UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                   FORM 10-QSB

         (Mark One)
|X|      QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE
         ACT OF 1934

                  For the quarterly period ended June 30, 2006


|_|      TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT

                  For the transition period from _____ to _____


                         COMMISSION FILE NUMBER 0-25675

                              PATRON SYSTEMS, INC.
        (EXACT NAME OF SMALL BUSINESS ISSUER AS SPECIFIED IN ITS CHARTER)

            DELAWARE                                      74-3055158
(STATE OR OTHER JURISDICTION OF                (IRS EMPLOYER IDENTIFICATION NO.)
 INCORPORATION OR ORGANIZATION)

            5775 FLATIRON PARKWAY, SUITE 230                 80301
                      BOULDER, CO
        (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)           (ZIP CODE)

                                 (303) 541-1005
                           (ISSUER'S TELEPHONE NUMBER)

Check  whether the issuer (1) filed all reports  required to be filed by Section
13 or 15(d) of the  Exchange  Act during the past 12 months (or for such shorter
period that the Registrant was required to file such reports),  and (2) has been
subject to such filing requirements for the past 90 days. Yes |_|  No |X|

Indicate by check mark whether the  registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes |_|  No |X|


State the number of shares outstanding of each of the issuer's classes of common
equity,  as of the latest  practicable  date:  14,461,851 shares of common stock
outstanding as of August 4, 2006.

Transitional Small Business Disclosure Format (Check one):  Yes |_|  No |X|


<PAGE>


                              PATRON SYSTEMS, INC.

                          FORM 10-QSB QUARTERLY REPORT
                       ----------------------------------

                                TABLE OF CONTENTS


PART I - FINANCIAL INFORMATION                                              PAGE
                                                                            ----
ITEM 1. FINANCIAL STATEMENTS ..................................................3

Condensed Consolidated Balance Sheet at June 30, 2006 (unaudited)..............3
Condensed Consolidated Statements of Operations for the Three and
         Six Months Ended June 30, 2006 (unaudited)............................4
Condensed Consolidated Statement of Stockholders' Equity for the
         Six Months Ended June 30, 2006 (unaudited)............................5
Condensed Consolidated Statements of Cash Flows for the
         Six Months Ended June 30, 2006 and June 30, 2005 (unaudited)..........6
Notes to Condensed Consolidated Financial Statements (unaudited)...............7

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
        CONDITION AND RESULTS OF OPERATIONS...................................32

ITEM 3. CONTROLS AND PROCEDURES...............................................45


PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS.....................................................46

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS...........48

ITEM 6. EXHIBITS..............................................................48


SIGNATURES....................................................................49


                           FORWARD LOOKING STATEMENTS


The following discussion and explanations should be read in conjunction with the
financial  statements and related notes contained elsewhere in this Form 10-QSB.
Certain  statements  made in this  discussion are  "forward-looking  statements"
within the  meaning of the  Private  Securities  Litigation  Reform Act of 1995.
Forward-looking  statements  can be  identified  by  terminology  such as "may",
"will", "should", "expects", "intends", "anticipates",  "believes", "estimates",
"predicts",  or  "continue"  or the negative of these terms or other  comparable
terminology. Because forward-looking statements involve risks and uncertainties,
there are important factors that could cause actual results to differ materially
from those expressed or implied by these  forward-looking  statements.  Although
Patron  Systems  believes  that  expectations  reflected in the  forward-looking
statements are reasonable,  it cannot guarantee  future results,  performance or
achievements.  Moreover,  neither  Patron  Systems nor any other person  assumes
responsibility  for the  accuracy  and  completeness  of  these  forward-looking
statements.  Patron  Systems  is under  no duty to  update  any  forward-looking
statements  after the date of this report to conform such  statements  to actual
results.


