MANAGEMENTS DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION & RESULTS OF OPERATIONS Results of
Operations The table below summarizes changes in
selected operating indicators, showing certain income, cost and expense items
as a percentage of total revenue from continuing operations for each of the
past two years.  Inflation has not been
a significant factor in Datakeys operations to date.  Percentage of Total RevenueYear
  Ended December 31,
  2000
  1999Revenue
  100%
  100%Cost
  and ExpensesCost
  of goods sold
  53
  52Research
  and development
  56
  124Marketing
  and sales
  61
  108General
  and administrative
  16
  36Total
  cost and expenses
  186
  320Interest
  income
  4
  0Loss
  before income taxes
  (82)
  (220)Income
  taxes
  -
  -Net
  loss
  (82)%
  (220)%  Comparison of 2000 with 1999 Continuing
Operations Totalrevenue:Total revenue was $3,608,000 in 2000
compared to $1,316,000 in 1999.  The
substantial increase in revenue is due to increasing acceptance of our
information security solutions products and increases in technology license
fees.  Because of the discontinuance of
the EP operation, total revenue includes only sales and licensing of
Information Security Solutions products. Gross margins:  The gross profit margin decreased to 47
percent in 2000 from 48 percent in 1999 primarily because the Company began
amortizing a prepaid license fee to cost of sales in 2000.  This amortization was $220,000 or 6 percent
of sales in 2000. Research and
development:  Research and development (R&D) expense
increased by 23 percent to $2,003,000 in 2000 from $1,632,000 in 1999.  R&D expense increased during 2000 as the
Company invested in significant upgrades and enhancements to its information
security products. Marketing and
sales, General and administrative:  Marketing and sales expense increased 56
percent to $2,216,000 in 2000 from $1,418,000 in 1999.  The increase in 2000 marketing and sales
expense resulted from additions to the sales staff, including a new European
office, increased commissions due to higher revenue and continuing promotional
activities to promote the Companys information security products.General
and administrative expenses increased 23 percent to $582,000 in 2000 from
$472,000 in 1999 primarily as a result of increases in legal, audit and employment
related expenses to support the growth in the ISS business segment. Interest
income:  Interest income increased to $170,000 in
2000 from $3,000 in 1999, as the Company invested a portion of the proceeds of
a $4 million private placement completed in February 2000 in an interest
bearing account. Income tax
expense:As a result of the net cumulative operating
losses of approximately $14,800,000 at December 31, 2000, and $10,000,000 at
December 31, 1999 the Company recorded no income tax expense in either year. Net loss.Net loss in 2000 was $2,953,000 compared to
$2,891,000 in 1999, primarily due to the significant 2000 increase in
marketing, sales and R&D expenditures which exceeded the contribution from
increased revenues in the ISS business segment. Discontinued
Operations

The Company announced in February 2001
that it is phasing down or divesting its Electronic Products (EP) business
segment.  Accordingly, the operating
loss of $565,000 during 2000 as well as an estimated loss upon disposal of the
segment of $1,281,000 are reflected as losses from discontinued operations
compared to a loss from discontinued operations of $18,000 in 1999.  The increased loss from discontinued
operations in 2000 was primarily due to a reduction in revenue to $3,799,000
from $4,550,000 in 1999.



Comparison of 1999 with 1998

Continuing
Operations

Totalrevenue:Total revenue was $1,316,000 in 1999
compared to $629,000 in 1998.  The
substantial increase in revenue was due to increasing acceptance of the
Companys information security products and technology.

Gross margins:  The gross profit margin increased to 48
percent in 1999 from 28 percent in 1998, due primarily to an increase in
revenue during 1999.

Research and
development:  Research and development (R&D) expense
increased by 32 percent to $1,632,000 in 1999 from $1,232,000 in 1998.  R&D expense increased during 1999 as the
Company invested in significant upgrades and enhancements to its information
security products.

