas R. King, Terrence W. Glarner and Eugene W. Courtney31.1*
    
    Certification of Chief Executive Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 20031.2*
    
    Certification of Chief Financial Officer Pursuant to Section
302 of the Sarbanes-Oxley Act of 200232.1*
    
    Certification of Chief Executive Officer Pursuant to Section
906 of the Sarbanes Oxley Act of 200232.2*
    
    Certification of Chief Financial Officer Pursuant to Section
906 of the Sarbanes Oxley Act of 2002
 * Filed herewith. **Designates a management contract or compensatory plan or arrangement. 22




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##### Table of Contents



(MCGLADREY & PULLEN LOGO) 
 Independent Auditors Report To the Stockholders
Datakey, Inc.
Burnsville, Minnesota We have audited the accompanying balance sheets of Datakey, Inc. as of December
31, 2003 and 2002, and the related statements of operations, stockholders
equity and cash flows for the years then ended. These financial statements are
the responsibility of the Companys management. Our responsibility is to
express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Datakey, Inc. as of December
31, 2003 and 2002, and the results of its operations and its cash flows for the
years then ended, in conformity with accounting principles generally accepted
in the United States of America. (McGladrey & Pullen, LLP) Minneapolis, Minnesota
February 3, 2004 F-1




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##### Table of Contents



Datakey, Inc. 
 Balance SheetsDecember 31, 2003 and 2002 2003
    
    2002Assets (Note 5)Current AssetsCash and cash equivalents
    
    $
    2,702,222
    
    
    $
    2,562,611Trade receivables, less allowance for doubtful accounts of
$31,000 in 2003 and $55,000 in 2002 (Note 9)
    
    
    930,183
    
    
    
    1,700,434Inventories (Note 3)
    
    
    442,775
    
    
    
    996,532Prepaid expenses and other
    
    
    68,296
    
    
    
    65,259Total current assets
    
    
    4,143,476
    
    
    
    5,324,836Other AssetsLicenses, less accumulated amortization (Note 4)
    
    
    445,739
    
    
    
    236,817Loan origination costs, less accumulated amortization
    
    
    71,896
    
    
    
    Patents, less accumulated amortization
    
    
    8,956
    
    
    
    526,591
    
    
    
    236,817Equipment and Leasehold Improvements, at costProduction tooling
    
    
    30,230
    
    
    
    23,650Equipment
    
    
    723,086
    
    
    
    735,916Furniture and fixtures
    
    
    168,802
    
    
    
    166,520Leasehold improvements
    
    
    310,912
    
    
    
    310,9121,233,030
    
    
    
    1,236,998Less accumulated depreciation
    
    
    (1,085,555
    )
    
    
    (927,844
    )147,475
    
    
    
    309,154Total assets
    
    $
    4,817,542
    
    
    $
    5,870,807Liabilities and Stockholders EquityCurrent LiabilitiesNotes payable (Notes 2 and 5)
    
    $
    1,522,951
    
    
    $
    Accounts payable
    
    
    413,864
    
    
    
    574,266Accrued expenses:Compensation
    
    
    266,762
    
    
    
    287,718Interest
    
    
    41,096
    
    
    
    Other
    
    
    64,115
    
    
    
    154,267Deferred revenue
    
    
    306,324
    
    
    
    355,338Total current liabilities
    
    
    2,615,112
    
    
    
    1,371,589Commitments and Contingencies (Notes 2, 4, 5 and 10)Stockholders Equity (Notes 7 and 8)Convertible preferred stock, voting, liquidation value $2.50 per share;
authorized 400,000 shares; issued and outstanding 150,000
    
    
    375,000
    
    
    
    375,000Common stock, par value $0.05 per share; authorized 20,000,000 shares;
issued and outstanding 11,732,708 in 203 and 10,082,750 in 2002
    
    
    586,635
    
    
    
    504,138Additional paid-in capital
    
    
    20,621,092
    
    
    
    18,921,150Accumulated deficit
    
    
    (19,380,297
    )
    
    
    (15,301,070
    )Total stockholders equity
    
    
    2,202,430
    
    
    
    4,499,218Total liabilities and stockholders equity
    
    $
    4,817,542
    
    
    $
    5,870,807
 See Notes to Financial Statements. F-2




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##### Table of Contents



Datakey, Inc.Statements of OperationsYears Ended December 31, 2003 and 2002 2003
    
    2002Net sales (Note 9)
    
    $
    4,113,374
    
    
    $
    7,257,109Costs and expenses:Costs of goods sold
    
    
    2,239,782
    
    
    
    3,601,347Research and development, engineering and technical support
    
    
    2,054,427
    
    
    
    2,314,391Marketing and sales
    
    
    3,058,285
    
    
    
    3,346,501General and administrative
    
    
    692,184
    
    
    
    707,296Total costs and expenses
    
    
    8,044,678
    
    
    