                                       2
<PAGE>


PART I - FINANCIAL INFORMATION


ITEM 1  FINANCIAL STATEMENTS


                      PATRON SYSTEMS, INC. AND SUBSIDIARIES
                      CONDENSED CONSOLIDATED BALANCE SHEET
                                   (unaudited)

                                                                      JUNE 30,
                                                                        2006
ASSETS                                                              ------------
Current Assets
  Cash ........................................................    $    195,432
  Accounts receivable, net ....................................         571,248
  Other current assets ........................................         231,573
                                                                   ------------
     Total current assets .....................................         998,253

Property and equipment, net ...................................         125,608
Intangible assets, net ........................................       1,399,618
Goodwill ......................................................       9,510,716
                                                                   ------------
     Total assets .............................................    $ 12,034,195
                                                                   ============

LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
  Accounts payable ............................................    $  1,023,432
  Accrued payroll and related expenses ........................         280,673
  Accrued interest ............................................         604,444
  Dividends payable ...........................................         124,784
  Demand notes payable ........................................         447,556
  Bridge notes payable ........................................         544,975
  Notes payable (to creditors of acquired business,
    including $554,202 to related parties) ....................         799,982
  Expense reimbursements due to officers and stockholders .....         130,201
  Notes payable to officers and stockholders ..................          90,000
  Other current liabilities ...................................         742,051
  Accrued registration rights penalty .........................          87,174
  Deferred revenue ............................................         498,780
                                                                   ------------
     Total current liabilities ................................       5,374,052

Commitments and contingencies

Stockholders' Equity
  Preferred stock, par value $0.01 per share, 75,000,000
    shares authorized,
       - Series A convertible: 2,160 shares authorized;
          964 shares issued and outstanding
          liquidation preference of $5,581,250 ................              10
       - Series A-1 convertible: 50,000,000 authorized;
          36,388,907 issued and outstanding
          liquidation preference of $29,111,126 ...............         363,889
  Common stock, par value $0.01 per share, 150,000,000
    shares authorized, 2,131,496 shares issued and
    outstanding ...............................................          21,316
  Additional paid-in capital ..................................      97,792,968
  Deferred compensation .......................................      (1,108,922)
  Accumulated deficit .........................................     (90,409,118)
                                                                   ------------
     Total stockholders' equity ...............................       6,660,143
                                                                   ------------
     Total liabilities and stockholders' equity ...............    $ 12,034,195
                                                                   ============

See notes to condensed consolidated financial statements.


                                       3
<PAGE>


<TABLE>
                      PATRON SYSTEMS, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (unaudited)

<CAPTION>
                                                             SIX MONTHS ENDED             THREE MONTHS ENDED
                                                                 JUNE 30,                      JUNE 30,
                                                        --------------------------    --------------------------
                                                            2006           2005           2006           2005
                                                        -----------    -----------    -----------    -----------
<S>                                                     <C>            <C>            <C>            <C>
Revenue .............................................   $   580,745    $    90,843    $   318,960    $    84,413
                                                        -----------    -----------    -----------    -----------
Cost of Sales
  Cost of products/services .........................        29,897          2,003           --             --
  Amortization of technology ........................        55,044        147,731         27,522        128,501
                                                        -----------    -----------    -----------    -----------
    Total cost of sales .............................        84,941        149,734         27,522        128,501
                                                        -----------    -----------    -----------    -----------
  Gross profit (loss) ...............................       495,804        (58,891)       291,438        (44,088)
                                                        -----------    -----------    -----------    -----------

Operating Expenses
  Salaries and related expenses .....................     2,448,188      1,076,437      1,438,065      1,214,588
  Consulting expense (non-employee stock based
    compensation) ...................................          --          952,875           --          444,375
  Professional fees .................................       885,897        653,383        227,782        511,982
  General and administrative ........................       621,575        757,486        297,666         35,422
  Amortization of intangibles .......................        61,627         38,877         30,813         30,814
  Stock based penalties under accomodation agreements          --          689,102           --          320,102
  Stock based penalty under collateralized financing
    arrangement .....................................         5,246           --            2,394           --
  Loss on collateralized financing arrangement ......          --          366,193           --          366,193
  Loss/(gain) associated with settlement agreements .       486,597       (389,103)      (371,616)      (389,103)
                                                        -----------    -----------    -----------    -----------
     Total operating expenses .......................     4,509,130      4,145,250      1,625,104      2,534,373