Marketing and
sales, General and administrative:  Marketing and sales expense increased 1
percent to $1,418,000 in 1999 from $1,406,000 in 1998.  The increase in 1999 expense resulted from
increases in advertising and promotional activities to promote the Companys
information security products.General
and administrative expenses increased 4 percent to $472,000 in 1999 from
$453,000 in 1998 primarily as a result of increases in office rental and real
estate tax.

Interest
income:  Interest income decreased to $3,000 in 1999
from $58,000 in 1998 due to a decline in the Companys interest bearing cash
equivalent accounts.

Income tax
expense:As a result of the net cumulative operating
losses of approximately $10,000,000 at December 31, 1999, and $8,000,000 at
December 31, 1998, the Company recorded no income tax expense in either year.

Net loss.Net loss in 1999 was $2,909,000 compared to
$2,860,000 in 1998 primarily due to the significant 1999 increase in R&D
expenditures in the ISS business segment that exceeded the contribution from
additional revenue.

Discontinued
Operations

Loss in the EP
business segment, now reflected as discontinued operations, was $18,000 in 1999
compared to income of $573,000 in 1998. 
The loss in 1999 was primarily due to a reduction in revenue to
$4,550,000 in 1999 from $5,241,000 in 1998.

Liquidity and Capital Resources

The Company had an increase of $1,188,000
in cash and cash equivalents in 2000 compared to a reduction of $509,000 in
cash and cash equivalents in 1999.  The
2000 increase is due to proceeds from the sale of common stock during the year
of $5,439,000, offset by the net loss of $4,799,000.  The net loss was due, in part, to significant expenditures
totaling $4,219,000 in research and development and marketing which were
related to the Companys information security products.  The Company invested $630,000 in the
purchase of equipment and maintenance of licenses and patents in 2000 compared
to $271,000 in 1999.  Cash and cash equivalents
as of December 31, 2000, were $1,533,000 as compared to $345,000 as of December
31, 1999.  In the first quarter of 2001,
the Company completed the private placement of common stock and warrants in a
private placement transaction which generated net proceeds of approximately
$4,500,000.

Datakeys balance sheet reflected $3,478,000
in working capital and a current assets to current liabilities ratio of 3.8 to
1 as of December 31, 2000.

In 2001, the Company plans to increase
expenditures for new product development, marketing activities and inventory
levels to support anticipated revenue growth. 
Based on its current plan, which assumes significantly increased
revenues from the sale of information security products and technology
licensing arrangements, the Company believes its working capital together with
its bank line of credit, which the Company plans to extend for another year,
and proceeds from the recent sale of securities will be sufficient to fund its
planned operations and product development and promotional activities in
2001.  In the event that the revenues
for the Companys products and licenses are significantly less than projected,
the Companys ability to extend its current bank credit line may be jeopardized
and the Companys ability to maintain its current business operations would be
materially and adversely affected.

Outlook & Risks

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

Revenue:    Revenue is expected to increase
significantly in 2001 as more pilot programs move into a deployment phase,
additional pilot programs are commenced and additional licensing agreements are
arranged.  Revenue increases depend on customer
acceptance, competition, and the effectiveness of the Companys marketing and
sales organization.  There is no
assurance that the Company will achieve its revenue plan.

Gross margins:  A gradual improvement in gross profit
margins during 2001 is expected through effective material purchasing and an
anticipated increase in revenue from information security products and license
fees.  Such an increase in gross margin
depends on achievement of the expected purchasing prices, realization of the
revenue increases, and a continuation of improvement in manufacturing
processes.

Research and
development:  The Company intends to increase funding for
new product development activities in 2001 by about 40 percent compared to 2000
to accelerate the pace at which new products and product enhancements are
released into the marketplace.  The
ability to increase such funding depends in significant part on the Companys
ability to meet its 2001 revenue plan.

Marketing and
sales, General and administrative:  Marketing and sales expenses are expected to
increase about 70 percent in 2001 to support new product introductions,
increase the number of sales and marketing personnel dedicated to the Companys
information security products and licenses and to support the expected increase
in revenue. General and administrative expenses in 2001
are expected to increase about 50 percent from the 2000 level to support the
growth in the level of activity and because certain fixed G&A expenses that
were previously allocated, in part, to the EP business segment will be fully
absorbed in 2001 by continuing operations.