    9,969,535Operating loss
    
    
    (3,931,304
    )
    
    
    (2,712,426
    )Interest income
    
    
    16,124
    
    
    
    44,637Interest expense
    
    
    (164,047
    )
    
    
    Loss from continuing operations before income taxes
    
    
    (4,079,227
    )
    
    
    (2,667,789
    )Income tax expense (Note 6)
    
    
    
    
    
    
    Net loss from continuing operations
    
    
    (4,079,227
    )
    
    
    (2,667,789
    )Gain on disposal of discontinued segment (Note 11)
    
    
    
    
    
    
    351,046Net loss
    
    $
    (4,079,227
    )
    
    $
    (2,316,743
    )Loss per share:Basic and diluted loss from continuing operations
    
    $
    (0.39
    )
    
    $
    (0.26
    )Basic and diluted gain from discontinued operations
    
    
    
    
    
    
    0.03Basic and diluted loss per share
    
    $
    (0.39
    )
    
    $
    (0.23
    )Weighted-average common shares:Basic and diluted
    
    
    10,423,140
    
    
    
    10,074,871
 See Notes to Financial Statements. F-3




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##### Table of Contents



Datakey, Inc. 
 Statements of Stockholders EquityYears Ended December 31, 2003 and 2002 Convertible PreferredStock
    
    Common StockAdditionalPaid-In
    
    AccumulatedShares
    
    Amount
    
    Shares
    
    Amount
    
    Capital
    
    Deficit
    
    TotalBalance, Dec. 31, 2001
    
    
    150,000
    
    
    $
    375,000
    
    
    
    9,974,012
    
    
    $
    498,701
    
    
    $
    18,580,288
    
    
    $
    (12,984,327
    )
    
    $
    6,469,662Exercise of stock options
    
    
    
    
    
    
    
    
    
    
    6,667
    
    
    
    333
    
    
    
    9,667
    
    
    
    
    
    
    
    10,000Exercise of warrants
    
    
    
    
    
    
    
    
    
    
    80,268
    
    
    
    4,014
    
    
    
    272,109
    
    
    
    
    
    
    
    276,123Issuance of common
stock in accordance with
employee stock purchase
plan (Note 8)
    
    
    
    
    
    
    
    
    
    
    21,803
    
    
    
    1,090
    
    
    
    59,086
    
    
    
    
    
    
    
    60,176Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,316,743
    )
    
    
    (2,316,743
    )Balance, Dec. 31, 2002
    
    
    150,000
    
    
    
    375,000
    
    
    
    10,082,750
    
    
    
    504,138
    
    
    
    18,921,150
    
    
    
    (15,301,070
    )
    
    
    4,499,218Exercise of stock options
    
    
    
    
    
    
    
    
    
    
    12,259
    
    
    
    613
    
    
    
    (491
    )
    
    
    
    
    
    
    122Exercise of warrants
    
    
    
    
    
    
    
    
    
    
    1,600,000
    
    
    
    80,000
    
    
    
    1,040,000
    
    
    
    
    
    
    
    1,120,000Issuance of common
stock in accordance with
employee stock purchase
plan (Note 8)
    
    
    
    
    
    
    
    
    
    
    37,699
    
    
    
    1,884
    
    
    
    43,730
    
    
    
    
    
    
    
    45,614Compensation expense
recorded on stock
options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,703
    
    
    
    
    
    
    
    7,703Compensation expense
recorded on warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,500
    
    
    
    
    
    
    
    7,500Issuance of warrants
with note payable
(Note 5)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    601,500
    
    
    
    
    
    
    
    601,500Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,079,227
    )
    
    
    (4,079,227
    )Balance, Dec. 31, 2003
    
    
    150,000
    
    
    $
    375,000
    
    
    
    11,732,708
    
    
    $
    586,635
    
    
    $
    20,621,092
    
    
    $
    (19,380,297
    )
    
    $
    2,202,430
 See Notes to Financial Statements. F-4




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##### Table of Contents



Datakey, Inc. 
 Statements of Cash FlowsYears Ended December 31, 2003 and 2002 2003
    
    2002Cash Flows From Operating ActivitiesNet Loss
    
    $
    (4,079,227
    )
    
    $
    (2,316,743
    )Adjustments to reconcile net loss to net cash used in operating activities:Depreciation
    
    
    183,922
    
    
    
    170,528Amortization
    
    
    145,801
    
    
    
    182,847Amortization of debt discount
    
    
    122,951
    
    
    
    Loss on disposal of equipment
    
    
    
    
    
    
    682Noncash compensation
    
    
    16,703
    
    
    
    Changes in operating assets and liabilities:Trade receivable
    
    
    770,251
    
    
    
    536,366Inventories
    
    
    553,757
    
    
    
    (70,504
    )Prepaid expenses
    
    
    (3,037
    )
    
    
    19,174Accounts payable
    
    
    (160,402
    )
    