Operating loss ......................................    (4,013,326)    (4,204,141)    (1,333,666)    (2,578,461)

Other Income (Expense)
  Interest income ...................................         1,961         19,250          1,961           --
  Loss on sale of property and equipment ............          (125)          --             (187)          --
  Interest expense ..................................    (1,703,935)    (2,196,535)       (88,421)    (1,701,547)
                                                        -----------    -----------    -----------    -----------
     Total other income (expense) ...................    (1,702,099)    (2,177,285)       (86,647)    (1,701,547)
                                                        -----------    -----------    -----------    -----------
Loss from continuing operations before income taxes .    (5,715,425)    (6,381,426)    (1,420,313)    (4,280,008)

  Income taxes ......................................          --             --             --             --
                                                        -----------    -----------    -----------    -----------
Loss from continuing operations .....................    (5,715,425)    (6,381,426)    (1,420,313)    (4,280,008)
                                                        -----------    -----------    -----------    -----------

Loss from discontinued operations ...................      (104,962)      (850,874)          --         (748,497)
Loss on disposal of discontinued operations .........       (75,920)          --          (75,920)          --
                                                        -----------    -----------    -----------    -----------
                                                           (180,882)      (850,874)       (75,920)      (748,497)
                                                        -----------    -----------    -----------    -----------

Net loss ............................................    (5,896,307)    (7,232,300)    (1,496,233)    (5,028,505)

Preferred stock dividend ............................      (124,784)          --         (124,784)          --
                                                        -----------    -----------    -----------    -----------
Net loss available to common stockholders ...........   $(6,021,091)   $(7,232,300)   $(1,621,017)   $(5,028,505)
                                                        ===========    ===========    ===========    ===========

Net Loss Per Share - Basic and Diluted
  - Continuing operations ...........................   $     (2.75)   $     (3.47)   $     (0.71)   $     (2.11)
                                                        ===========    ===========    ===========    ===========
  - Discontinued operations .........................   $     (0.08)   $     (0.46)   $     (0.04)   $     (0.36)
                                                        ===========    ===========    ===========    ===========
  - Total net loss per share available to common
      stockholders ..................................   $     (2.83)   $     (3.93)   $     (0.75)   $     (2.47)
                                                        ===========    ===========    ===========    ===========

Weighted Average Number of Shares Outstanding
   - Basic and diluted ..............................     2,127,543      1,838,106      2,170,653      2,032,823
                                                        ===========    ===========    ===========    ===========
</TABLE>

See notes to condensed consolidated financial statements.


                                       4
<PAGE>


<TABLE>
                      PATRON SYSTEMS, INC. AND SUBSIDIARIES
            CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
                     FOR THE SIX MONTHS ENDED JUNE 30, 2006
                                   (UNAUDITED)

<CAPTION>
                                           SHARES OF      PAR VALUE      SHARES OF      PAR VALUE
                                           SERIES A       SERIES A      SERIES A-1     SERIES A-1       SHARES OF       PAR VALUE
                                           PREFERRED      PREFERRED      PREFERRED      PREFERRED         COMMON          COMMON
                                             STOCK          STOCK          STOCK          STOCK           STOCK           STOCK
                                          ------------   ------------   ------------   ------------    ------------    ------------
<S>                                               <C>    <C>              <C>          <C>               <C>          <C>
Balance - January 1, 2006 .............           --     $       --             --     $       --        1,978,655    $     19,787

Fair value of unamortized stock options
   granted prior to January 1, 2006 ...           --             --             --             --             --              --
Current year option grants ............           --             --             --             --             --              --
Issuance of Series A Preferred Stock
   to investors .......................            964             10           --             --             --              --
Issuance of warrants in connection
   with bridge loan extension -
   extension warrants .................           --             --             --             --             --              --
Conversion option penalty incurred
   upon default of Bridge Financing III           --             --             --             --             --              --
Issuance of Series A-1 Preferred stock
   in settlement of debt ..............           --             --       36,388,907        363,889        (98,334)           (983)
Issuance of shares in connection with
   anti-dilution provision ............           --             --             --             --          251,175           2,512
Amortization of deferred compensation .           --             --             --             --             --              --
Series A dividends ....................           --             --             --             --             --              --
Net Loss ..............................           --             --             --             --             --              --
                                          ------------   ------------   ------------   ------------    ------------    ------------