Given the level of expected increases in
expenses, the Companys ability to approach or attain profitability by the end
of 2001 will depend on the Companys attainment of its revenue objectives for
2001.

Expected loss:  The Companys goal is to reach quarterly
profitability by the second half of 2001 but expects to report a loss for the
year.  The Companys ability to attain
profitability in the second half of 2001 and thereafter will depend primarily
on its ability to significantly increase the revenue from its information
security products and from technology licensing.  Based upon the level of sales of information security products
and license fees to date, there has not been sufficient market acceptance to be
assured that revenue will increase significantly or that the Company will ever
attain profitability.

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, 2000 and 1999, 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 generally accepted
auditing standards. 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, 2000 and 1999, and the results of its operations and its cash
flows for the years then ended, in conformity with generally accepted
accounting principles.

/s/ McGladrey & Pullen LLP

Minneapolis, Minnesota
February 2, 2001, except for Note 3
as to which the date is February 26, 2001

DATAKEY, INC.

BALANCE SHEETS
December 31, 2000 and 1999

ASSETS (Note 3)
  2000
  1999Current AssetsCash and cash equivalents
  $1,532,558
  $344,922Trade receivables, less allowance for doubtful accounts of
  $26,000 (Note7)
  989,020
  1,474,480Inventories (Note 2)
  513,846
  1,328,991Prepaid expenses and other
  113,176
  29,981Net assets of discontinued operations
  (Note 10)
  1,561,999
  -Total current
  assets
  4,710,599
  3,178,374Other AssetsLicenses and patents, less amortization
  of $698,517 in 2000 and $364,832 in 1999 (Note 8)
  498,961
  668,036Equipment and Leasehold Improvements, at
  costProduction tooling
  1,162,750
  1,306,260Equipment
  2,690,894
  2,768,214Furniture and fixtures
  322,095
  317,103Leasehold improvements
  278,371
  278,3714,454,110
  4,669,948Less accumulated depreciation
  4,227,882
  3,917,996226,228
  751,952$5,435,788
  $4,598,362

See
Notes to Financial Statements.

LIABILITIES AND
  STOCKHOLDERS' EQUITY
  2000
  1999Current LiabilitiesAccounts payable
  $386,613
  $803,887Accrued expenses:Compensation
  226,803
  197,335Other
  74,031
  70,166Deferred revenue
  63,797
  26,978Net liabilities from discontinued
  operations (Note 10)
  480,875
  -Total
  current liabilities
  1,232,119
  1,098,366Commitments and Contingencies (Notes 3, 5, 8 and 10)Stockholders' Equity (Notes 5, 6 and 11)Convertible preferred stock, voting,
  liquidation value $2.50 per share; authorized 400,000 shares; issued and
  outstanding 150,000 shares
  375,000
  375,000Common stock, par value $0.05 per share;
  authorized 20,000,000 shares; issued and outstanding 8,269,173 shares in 2000
  and 6,322,285 shares in 1999
  413,459
  316,114Additional paid-in capital
  13,906,744
  8,501,543Accumulated deficit
  (10,491,534)
  (5,692,661)4,203,669
  3,499,996$5,435,788
  $4,598,362

DATAKEY, INC.