    
    7,921Deferred revenue
    
    
    (49,014
    )
    
    
    (119,559
    )Accrued expenses
    
    
    (70,012
    )
    
    
    10,768Net cash used in operating activities
    
    
    (2,568,307
    )
    
    
    (1,578,520
    )Cash Flows from Investing ActivitiesPurchases of equipment
    
    
    (22,243
    )
    
    
    (89,607
    )Purchase of licenses
    
    
    (334,620
    )
    
    
    (227,825
    )Increase in patents
    
    
    (10,139
    )
    
    
    Net cash used in investing activities
    
    
    (367,002
    )
    
    
    (317,432
    )Cash Flows from Financing ActivitiesProceeds from note payable
    
    
    2,000,000
    
    
    
    Loan origination costs
    
    
    (90,816
    )
    
    
    Net proceeds from issuance of common stock
    
    
    1,165,736
    
    
    
    346,299Net cash used in financing activities
    
    
    3,074,920
    
    
    
    346,299Increase (decrease) in cash and cash equivalents
    
    
    139,611
    
    
    
    (1,549,653
    )Cash and Cash EquivalentsBeginning
    
    
    2,562,611
    
    
    
    4,112,264Ending
    
    $
    2,702,222
    
    
    $
    2,562,611Supplemental Disclosures of Noncash ItemsIssuance of warrants in connection with notes payable (Note 5)
    
    $
    600,000
    
    
    $
    Cash paid for interest
    
    
    
    
    
    
    
 See Notes to Financial Statements. F-5




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 1.
    
    Nature of Business and Significant Accounting Policies Nature of business:Datakey, Inc. provides products and systems directed to the
information security market, which enables user identification and
authentication, secure data exchange and information validation. The Company
has a wholly owned subsidiary which is inactive. A summary of significant accounting policies follows: Use of estimates:The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates. Cash and cash equivalents:For purposes of reporting in the statements of cash
flows, the Company includes all cash accounts and all highly liquid debt
instruments purchased with an original maturity of three months or less as cash
and cash equivalents on the accompanying balance sheets. The Company maintains its cash in bank deposit accounts, which, at times, may
exceed federally insured limits. The Company has not experienced any losses in
such accounts. Trade receivables:Trade receivables are carried at original invoice amount
less an estimate made for doubtful receivables based on a review of all
outstanding amounts on a quarterly basis. Management determines the allowance
for doubtful accounts by identifying troubled accounts and by using historical
experience applied to an aging of accounts. Trade receivables are written off
when deemed uncollectible. Recoveries of trade receivables previously written
off are recorded when received. A trade receivable is considered to be past due if any portion of the
receivable balance is outstanding for more than 60 days. Inventories:Inventories are stated at the lower of cost (first-in, first-out
method) or market. Depreciation:Depreciation of equipment and leasehold improvements is computed
on the straight-line and accelerated methods over the following estimated
useful lives: YearsProduction tooling
    
    
    2  5Equipment
    
    
    3  7Furniture and fixtures
    
    
    7Leasehold improvements
    
    Life of lease
 Patents:Patents are stated at cost and are being amortized over their
estimated useful life of five years using the straight-line basis. The gross
amount of patent cost was $10,139 and accumulated amortization was $1,183 at
December 31, 2003. Loan origination costs:Loan origination costs are being amortized on a
straight-line basis over one year, the term of the related debt. The gross
amount of such costs was $90,816 and accumulated amortization was $18,920 at
December 31, 2003. Income taxes:Deferred taxes are provided on an asset and liability method
whereby deferred tax assets are recognized for deductible temporary differences
and operating loss or tax credit carryforwards, and deferred tax liabilities
are recognized for taxable temporary differences. Temporary differences are the
differences between the amounts of assets and liabilities recorded for income
tax and financial reporting purposes. Deferred tax assets are reduced by a
valuation allowance when management determines that it is more likely than not
that F-6




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 1.
    