BALANCE - JUNE 30, 2006 ...............            964   $         10     36,388,907   $    363,889      2,131,496    $     21,316
                                          ============   ============   ============   ============   ============    ============


<CAPTION>
                                                              COMMON
                                            ADDITIONAL        STOCK
                                             PAID IN        REPURCHASE       DEFERRED       ACCUMULATED
                                             CAPITAL        OBLIGATION     COMPENSATION       DEFICIT         TOTAL
                                           ------------    ------------    ------------    ------------    -----------
<S>                                       <C>             <C>             <C>             <C>             <C>
Balance - January 1, 2006 .............   $ 65,601,272    $ (1,300,000)   $     (7,500)   $(84,388,027)   $(20,074,468)

Fair value of unamortized stock options
   granted prior to January 1, 2006 ...      1,214,907            --        (1,214,907)           --              --
Current year option grants ............        131,439            --          (131,439)           --              --
Issuance of Series A Preferred Stock
   to investors .......................      4,820,490            --              --              --         4,820,500
Issuance of warrants in connection
   with bridge loan extension -
   extension warrants .................         48,129            --              --              --            48,129
Conversion option penalty incurred
   upon default of Bridge Financing III        550,000            --              --              --           550,000
Issuance of Series A-1 Preferred stock
   in settlement of debt ..............     25,429,243       1,300,000            --              --        27,092,149
Issuance of shares in connection with
   anti-dilution provision ............         (2,512)           --              --              --              --
Amortization of deferred compensation .           --              --           244,924            --           244,924
Series A dividends ....................           --              --              --          (124,784)       (124,784)
Net Loss ..............................           --              --              --        (5,896,307)     (5,896,307)
                                           ------------    ------------    ------------    ------------    -----------

BALANCE - JUNE 30, 2006 ...............   $ 97,792,968    $       --      $ (1,108,922)   $(90,409,118)   $  6,660,143
                                          ============    ============    ============    ============    ============
</TABLE>

See notes to condensed consolidated financial statements.


                                       5
<PAGE>

<TABLE>
                      PATRON SYSTEMS, INC. AND SUBSIDIARIES
                 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (unaudited)

<CAPTION>
                                                                     SIX MONTHS ENDED JUNE 30,
                                                                   ----------------------------
                                                                       2006            2005
                                                                   ------------    ------------
<S>                                                                <C>             <C>
Cash Flows from Operating Activities
  Net loss from continuing operations ..........................   $ (5,715,425)   $ (6,381,426)
                                                                   ============    ============
  Adjustments to reconcile net loss to net cash used in
  operating activities:
    Depreciation and amortization ..............................        143,420         192,298
    Stock based compensation ...................................        244,924         952,875
    Non-cash interest expense ..................................        901,438       1,887,625
    Loss (gain) associated with settlement agreements ..........        486,597        (389,103)
    Accrued registration penalty ...............................          5,246            --
    Loss on disposition of discontinued operations .............         75,920            --
    Loss on sale of fixed assets ...............................            125            --
    Stock based penalty under accomodation agreements ..........           --           689,102
    Gain on settlement of consulting agreement payable .........           --          (228,900)
    Loss on collateralized financing arrangement ...............           --           366,194
    Non-cash interest income ...................................           --           (19,250)
    Changes in assets and liabilities:
      Restricted cash escrowed to settle liabilities assumed ...        511,691        (527,003)
      Prepaid expenses .........................................           --            51,487
      Accounts receivable ......................................       (347,104)         14,429
      Other current assets .....................................        (12,874)         44,299
      Accounts payable .........................................       (489,363)       (393,819)
      Accrued interest .........................................        517,268        (342,746)
      Deferred revenue .........................................        166,699          28,017
      Accrued payroll and payroll related expenses .............       (246,891)     (1,015,946)
      Other current liabilities ................................         29,607         367,897
      Consulting agreements payable ............................           --           (50,000)
      Expense reimbursements due to officers and stockholders ..        (29,835)           --
      Other accrued expenses ...................................           --            (3,413)
                                                                   ------------    ------------
  Total adjustments ............................................      1,956,868       1,624,043
                                                                   ------------    ------------
NET CASH USED IN CONTINUING OPERATIONS .........................     (3,758,557)     (4,757,383)
                                                                   ------------    ------------
NET CASH USED IN DISCONTINUED OPERATIONS .......................       (197,882)       (844,222)
                                                                   ------------    ------------
NET CASH USED IN OPERATING ACTIVITIES ..........................     (3,956,439)     (5,601,605)
                                                                   ------------    ------------