STATEMENTS OF OPERATIONS
Years Ended December 31, 2000 and 1999

2000
  1999Net sales (Note 7)
  $3,608,480
  $1,315,622Costs and expenses:Cost of goods sold
  1,904,221
  688,268Research and development
  2,003,455
  1,631,984Marketing and sales
  2,216,282
  1,417,970General and administrative
  582,238
  471,557Total
  costs and expenses
  6,706,196
  4,209,779Operating
  loss
  (3,097,716)
  (2,894,157)Interest income
  169,909
  11,340Interest expense
  (25,000)
  (8,442)Loss
  from continuing operations before income taxes
  (2,952,807)
  (2,891,259)Income tax expense (Note 4)
  -
  -Net
  loss from continuing operations
  (2,952,807)
  (2,891,259)Discontinued operations (Note 10)Loss from operations of discontinued
  segment
  (565,066)
  (17,880)Loss on disposal of discontinued segment
  (1,281,000)
  -Loss
  from discontinued operations
  (1,846,066)
  (17,880)Net
  loss
  $(4,798,873)
  $(2,909,139)Net loss from continuing operations attributable to
  common stockholders:Net loss from continuing operations
  $(2,952,807)
  $(2,891,259)Preferred stock dividends (Note 5)
  -
  (81,568)Net loss from
  continuing operations attributable to
  common stockholders
  $(2,952,807)
  $(2,972,827)Loss per share:Basic and diluted loss from continuing
  operations
  $(0.37)
  $(0.80)Basic and diluted loss from discontinued
  operations
  (0.23)
  -Basic and diluted loss per
  common share
  $(0.60)
  $(0.80)Weighted-average common shares:Basic and diluted
  7,977,281
  3,730,499See
Notes to Financial Statements.

DATAKEY, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY
Years Ended December 31, 2000 and 1999

Series A Cumulative
  Preferred Stock
  
  
  Additional Paid-In
  CapitalConvertible
  Preferred Stock
  Common Stock
  Accumulated DeficitShares
  Amount
  Shares
  Amount
  Shares
  Amount
  TotalBalance, December 31, 1998
  150,000
  $375,000
  83,957
  $1,326,519
  3,045,704
  $152,285
  $4,793,665
  $(2,842,958)
  $3,804,511Conversion of Series A preferred
  stock, including accrued dividends, to common stock (Note 5)
  -
  -
  (83,957)
  (1,326,519)
  997,555
  49,878
  1,284,228
  (7,587)
  -Issuance of common stock (net of
  offering expenses of $309,394)
  -
  -
  -
  -
  2,279,026
  113,951
  2,423,239
  -
  2,537,190Preferred stock dividends (Note 5)
  -
  -
  -
  -
  -
  -
  -
  (73,981)
  (73,981)Preferred stock dividends forgiven
  (Note 5)
  -
  -
  -
  -
  -
  -
  -
  141,004
  141,004Compensation expense from stock
  options
  -
  -
  -
  -
  -
  -
  411
  -
  411Net loss
  -
  -
  -
  -
  -
  -
  -
  (2,909,139)
  (2,909,139)Balance, December 31, 1999
  150,000
  375,000
  -
  -
  6,322,285
  316,114
  8,501,543
  (5,692,661)
  3,499,996Issuance of common stock (net of
  offering expenses of $409,745)
  -
  -
  -
  -
  1,946,888
  97,345
  5,341,229
  -
  5,438,574Compensation expense from stock
  options
  -
  -
  -
  -
  -
  -
  63,972
  -
  63,972Net loss
  -
  -
  -
  -
  -
  -
  -
  (4,798,873)
  (4,798,873)Balance, December 31, 2000
  150,000
  $375,000
  -
  $-
  8,269,173
  $413,459
  $13,906,744
  $(10,491,534)
  $4,203,669See
Notes to Financial Statements.