    Nature of Business and Significant Accounting Policies (Continued) some portion or all of the deferred tax assets will not be realized. Deferred tax assets and
liabilities are adjusted for the effects of changes in tax laws and rates on
the date of enactment. Revenue recognition and deferred revenue:The revenue from products and systems
sold by the information security business segment is recognized upon shipment
to the customer, as the Company has no future obligation for support, upgrades
or other services. If the customer purchases an extended maintenance contract,
revenue from the contract is deferred and recognized over the term of the
contract. The revenue from products sold by the electronic products business segment was
recognized upon shipment, FOB shipping point. This segment, now discontinued,
fulfilled its last contract in 2002. Shipping and handling charges to customers are included in net sales. Shipping
and handling costs incurred by the Company are included in cost of goods sold. Software development costs:The Companys policy is to charge to expense those
costs of software development incurred until the point of technical feasibility
is attained, at which time such costs are capitalized, subject to review of net
realizable value. Although technical feasibility for the Companys products has been attained,
the Company is unable to ascertain the market acceptance of the products. As a
result, the Company has charged these costs to operations, as the net
realizable value is not determinable. Company plans for new product development
and/or significant product enhancements in the future may result in an
increased level of capitalized software costs as market acceptance of its
products becomes determinable. Research and development, engineering and technical support:Research and
development costs, engineering and technical support are charged to expense as
incurred and consist primarily of engineering expenses related to product
development. Engineering and technical support consist primarily of maintenance
of the Companys products and systems. Research and development costs were
approximately $1,763,000 and $1,903,000 during 2003 and 2002, respectively, of
which approximately $1,232,000 and $1,142,000 were software development costs. Advertising:Expenditures for advertising costs are expensed as incurred.
Advertising and product promotion expense was approximately $72,000 and
$106,000 during 2003 and 2002, respectively. Fair value of financial instruments:The Companys financial instruments
consist of cash and cash equivalents and short-term trade receivables and
payables for which current carrying amounts approximate fair value. The fair value of the Companys note payable was estimated based on interest
rates for the same or similar debt having the same or similar remaining
maturities with similar risk and collateral requirements. At December 31, 2003,
the carrying value of the note payable approximates its fair value. Loss per share:The Company computes basic and diluted net loss per share based
upon the weighted-average number of common shares outstanding during each year.
Potential common shares, such as options and warrants (see Note 8), were not
included in the computation of diluted loss per common share since their effect
would be anti-dilutive. Due to the losses from continuing operations in 2003
and 2002, basic and diluted loss per share were the same for both years. Stock-based compensation:The Company regularly grants options to its employees
under various plans as described below. As permitted under accounting
principles generally accepted in the United States of America, these grants are
accounted for following APB Opinion No. 25 and related interpretations.
Accordingly, compensation cost has been recognized for those grants whose
exercise price is less than the fair market value of the stock on the date of
grant. Compensation expense recorded for employee grants for the year ended
December 31, 2003, was $7,703. There was no compensation expense recorded for
employee grants for the year ended December 31, 2002. F-7




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 1.
    
    Nature of Business and Significant Accounting Policies (Continued) The Company also grants options and warrants to nonemployees for goods and
services and in conjunction with certain agreements. These grants are accounted
for under FASB Statement No. 123 based on the grant date fair values. Had compensation cost for all of the stock-based compensation grants and
warrants issued been determined based on the fair values at the grant date
consistent with the provisions of Statement No. 123, the Companys net loss and
net loss per basic and diluted common share would have been as indicated below. Years Ended December 312003
    
    2002Net loss, as reported
    
    $
    (4,079,227
    )
    
    $
    (2,316,743
    )Deduct total stock-based employee
compensation expense determined under fair
value method for all awards
    
    
    (640,305
    )
    
    
    (747,322
    )Net loss, pro forma
    
    $
    (4,719,532
    )
    
    $
    (3,064,065
    )Basic and diluted loss per share, as reported
    
    $
    (0.39
    )
    
    $
    (0.23
    )Basic and diluted, pro forma
    
    
    (0.45
    )
    
    
    (0.30
    )
 The above pro forma effects on net loss and net loss per basic and diluted
common share are not likely to be representative of the effects on reported net
loss or net loss per common share for future years because options vest over
several years and additional awards generally are made each year. Product warranty:The Company provides a limited 90-day warranty for the
replacement of defective products. The Companys standard warranty policy
requires the Company to repair or replace defective products at no cost to its
customers. The Company estimates the costs that may be incurred under its basic
limited warranty and records a liability in the amount of such costs at the
time product revenue is recognized. Factors that affect the Companys warranty
liability include the number of units sold, historical and anticipated rates of
warranty claims, and cost per claim. The Company periodically assesses the
adequacy of its recorded warranty liabilities and adjusts the amounts as
necessary. The Company utilizes historical trends and information received from
its customers to assist in determining the appropriate loss reserve levels. Changes in the Companys warranty liability are as follows: Years Ended December 312003
    
    2002Balance, beginning
    
    $
    4,175
    
    
    $
    26,894Reduction of accrual to
estimated required amount based
upon
current experience
    
    
    
    
    
    
    (20,000
    )Payments made
    
    
    (1,802
    )
    
    
    (2,719
    )Balance, ending
    
    $
    2,373
    
    
    $
    4,175
  Note 2.
    
    Corporate Liquidity The Company anticipates that its working capital, including cash of $2.7
million, will provide sufficient liquidity to fund 2004 operations. Should the
$2,000,000 note not be converted into common stock, the Company plans to raise
additional capital during 2004 to enable it to repay the note together with
$200,000 of interest due in October 2004. The Company is reviewing multiple
avenues of future funding, but does not have any commitments for such funding
at this time. F-8




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 3.
    