CASH FLOWS USED IN INVESTING ACTIVITIES
  Cash payments in purchase business combinations ..............           --          (857,633)
  Cash acquired in purchase business combinations ..............           --           406,834
  Purchase and development of technology .......................       (283,530)           --
  Proceeds from sale of fixed assets ...........................          1,755            --
  Purchase of fixed assets .....................................        (46,948)        (37,634)
                                                                   ------------    ------------
NET CASH USED IN CONTINUING INVESTING ACTIVITIES ...............       (328,723)       (488,433)
                                                                   ------------    ------------
NET CASH USED IN DISCONTINUED INVESTING ACTIVITIES .............        (78,920)        (10,182)
                                                                   ------------    ------------
NET CASH USED IN INVESTING ACTIVITIES ..........................       (407,643)       (498,615)
                                                                   ------------    ------------

CASH FLOWS FROM FINANCING ACTIVITIES
  Expenses repaid to officers and stockholders .................           --          (373,060)
  Payments on settlement of accommodation agreements ...........       (125,000)           --
  Advances from stockholders ...................................           --         1,650,000
  Deferred financing costs .....................................        (54,000)       (621,739)
  Proceed from issuance of Series A Preferred Stock ............      4,640,501            --
  Repayments of amounts due under settlement with former officer           --          (200,000)
  Proceeds from issuance of bridge notes .......................           --         3,500,000
  Repayments of notes payable ..................................         (7,001)           --
  Proceeds from disposition of discontinued operations .........         50,000            --
  Proceeds received in connection with financing settlement ....         55,000            --
  Proceeds from issuance of notes, less fees ...................           --         2,543,000
  Repayments of advances from stockholders .....................           --           (32,774)
                                                                   ------------    ------------
NET CASH PROVIDED BY CONTINUING FINANCING ACTIVITIES ...........      4,559,500       6,465,427
                                                                   ------------    ------------
NET CASH USED BY DISCONTINUED FINANCING ACTIVITIES .............           --           (93,483)
                                                                   ------------    ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ......................      4,559,500       6,371,944
                                                                   ------------    ------------

NET INCREASE IN CASH ...........................................        195,418         271,724

CASH, beginning of period ......................................             14          45,901
                                                                   ------------    ------------
CASH, end of period ............................................   $    195,432    $    317,625
                                                                   ============    ============

Supplemental Disclosures of Cash Flow Information:

Cash paid during the period for:
  Interest .....................................................   $    285,517    $    515,798
                                                                   ============    ============

Supplemental non-cash investing and finanical activity
  Current tangible assets acquired .............................   $       --      $    300,911
  Non-current tangible assets acquired .........................           --         2,756,470
  Current liabilities assumed with acquisitions ................           --        (8,379,271)
  Non-current liabilities assumed with acquisitions ............           --          (439,126)
  Intangible assets acquired ...................................           --         3,101,000
  Goodwill recognized on purchase business combinations ........           --        22,433,752
  Non-cash consideration .......................................           --       (19,332,500)
  Cash acquired in purchase business combinations ..............           --           416,397
                                                                   ------------    ------------
  Cash paid to acquire businesses ..............................   $       --      $    857,633
                                                                   ============    ============
</TABLE>

See notes to condensed consolidated financial statements.