STATEMENTS OF CASH FLOWS
Years Ended December 31, 2000 and 1999

2000
  1999Cash Flows From Operating ActivitiesNet loss
  $(4,798,873)
  $(2,909,139)Adjustments to reconcile net loss to net
  cash used in operating activities:Depreciation
  353,881
  440,820Amortization
  543,580
  135,309Loss on disposal of
  discontinued segment
  1,281,000
  -Loss on disposal of
  equipment
  10,051
  33,854Noncash compensation
  63,972
  411Changes in assets and
  liabilities:Trade
  receivables
  (12,821)
  (614,844)Inventories
  (1,112,343)
  (321,043)Accounts payable
  (59,734)
  368,014Deferred revenue
  36,819
  26,978Other
  73,473
  64,884Net cash used in operating activities
  (3,620,995)
  (2,774,756)Cash Flows From Investing ActivitiesPurchases of equipment
  (182,626)
  (177,475)Proceeds on sale of equipment
  -
  35,000License and patent costs
  (447,317)
  (128,864)Net cash used in investing activities
  (629,943)
  (271,339)Cash Flows From Financing ActivitiesNet proceeds from issuance of common
  stock
  5,438,574
  2,537,190Increase (decrease) in cash and cash equivalents
  1,187,636
  (508,905)Cash and Cash EquivalentsBeginning
  344,922
  853,827Ending
  $1,532,558
  $344,922Supplemental Disclosure of Noncash itemsCash paid for interest
  $25,000
  $8,442Supplemental Schedule of Noncash Investing and
  Financing ActivitiesPreferred stock dividend converted to
  common stock
  $-
  $7,587Preferred stock dividends forgiven (Note
  5)
  -
  141,004See
Notes to Financial Statements.



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 also provides electronic products, consisting of proprietary memory
keys, cards, and other custom-shaped tokens, that serve as a convenient way to
carry electronic information and are packaged to survive in portable
environments. The Company 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 generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

Cash and cash equivalents:For purposes of reporting 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 consolidated balance sheets.

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

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

Licenses and patents:Licenses
and patents are stated at cost. Patents are being amortized using the
straight-line method over their economic useful lives, which have been
estimated to be five years. 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.

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

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

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

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

The revenue from products sold by the electronic
products business segment is recognized upon shipment.

In December 1999, the staff of the Securities and
Exchange Commission issued Staff Accounting Bulletin No. 101 (SAB No. 101),
Revenue Recognition in Financial Statements. SAB No. 101 summarizes some of
the staffs interpretations of the application of generally accepted accounting
principles related to revenue recognition. The Company adopted SAB No. 101
during the year ended December 31, 2000. The adoption of SAB No. 101 did not
have a significant affect on the financial statements.

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.

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

Advertising:Expenditures
for advertising costs are expensed as incurred. Advertising and product
promotion expense was approximately $213,000 and $104,000 during 2000 and 1999,
respectively.

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

Loss per share:The Company computes basic and diluted net
loss per share based upon the weighted-average number of common shares outstanding
during each year. In 1999, preferred stock dividends (Note 5) are included in
the net loss attributable to common stockholders in calculating basic and
diluted loss per share. Potential common shares, such as options, warrants, and
convertible preferred stock (as discussed in Note 6), were not included in the
computation of diluted loss per common share as their effect is anti-dilutive.

Due to the losses in 2000 and 1999, basic and
diluted loss per share were the same for each of these years.

Note 2.        Inventories

Inventories consist of the following components as of December 31,
2000 and 1999:

2000
  1999Raw
  materials
  $459,729
  $1,225,307Work in
  process
  71,314
  173,385Finished
  goods
  398,510
  378,452Inventory
  obsolescence reserve
  (415,707)
  (448,153)$513,846
  $1,328,991

Note 3.        Financing Agreements

The Company has available a $1,000,000 line of
credit from a bank which bears interest at the prime rate plus 1.25 percent
(10.25 percent at December 31, 2000) and is secured by substantially all assets
of the Company. The line of credit expires in May 2001 and is subject to annual
renewal. There were no balances outstanding as of December 31, 2000 or 1999.

The Company also has a standby letter of credit with
a bank up to $500,000 in favor of one of its vendors. In connection with this
letter of credit, the Company has assigned $250,000 held in an account at the
bank. The letter of credit expires January 2002. There were no draws against
the letter of credit as of December 31, 2000.

In January 2001 the Company entered into a line of
credit with a shareholder. The Company may borrow up to $1,000,000 through
March 31, 2001. Advances are unsecured and bear interest at 12% for the first
three months during which any individual advance remains outstanding. After
three months interest accrues at 15 percent until the advance is paid off. As
of February 2, 2001, $500,000 was outstanding under this agreement. This
advance was repaid in full February 26, 2001.