    Inventories Inventories consist of the following components as of December 31, 2003 and
2002: 2003
    
    2002Raw materials
    
    $
    303,405
    
    
    $
    585,743Work in process
    
    
    24,556
    
    
    
    22,024Finished goods
    
    
    233,615
    
    
    
    553,417Inventory obsolescence reserve
    
    
    (118,801
    )
    
    
    (164,652
    )$
    442,775
    
    
    $
    996,532
  Note 4.
    
    Licenses The Company utilizes technology in its products which is licensed from third
parties. Licenses are stated at cost. The costs of the license agreements are
amortized to cost of goods sold as the products incorporating the licensed
units are sold or over the life of the agreement. Under these agreements, the
Company generally agrees to purchase a minimum quantity of software units over
a specified period of time. December 312003
    
    2002Licenses:Gross carrying amount
    
    $
    854,620
    
    
    $
    546,000Accumulated amortization
    
    
    (408,881
    )
    
    
    (309,183
    )Net carrying amount
    
    $
    445,739
    
    
    $
    236,817
 Aggregate amortization expense in 2003 was $34,699 and in 2002 was $182,847.
The Company expects that the remainder of the December 31, 2003, carrying
amount of the license agreements will be charged to amortization in 2004 based
upon the expected sales of its products which incorporate the licenses. The
terms of one of the license agreements require the Company to purchase an
additional 12,500 licenses for $81,250 by March 2004. The Company presently
expects to acquire and utilize the minimum number of licenses under the
agreement in 2004. The Company reviews its license costs for impairment and records impairment
charges if sales of products incorporating the licenses are less than expected.
As a result, the Company recognized impairment expense of $91,000 in 2003 and
$48,667 in 2002 to reduce the carrying amount of certain license costs to the
amount required based on sales levels. These impairment charges are included in
the caption cost of goods sold in the accompanying statements of operations.  Note 5.
    
    Note Payable In October 2003, the Company entered into a $2 million convertible secured note
payable with a group of accredited investors. The note bears interest at 10
percent and is secured by substantially all assets. All principal and interest
is due in October 2004. The note is convertible into shares of the Companys
common stock at a conversion price of $1.25 per share. In connection with this financing, the Company granted the note holders 4
million warrants with a term of seven years and an exercise price of $0.77. The
warrants were valued at $600,000 using the Black-Scholes pricing model. As
required by generally accepted accounting principles, the $600,000 was recorded
as a discount on the note payable, with an offsetting entry to additional
paid-in capital of the same amount. The discount is being recognized as
interest expense over the term of the debt. The selling agents received 10,000
warrants with the same terms as the note holder warrants. The agent warrants
were valued at $1,500 using the Black-Scholes pricing model. The carrying value of the note at December 31, 2003, is as follows: Convertible note payable
    
    $
    2,000,000Unamortized discount
    
    
    (477,049
    )Balance on December 31, 2003
    
    $
    1,522,951
 F-9




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 5.
    
    Note Payable (Continued) At maturity, $200,000 of accrued interest will be due. Such accrued interest on
this note was $41,096 at December 31, 2003.  Note 6.
    
    Income Taxes The income tax benefit is different from that which would be computed by
applying the U.S. federal income tax rate (35 percent) to pretax loss as
follows: December 312003
    
    2002Computed expected federal tax benefit at statutory rates
    
    $
    (1,428,000
    )
    
    $
    (811,000
    )Effect of net operating loss with no current benefit
    
    
    1,428,000
    
    
    
    811,000Actual tax benefit
    
    $
    
    
    
    $
    
 Deferred taxes consist of the following components as of December 31, 2003 and
2002: 2003
    
    2002Deferred tax assets:Net operating loss carryforwards
    
    $
    8,739,000
    
    
    $
    7,247,000Research and development tax credit
    
    
    456,000
    
    
    
    415,000Allowance for doubtful accounts
    
    
    11,000
    
    
    
    20,000Inventory
    
    
    43,000
    
    
    
    59,000Accrued expenses and deferred revenue
    
    
    69,000
    
    
    
    91,000Contribution carryforward
    
    
    7,000
    
    
    
    7,000Depreciation
    
    
    50,000
    
    
    
    31,000Total gross deferred tax assets
    
    
    9,375,000
    
    
    
    7,870,000Valuation allowance
    
    
    (9,375,000
    )
    
    
    (7,870,000
    )Net deferred taxes
    
    $
    
    
    
    $
    
 Realization of deferred tax assets is dependent upon the generation of
sufficient future taxable income. Management has determined that significant
uncertainty exists regarding the realizability of the net deferred tax assets
and, accordingly, has provided a valuation allowance against them. At December 31, 2003, the Companys net operating loss and tax credit
carryforwards expire as follows: Research andOperating Loss
    
    Development TaxExpiring Year Ended December 31
    
    Carryforward
    
    Credit Forward2011
    
    $
    1,850,000
    
    
    $
    2012
    
    
    3,540,000
    
    
    
    113,0002018
    
    
    2,560,000
    
    
    
    59,0002019
    
    
    2,450,000
    
    
    
    67,0002020
    
    
    3,114,000
    
    
    
    40,0002021
    
    
    4,422,000
    
    
    
    70,0002022
    
    
    2,193,000
    
    
    
    66,0002023
    
    
    4,146,000
    
    
    
    41,000$
    24,275,000
    
    
    $
    456,000
 F-10




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 6.
    