                                       6
<PAGE>


                      PATRON SYSTEMS, INC. AND SUBSIDIARIES
        NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
                                  JUNE 30, 2006

NOTE 1 - BASIS OF INTERIM FINANCIAL STATEMENT PRESENTATION

The accompanying unaudited Condensed Consolidated Financial Statements of Patron
Systems,  Inc. and subsidiaries (the "Company,"  "Patron," "we," "us," or "our")
have been prepared in accordance with accounting  principles  generally accepted
in the United States for interim  financial  information and the instructions to
Form 10-QSB. Accordingly,  they do not include all the information and footnotes
required by accounting  principles  generally  accepted in the United States for
complete  financial  statements.  In the opinion of management,  all adjustments
(which include only normal  recurring  adjustments)  necessary to present fairly
the financial  position,  results of  operations  and cash flows for all periods
presented  have been made.  The results of operations  for the  three-month  and
six-month  periods  ended June 30, 2006 are not  necessarily  indicative  of the
operating  results that may be expected for the entire year ending  December 31,
2006.

This form 10-QSB should be read in conjunction with the Company's 10-KSB for the
year ended December 31, 2005.


NOTE 2 - THE COMPANY

ORGANIZATION AND DESCRIPTION OF BUSINESS

Patron Systems,  Inc. ("Systems") is a Delaware corporation formed in April 2002
to provide  comprehensive,  end-to-end  information security solutions to global
corporations and government institutions.

Pursuant to an Amended and Restated Share Exchange  Agreement  dated October 11,
2002, Combined  Professional  Services ("CPS"),  Systems and the stockholders of
Systems  consummated a share  exchange  ("Share  Exchange").  As a result of the
Share  Exchange,   the  former  stockholders  of  Systems  became  the  majority
stockholders of CPS. Accordingly,  Systems became the accounting acquirer of CPS
and the exchange was accounted for as a reverse merger and  recapitalization  of
Systems.  CPS  subsequently  merged with  Systems,  with Systems  surviving  the
merger. The combined entity continued to use the name Patron Systems, Inc.

REVERSE STOCK SPLIT AND AMENDMENT TO CERTIFICATE OF INCORPORATION

As described in Note 20, the Company's  stockholders  approved an amended to its
certificate of  incorporation  to effectuate a 1-for-30  reverse stock split and
certain  other  transactions  intended to  recapitalize  the Company.  All share
information included in the accompanying  financial statements and notes thereto
give retroactive effect to the reverse split.


NOTE 3 - LIQUIDITY AND FINANCIAL CONDITION

The  accompanying  financial  statements  have been  prepared  assuming that the
Company will  continue as a going  concern.  The Company  incurred a net loss of
$5,896,307  for the six months ended June 30, 2006,  which includes an aggregate
of  $1,857,670 of non-cash  charges  including  the  conversion  option cost for
bridge note and  subordinated  note  holders,  non-cash  interest  expense,  the
amortization  of deferred  compensation  and the charge for stock  option  based
compensation.  The  Company  used  net  cash  in  its  operating  activities  of
$3,956,439  during the six months ended June 30,  2006.  The  Company's  working
capital  deficiency at June 30, 2006  amounted to $4,375,799  and the Company is
continuing  to  experience  shortages  in working  capital.  The Company is also
involved in litigation and is being  investigated by the Securities and Exchange
Commission with respect to certain of its press releases and its use of form S-8
to register shares of common stock issued to certain  consultants (Note 15). The
Company  cannot provide any assurance that the outcome of these matters will not
have a material  adverse  affect on its ability to sustain the  business.  These
matters raise  substantial  doubt about the  Company's  ability to continue as a
going


                                       7
<PAGE>


concern.  The accompanying  financial  statements do not include any adjustments
that may result from the outcome of this uncertainty.