Note 4.        Income Taxes

There has been no tax expense recorded due to losses
in both 2000 and 1999.

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 312000
  1999Computed
  "expected" federal tax benefit at statutory rates
  $(1,680,000)
  $(1,018,000)Effect of
  net operating loss with no current benefit
  1,680,000
  1,018,000Actual tax
  expense
  $-
  $-



Deferred taxes consist of the following components
as of December 31, 2000 and 1999:

2000
  1999Deferred
  tax assets:Allowance
  for doubtful accounts
  $9,000
  $9,000Inventory
  270,000
  244,000Warranty
  reserve
  10,000
  11,000Compensation
  and benefits
  35,000
  26,000Net
  operating loss carryforward
  5,279,000
  3,700,000Reserve
  for discontinued operations
  461,000
  -Research
  and development tax credit
  279,000
  239,000Contributions
  carryforward
  15,000
  15,000Total gross
  deferred tax assets
  6,358,000
  4,244,000Valuation
  allowance
  (6,314,000)
  (4,200,000)Net deferred
  tax assets
  44,000
  44,000Deferred
  tax liability:Depreciation
  (44,000)
  (44,000)Net
  deferred taxes
  $-
  $-

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

At December 31, 2000, the Companys net operating loss and tax
credit carry-forwards expire as follows:



Operating Loss
  Carry-forward
  Research and
  Development
  Tax Credit
  Carry-forward2011
  $1,850,000
  $-2012
  3,540,000
  113,0002018
  2,560,000
  59,0002019
  2,450,000
  67,0002020
  4,386,000
  40,000$14,786,000
  $279,000

The use of
the federal net operating losses may be limited 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 carry-forward. Utilization of the
carry-forwards is dependent upon the Company attaining profitable operations in
the future.

Note 5.        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, have a liquidation preference of $2.50 per share, and share in
dividends paid on common stock.

Series A convertible cumulative
preferred stock:In May 1998, the Company completed a $1.58 million convertible preferred
stock offering. The holders of the Series A convertible preferred stock were
entitled to receive dividends at the rate of 8 percent annually, which were
payable at the option of the Company in cash or shares of the Companys common
stock. Accumulated dividends of $7,587 were paid in 1999 by issuance of 2,457
shares of common stock. Dividends of $141,004 were forgiven by two stockholders
in exchange for the right to convert their Series A convertible preferred stock
into common stock at $1.25 per common share. All outstanding shares of the
Series A convertible cumulative preferred stock were converted into 995,098
shares of common stock during 1999.

Undesignated stock:The
Company has 9,600,000 shares of undesignated capital stock.

Note 6.        Stock Options and
Warrants

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

The Company has adopted the disclosure-only
provisions of Statement of Financial Accounting Standards No. 123, Accounting
for Stock-Based Compensation. In 2000 and 1999, compensation cost of
$63,972 and $411 was recognized for the stock options. Had compensation cost
for the Companys stock options been determined based on the fair value at the
grant date for awards in 2000 and 1999, consistent with the provisions of SFAS
No. 123, the Companys net loss attributable to common stockholders and
basic and diluted loss per share would have changed to the pro forma amounts
indicated below:



Years Ended December 312000
  1999Net loss
  attributable to common stockholders, as reported
  $(4,798,873)
  $(2,990,707)Net loss
  attributable to common stockholders, pro forma
  (5,268,742)
  (3,305,195)Basic and
  diluted loss per share, as reported
  (0.60)
  (0.80)Basic and diluted
  loss per share, pro forma
  (0.66)
  (0.89)The fair value of each option grant is estimated on
the date of grant using the Black-Scholes option-pricing model, with the
following weighted-average assumptions used for grants in 2000 and 1999:

Years Ended December 312000
  1999Expected
  dividend yield
  -
  -Expected
  stock price volatility
  101.36%
  75.53%Risk-free
  interest rate
  6.40%
  5.63%Expected
  life of options
  4.88 years
  4.83 yearsWeighted-average
  fair value of options granted during the year
  $3.95
  $1.42The pro forma effect on net loss attributable to
common stockholders in 2000 and 1999 is not representative of the pro forma
effect in future years because it does not take into consideration pro forma
compensation expense related to grants made prior to 1995.