    Income Taxes (Continued) The use of the federal net operating losses will be limited to $5.5 million per
year under the provisions of the Internal Revenue Code, Section 382, which
relates to a 50 percent change in control over a three-year period. Further
changes of control may result in additional limitations of the remaining
carryforward. Utilization of the carryforwards is dependent upon the Company
attaining profitable operations in the future.  Note 7.
    
    Stockholders Equity Convertible preferred stock:The preferred stock is convertible at the rate of
one share of common stock for each share of preferred stock, subject to certain
anti-dilution adjustments. Conversion is mandatory in the event of certain
future public offerings of corporate stock. The holders of the preferred stock
have certain piggyback and demand registration rights, voting rights and a
liquidation preference of $2.50 per share, and share in dividends paid on
common stock. Series B Preferred Stock:The Board of Directors has designated 120,000 shares
of previously undesignated stock as Series B Preferred Stock. The shares have a
par value of $0.05 per share and a liquidation value equal to the greater of
$100 or 100 times the aggregate amount to be distributed per share to holders
of common stock. Shares of Series B Preferred Stock are not convertible into
shares of the Companys common stock. Each share of Series B Preferred Stock
will be entitled to a minimum preferential quarterly dividend payment of $1 per
share but will be entitled to an aggregate dividend of 100 times the dividend
declared per share of common stock. Each share of Series B Preferred Stock has
100 votes. In the event of any merger, consolidation or other transaction in
which common stock is exchanged, each share of Series B Preferred Stock will be
entitled to receive 100 times the amount received per share of common stock.
There are no shares of Series B Preferred Stock outstanding. Shareholder Rights Plan:On October 19, 2001, the Companys Board of Directors
adopted a Shareholder Rights Plan, which took effect on October 26, 2001. Under
the plan, rights were constructively distributed as a dividend at the rate of
one right for each share of common stock or convertible preferred stock of the
Company held by the shareholders of record as of the close of business on
November 9, 2001. The Board further authorized the issuance of one right
(subject to adjustment) with each share of common stock or convertible
preferred stock issued subsequent to November 9, 2001, but prior to the
expiration date. Each right entitles its holder to purchase one-hundredth of a
share of Series B Preferred Stock at an exercise price of $60, subject to
adjustment. The rights will only be exercisable if a person or group acquires,
has the right to acquire, or has commenced a tender offer for 15 percent or
more of the outstanding common stock. The rights are nonvoting, pay no
dividends, expire on November 9, 2011, and may be redeemed by the Company for
$0.001 per right at any time before the 10th day (subject to adjustment) after
a 15 percent position is acquired. The rights have no effect on earnings per
share until they become exercisable. After the rights are exercisable, if the Company is acquired in a merger or
other business combination, or if 50 percent or more of the Companys assets
are sold, each right will entitle its holder (other than the acquiring person
or group) to purchase, at the then current exercise price, common stock of the
acquiring entity having a value of twice the exercise price. Undesignated stock:The Company has 9,480,000 shares of undesignated capital
stock. F-11




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 8.
    
    Stock Options and Warrants As discussed in Note 1 to the financial statements, the Company accounts for
employee stock-based compensation under APB Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations. The pro forma fair
value of each option grant as presented in Note 1 to the financial statements
is estimated on the date of grant using the Black-Scholes option pricing model
with the following weighted-average assumptions used for grants in 2003 and
2002: Years Ended December 312003
    
    2002Expected dividend yield
    
    
    
    
    
    
    Expected stock price volatility
    
    
    95.10
    %
    
    
    99.17
    %Risk-free interest rate
    
    
    2.00
    %
    
    
    2.54
    %Expected life of options
    
    3.00 years
    
    5.00 yearsWeighted-average fair value of options granted during the year
    
    $
    0.52
    
    
    $
    2.42
 The Company has reserved 1,800,000 common shares for issuance as qualified and
nonqualified stock options for its key employees and directors. The Company has
also reserved 100,000 common shares for issuance as nonqualified options to
various distributors, dealers and consultants. Option prices are generally at
the fair market value of the stock at the time an option is granted. Options
become exercisable as determined at the date of grant by a committee of the
Board of Directors. Options expire 10 years after the date of grant, unless an
earlier expiration date is set at the time of grant. Additional information relating to all outstanding options as of December 31,
2003 and 2002, is as follows: 2003
    
    2002Weighted-
    
    
    
    
    