The Company expects to continue  incurring losses for the foreseeable future due
to the  inherent  uncertainty  that is related to  establishing  the  commercial
feasibility of technological  products and developing a presence in new markets.
The Company's ability to successfully market its software products, grow revenue
and generate cash flows of certain businesses it acquired in 2005 is critical to
the  realization of its business  plan.  The Company raised  $4,640,501 of gross
proceeds  ($4,301,450  net  proceeds  after the  payment of certain  transaction
expenses) in financing  transactions  during the six months ended June 30, 2006.
The Company used  $3,956,439 of these  proceeds to fund its operations and a net
of $407,643 in investing  activities.  On January 12, 2006, the Company  offered
its creditors and claimants an agreement to receive Series A-1 Preferred  Stock,
par value $0.01 per share  ("Series  A-1  Preferred")  for  amounts  owed to the
holders  of  the  Company's  indebtedness  (including  lenders,  past-due  trade
accounts, and employees, consultants and other service providers with claims for
fees, wages or expenses) (Note 16). As of June 30, 2006, creditors  representing
approximately 91% of the Company's  outstanding claims accepted this proposal by
signing and returning to the Company the Stock Subscription Agreement and Mutual
Release.  On July 21,  2006,  the  Company's  Board of  Directors  approved  the
completion of the creditor and claimant  liabilities  restructuring.  A total of
$29,592,756 of debts,  liabilities and other claims were settled by the issuance
of Series A-1 Preferred  Stock.  In addition,  the Company  settled  $382,584 in
claims for  $12,140.  The total of all these  settlements  represent  94% of the
outstanding  claims.  The Company is currently unable to provide  assurance that
the  acceptance of the claims  settlement  will  actually  improve the Company's
ability to fund the  further  development  of its  business  plan or improve its
operations.

The  Company is  currently  in the  process of  attempting  to raise  additional
capital and has taken certain steps to conserve its liquidity while it continues
to integrate the businesses  acquired in 2005. Although management believes that
the  Company  has access to capital  resources,  the Company has not secured any
commitments  for additional  financing at this time nor can the Company  provide
any  assurance  that it will be  successful  in its efforts to raise  additional
capital and/or successfully execute its business plan.


NOTE 4 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION

The consolidated  financial  statements  include the accounts of the Company and
its  wholly-owned  subsidiaries,   Entelagent  Software  Corporation,   Complete
Security  Solutions,  Inc.  and PILEC  Disbursement  Company.  The  accounts  of
LucidLine,  Inc. have been included in discontinued operations through April 18,
2006,  the  date  on  which  LucidLine  was  sold  (Note  19).  All  significant
inter-company transactions have been eliminated.

CASH

The Company  considers  all highly  liquid  securities  purchased  with original
maturities of three months or less to be cash.

REVENUE RECOGNITION

The Company derives revenues from the following  sources:  (1) sales of computer
software,  which includes new software licenses and software updates and product
support  revenues and (2) services,  which  include  internet  access,  back-up,
retrieval and restoration services and professional consulting services.

The Company  applies the revenue  recognition  principles  set forth under AICPA
Statement of Position ("SOP") 97-2 "Software Revenue Recognition" and Securities
and  Exchange   Commission  Staff  Accounting   Bulletin  ("SAB")  104  "Revenue
Recognition"  with  respect to its  revenue.  Accordingly,  the Company  records
revenue when (i) persuasive evidence of an arrangement exists, (ii) delivery has
occurred,   (iii)  the  vendor's  fee  is  fixed  or   determinable,   and  (iv)
collectability is reasonably assured.


                                       8
<PAGE>


The Company  generates  revenues  through sales of software  licenses and annual
support subscription  agreements,  which include access to technical support and
software  updates  (if  and  when  available).  Software  license  revenues  are
generated  from  licensing the rights to use products  directly to end-users and
through third party service providers.

Revenues from software license agreements are generally recognized upon delivery
of software to the customer.  All of the Company's  software sales are supported
by a written  contract or other evidence of sale  transaction such as a customer
purchase order.  These forms of evidence  clearly  indicate the selling price to
the  customer,  shipping  terms,  payment  terms  (generally 30 days) and refund
policy,  if any. The selling  prices of these products are fixed at the time the
sale is consummated.