Additional information relating to all outstanding
options as of December 31, 2000 and 1999, is as follows:

2000
  1999Weighted- Average Exercise Price
  
  Weighted-
  Average Exercise PriceShares
  SharesOptions outstanding
  at beginning of year
  1,011,581
  $3.24
  952,333
  $3.97Options
  exercised
  (136,126)
  3.42
  (8,000)
  3.63Options
  forfeited
  (128,666)
  3.55
  (243,500)
  4.61Options
  granted
  312,634
  5.48
  310,748
  2.10Options
  outstanding at end of year
  1,059,423
  $3.84
  1,011,581
  $3.24

The following table summarizes information about
stock options outstanding at December 31, 2000:

Options Outstanding
  Options ExercisableRange of Exercise
  Prices
  Number Outstanding at December 31, 2000
  Weighted- Average Remaining Contractual
  Life (Years)
  Weighted- Average Exercise Price
  Number Exercisable at December 31, 2000
  Weighted- Average Exercise Price$0.01
  8,397
  9.71
  $0.01
  4,697
  $0.01$1.50 - $2.25
  214,500
  8.42
  1.79
  81,502
  1.84$2.50 - $3.625
  402,626
  6.50
  3.12
  180,501
  3.25$3.81 - $5.25
  235,500
  8.27
  4.53
  94,400
  4.75$5.38 - $7.56
  113,400
  7.21
  5.98
  40,233
  5.86$8.00 - $8.38
  85,000
  9.28
  8.10
  7,000
  8.00$0.01 - $8.38
  1,059,423
  7.61
  $3.84
  408,333
  $3.62Employee stock purchase plan:Under its 1998 employee stock purchase plan,
which became effective for the plan year beginning January 1, 1999, the Company
is authorized to issue up to 100,000 shares of common stock to its full-time
employees, nearly all of whom are eligible to participate. Employees can choose
each year to have up to 10 percent of their earnings withheld to purchase the
Companys stock at a price that is 85 percent of the lower of its
beginning-of-year or end-of-year fair market value. During 2000 6,710 shares
were issued under the plan. No shares were issued under the plan in 1999.

Warrants:The Company has issued warrants to purchase
shares of common stock at prices between $1.25 and $6.60 per share. All
warrants are currently exercisable. The following tables summarize information
about warrants outstanding at December 31, 2000:

2000
  1999Shares
  Weighted- Average Exercise Price
  Shares
  Weighted-
  Average Exercise PriceWarrants
  outstanding at beginning of year
  1,505,617
  $1.59
  290,710
  $4.94Warrants
  exercised
  (1,004,052)
  1.34
  -
  -Warrants
  forfeited
  -
  -
  (699,658)
  3.16Warrants
  granted
  880,000
  5.05
  1,914,565
  1.65Warrants
  outstanding at end of year
  1,381,565
  $3.97
  1,505,617
  $1.59

Warrants outstanding at December 31, 2000 expire as follows:

2003
  83,6752004
  10,0002005
  880,0002008
  37,8902009
  370,0001,381,565Note 7.        Major Customers and
International Sales

Major customer:Sales to U.S. government
agencies for 2000 and 1999 were approximately $244,000 and $608,000 in 2000 and
1999, respectively. Accounts receivable from U.S. government agencies were
approximately $70,000 and $158,000 at December 31, 2000 and 1999, respectively.
In addition, sales to one customer were approximately $1,437,000, or
19 percent of total sales during the year ended December 31, 2000.
Accounts receivable from this customer were approximately $564,000 at
December 31, 2000. There were no major customers in 1999.