    Weighted-Average
    
    
    
    
    
    AverageExercise
    
    
    
    
    
    ExerciseShares
    
    Price
    
    Shares
    
    PriceOptions outstanding at beginning of year
    
    
    1,438,515
    
    
    $
    3.51
    
    
    
    1,146,053
    
    
    $
    3.66Options exercised
    
    
    (12,259
    )
    
    
    0.01
    
    
    
    (6,667
    )
    
    
    1.50Options forfeited
    
    
    (196,634
    )
    
    
    4.13
    
    
    
    (73,833
    )
    
    
    4.47Options granted
    
    
    400,657
    
    
    
    0.84
    
    
    
    372,962
    
    
    
    3.22Options outstanding at end of year
    
    
    1,630,279
    
    
    $
    2.81
    
    
    
    1,438,515
    
    
    $
    3.51
 The following table summarizes information about stock options outstanding at
December 31, 2003: Options Outstanding
    
    Options ExercisableWeighted-AverageRemainingNumber
    
    Contractual
    
    Weighted-
    
    Number
    
    Weighted-Outstanding
    
    Life at
    
    Average
    
    Exercisable
    
    AverageRange of
    
    at December
    
    December 31,
    
    Exercise
    
    at December
    
    ExerciseExercise Prices
    
    31, 2003
    
    2003 (Years)
    
    Price
    
    31, 2003
    
    Price$0.01
- $  0.76
    
    
    306,252
    
    
    
    9.43
    
    
    $
    0.70
    
    
    
    32,502
    
    
    $
    0.54$1.42
- $  2.40
    
    
    358,158
    
    
    
    7.54
    
    
    
    1.69
    
    
    
    242,991
    
    
    
    1.74$2.50 - $3.625
    
    
    472,527
    
    
    
    5.34
    
    
    
    3.10
    
    
    
    358,439
    
    
    
    3.16$3.74
- $  5.25
    
    
    408,342
    
    
    
    6.75
    
    
    
    4.15
    
    
    
    266,833
    
    
    
    4.29$5.38 - $7.563
    
    
    51,000
    
    
    
    6.16
    
    
    
    6.26
    
    
    
    51,000
    
    
    
    6.26$8.00
- $  8.38
    
    
    34,000
    
    
    
    6.32
    
    
    
    8.14
    
    
    
    26,000
    
    
    
    8.18$0.01
- $  8.38
    
    
    1,630,279
    
    
    
    6.99
    
    
    $
    2.81
    
    
    
    977,765
    
    
    $
    3.32
 At December 31, 2002, there were 740,729 options exercisable at a
weighted-average exercise price of $3.67. F-12




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 8.
    
    Stock Options and Warrants (Continued) Employee stock purchase plan:Under its 1998 employee stock purchase plan,
which became effective for the plan year beginning January 1, 1999, the Company
is authorized to issue up to 200,000 shares of common stock to its full-time
employees, nearly all of whom are eligible to participate. Employees can choose
each year to have up to 10 percent of their earnings withheld to purchase the
Companys stock at a price that is 85 percent of the lower of its
beginning-of-year or end-of-year fair market value. During 2003 and 2002,
37,699 and 21,803 shares, respectively, were issued under the plan. Warrants:The Company has issued warrants to purchase shares of common stock at
prices between $0.70 and $6.60 per share. All warrants are currently
exercisable. The following tables summarize information about warrants
outstanding at December 31, 2003 and 2002: 2003
    
    2002Weighted-
    
    
    
    
    
    Weighted-Average
    
    
    
    
    
    AverageExercise
    
    
    
    
    
    ExerciseShares
    
    Price
    
    Shares
    
    PriceWarrants at beginning of year
    
    
    2,995,243
    
    
    $
    3.44
    
    
    
    3,075,511
    
    
    $
    3.44Warrants exercised
    
    
    (1,600,000
    )
    
    
    0.70
    
    
    
    (80,268
    )
    
    
    3.44Warrants forfeited
    
    
    (97,353
    )
    
    
    3.12
    
    
    
    
    
    
    
    Warrants granted
    
    
    5,305,933
    
    
    
    0.77
    
    
    
    
    
    
    
    Warrants outstanding at end of year
    
    
    6,603,823
    
    
    $
    1.40
    
    
    
    2,995,243
    
    
    $
    3.44
 During 2003, the Company reduced the exercise price to $0.70 on 1,600,000
warrants originally issued in February 2001. Additionally, in October 2003, the
Company offered new warrants at an exercise price of $0.77 as an additional
incentive for warrant holders to exercise their warrants. All warrant holders
accepted either the September offer to exercise at $0.70 or the October offer
to exercise at $0.70 and to receive new warrants with a term of five years and
an exercise price of $0.77, providing a total of $1,120,000 to the Company. Warrants outstanding at December 31, 2003, expire as follows: 2004
    
    $
    10,0002005
    
    
    880,0002008
    
    
    37,8902009
    
    
    370,0002013
    
    
    5,305,933$
    6,603,823
  Note 9.
    