International sales:Export
sales to international customers for 2000 and 1999 were approximately $1,593,000
and $1,630,000, respectively. Accounts receivable from international customers
were approximately $277,000 and $388,000 at December 31, 2000 and 1999,
respectively. Sales to customers in Great Britain accounted for approximately
12 percent of sales in 2000. There were no individual countries accounting
for more than 10 percent of total sales in 1999.

Note 8.        Commitments and
Contingencies

License agreement:The
Company has entered into various license agreements to allow the Company to
bundle licensed products into certain of the Companys products. Under the
agreements, payments are based upon the number of units sold and the nature of
the item bundled. In these agreements, the Company agreed to purchase a minimum
quantity of software units over a specified period of time. The value of the
minimum purchase is included in the initial license agreement.

Lease:The Company leases its office and warehouse
facilities under a non-cancelable operating lease, which expires in June 2004.
In addition certain items of equipment are leased under non-cancelable
operating leases through June 2004.

Future lease commitments are as follows:

2001
  $243,0002002
  249,0002003
  237,0002004
  107,000$836,000Rent expense totaled approximately $240,000 and $189,000
in 2000 and 1999, respectively.

Employee benefits:The Company has
a discretionary defined contribution profit sharing plan in effect for its
employees. Contributions to the plan were $36,000 and $24,000 in 2000 and 1999,
respectively.

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 six percent. The Companys match was
approximately $36,000 and $25,000 in 2000 and 1999, respectively.

Note 9.        Operating Segments

The Company has two reportable segments:
Electronic Products (EP) and ISS Information Security Solutions (ISS). The
Electronic Products segment produces and markets proprietary memory keys,
cards, and other custom-shaped tokens that serve as a convenient way to carry
electronic information. 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.

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.

December 31, 2000EP
  ISS
  Unallocated
  TotalRevenue
  $3,799,000
  $3,608,000
  $-
  $7,407,000Depreciation
  and amortization
  314,000
  583,000
  -
  897,000Segment
  profit (loss)
  (565,000)
  (3,141,000)
  140,000
  (3,566,000)

December 31, 1999EP
  ISS
  Unallocated
  TotalRevenue
  $4,550,000
  $1,316,000
  -
  $5,866,000Depreciation
  and amortization
  411,000
  165,000
  -
  576,000Segment
  profit (loss)
  (18,000)
  (2,894,000)
  3,000
  (2,909,000)See Note 10 for discontinued operations disclosure for
the EP segment.

Note 10.      Discontinued
Operations

In February 2001 the Companys Board of Directors
approved managements plan to discontinue the operations of the EP segment. The
plan anticipates the phase down of operations through December 31, 2001, although
it is possible the operations could be sold if a purchaser is found. Some
deliveries for orders received prior to December 31, 2001 are expected to take
place through June 30, 2002. The financial statements have been prepared as if
the operation will be phased down.

The estimated loss on the phase down of the EP
segment includes the write-off of inventory, patents and equipment anticipated
to remain at the date of closedown and expenses associated with the phase down,
net of estimated operating income through that date. The phase down of the
segment is being accounted for as discontinued operations and, accordingly, its
net assets have been segregated from continuing operations in the accompanying
balance sheets and the results of its operations have been excluded from
continuing operations for all periods presented. Net assets and liabilities of
the EP segment at December 31, 2000 are summarized as follows:

Trade receivables
  $498,281Inventories
  1,927,488Equipment and leasehold improvements
  344,418Patents
  72,812Reserve for discontinued operations
  (1,281,000)Net assets from discontinued operations
  $1,561,999Accounts payable
  $357,540Accrued expenses:Compensation
  90,165Other
  33,170Net liabilities from discontinued operations
  $480,875The EP segment had total revenues of $3,798,687 and
$4,550,413 in 2000 and 1999, respectively.

Note 11.      Subsequent Events

In February 2001 the Company completed a $4,800,000
private placement of 1,600,000 shares of common stock with net proceeds of
approximately $4,500,000. In connection with the transaction, the Company
issued 1,680,268 warrants to purchase common stock with exercise prices between
$3.02 and $3.44 per share.