    Major Customers and International Sales Major customers:Direct and indirect sales to U.S. government agencies were
approximately $1,586,000 and $1,756,000, or 39 percent and 24 percent of total
sales, in 2003 and 2002, respectively. Accounts receivable from U.S. government
agencies were approximately $244,000 and $669,000 at December 31, 2003 and
2002, respectively. In addition to sales to U.S. government agencies, the
Company had sales to the following significant customers: Net Sales
    
    Trade ReceivablesYears Ended December 31
    
    as of December 312003
    
    2002
    
    2003
    
    2002Customer A
    
    $
    943,000
    
    
    $
    1,159,000
    
    
    $
    662,000
    
    
    $
    391,000Customer B
    
    
    470,000
    
    
    
    *
    
    
    
    
    
    
    
    N/ACustomer C (an agency of the
Canadian government)
    
    
    *
    
    
    
    2,127,000
    
    
    
    N/A
    
    
    
    66,000
 *This customer accounted for less than 10 percent of total sales. F-13




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 9.
    
    Major Customers and International Sales (Continued) International sales:Export sales to international customers, including Canada,
for 2003 and 2002 were approximately $2,181,000 and $4,168,000, or 53 percent
and 57 percent of total sales, respectively. Accounts receivable from
international customers were approximately $687,000 and $721,000 at December
31, 2003 and 2002, respectively. Sales to customers in Germany accounted for
approximately $679,000, or 17 percent of sales, in 2003. No other individual
country accounted for more than 10 percent of sales in 2003. Sales to customers
in Canada accounted for approximately $2,401,000, or 33 percent of sales, and
sales to customers in Germany accounted for approximately $768,000, or 11
percent of sales, in 2002. No other individual country accounted for more than
10 percent of sales in 2002.  Note 10.
    
    Commitments and Contingencies The Company leases its office and warehouse facilities under a noncancelable
operating lease, which expires in June 2004. In addition, certain items of
equipment are leased under noncancelable operating leases through February
2007. Future lease commitments are as follows: 2004
    
    $
    142,0002005
    
    
    13,0002006
    
    
    6,0002007
    
    
    1,000$
    162,000
 Rent expense totaled approximately $167,000 and $343,000 in 2003 and 2002,
respectively. In connection with the transaction described in Note 11, the Company is
subleasing a portion of its office space. The Company will receive monthly
rentals of $8,834 through June 2004. Sublease income during 2003 and 2002 was
approximately $106,000 in each year. Employee benefits:The Company maintains a voluntary 401(k) plan in effect for
its employees. The Company offers a match of 25 percent of the employees
contributions, up to 6 percent. The match was suspended in 2003 thus there was
no Company matching contribution to the plan. The Companys match was
approximately $39,000 in 2002. In addition, a discretionary contribution can be
authorized by the Board of Directors. There were no discretionary contributions
authorized in 2003 and 2002.  Note 11.
    
    Operating Segments and Discontinued Operations The Company formerly had two reportable segments: ISS Information Security
Solutions (ISS) and Electronic Products (EP). The ISS Information Security
Solutions segment produces and markets products for the information security
market, which enable user identification and authentication, secure data
exchange and information validation. EP produced proprietary memory keys, cards
and other custom-shaped tokens that serve as a convenient way to carry
electronic information. In February 2001, the Companys Board of Directors approved managements plan
to discontinue the operations of the EP segment. In August 2001, certain assets
of the EP segment were sold to an unrelated party for $550,000. One customer
contract was retained by the Company with final delivery taking place in 2002,
and the gain on disposal of the discontinued segment was the profit realized on
the contract in excess of the amounts accrued for in 2001. The disposal of the
segment was accounted for as discontinued operations and, accordingly, the
results of its operations have been excluded from continuing operations for all
periods presented. There were no assets or liabilities remaining from the EP
segment as of December 31, 2002. F-14




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##### Table of Contents



Datakey, Inc.Notes to Financial Statements  Note 11.
    
    Operating Segments and Discontinued Operations (Continued) The accounting policies of the segments are the same as those described in the
summary of significant accounting policies. There are no inter-segment
transactions. The Company evaluates performance based on operating earnings of
the respective segments. The following tables present information by segment.
There were no EP operations in 2003. Year Ended December 31, 2002ISS
    
    EP
    
    Unallocated
    
    TotalRevenue
    
    $
    7,257,000
    
    
    $
    870,000
    
    
    $
    
    
    
    $
    8,127,000Depreciation and amortization
    
    
    313,000
    
    
    
    40,000
    
    
    
    
    
    
    
    353,000Segment profit (loss)
    
    
    (2,712,000
    )
    
    
    351,000
    
    
    
    45,000
    
    
    
    (2,316,000
    )
 F-15