Revenue from post-contract customer support arrangements or undelivered elements
are deferred and  recognized at the time of delivery or over the period in which
the services are performed based on vendor specific  objective  evidence of fair
value for such  undelivered  elements.  Vendor  specific  objective  evidence is
typically  based on the price charged when an element is sold  separately or, if
an element is not sold  separately,  on the price  established  by an authorized
level of management,  if it is probable that the price, once  established,  will
not change  before  market  introduction.  The Company uses the residual  method
prescribed in SOP 98-9,  "Modification of SOP 97-2, Software Revenue Recognition
With Respect to Certain  Transaction" to allocate revenues to delivered elements
once it has  established  vendor-specific  objective  evidence of fair value for
such undelivered elements.

The Company provides its internet access and back-up,  retrieval and restoration
services  under  contractual  arrangements  with terms  ranging from 1 year to 5
years.   These  contracts  are  billed  monthly,   in  advance,   based  on  the
contractually  stated  rates.  At the  inception of a contract,  the Company may
activate the customer's account for a contractual fee that it amortizes over the
term of the  contract  in  accordance  with  Emerging  Issues  Task Force  Issue
("EITF") 00-21, "Revenue Arrangements with Multiple Deliverables." The Company's
standard contracts are automatically renewable by the customer unless terminated
on 30 days written notice.  Early termination of the contract  generally results
in an early  termination fee equal to the lesser of six months of service or the
remaining  term of the  contract.  These  revenues are included in  discontinued
operations as described in Note 19.

Professional  consulting  services  are  billed  based on the number of hours of
consultant   services  provided  and  the  hourly  billing  rates.  The  Company
recognizes revenue under these arrangements as the service is performed.

Revenue from the resale of third-party  hardware and software is recognized upon
delivery  provided  there are no  further  obligations  to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract  satisfies  the  requirements  of
EITF 99-19 "Reporting Revenue Gross as a Principal versus Net as Agent."

BUSINESS COMBINATIONS

In accordance  with business  combination  accounting,  we allocate the purchase
price of acquired  companies  to the tangible and  intangible  assets  acquired,
liabilities  assumed,  as well as in-process  research and development  based on
their estimated fair values.  We engaged a third-party  appraisal firm to assist
management  in  determining  the fair  values of  certain  assets  acquired  and
liabilities  assumed.  Such a valuation requires  management to make significant
estimates and assumptions, especially with respect to intangible assets.

Management makes estimates of fair value based upon  assumptions  believed to be
reasonable.  These estimates are based on historical  experience and information
obtained from the management of the acquired  companies.  Critical  estimates in
valuing certain of the intangible  assets include but are not limited to: future
expected  cash  flows  from  license  sales,  maintenance  agreements,  customer
contracts and acquired  developed  technologies;  expected  costs to develop the
in-process  research and development  into  commercially  viable  products;  the
acquired  company's brand awareness and market position,  as well as assumptions
about the  period of time the  acquired  brand will  continue  to be used in the
combined  company's product  portfolio;  and discount rates. These estimates are
inherently  uncertain  and  unpredictable.  Assumptions  may  be  incomplete  or
inaccurate,  and  unanticipated  events and  circumstances  may occur  which may
affect  the  accuracy  or  validity  of such  assumptions,  estimates  or actual
results.


                                       9
<PAGE>


ACCOUNTS RECEIVABLE

The  Company  adjusts  its  accounts  receivable  balances  that it  deems to be
uncollectible.  The  allowance  for  doubtful  accounts  is the  Company's  best
estimate  of the amount of  probable  credit  losses in the  Company's  existing
accounts receivable.  The Company reviews its allowance for doubtful accounts on
a monthly basis and  determines  the allowance  based on an analysis of its past
due  accounts.  All  past  due  balances  that  are  over 90 days  are  reviewed
individually  for  collectability.  Account balances are charged off against the
allowance  after all means of collection  have been  exhausted and the potential
for recovery is considered remote.

PROPERTY AND EQUIPMENT

Property and  equipment is stated at cost.  Depreciation  is computed  using the
straight-line  method over the estimated  useful lives of the assets  (generally
three to five  years).  Maintenance  and  repairs  are  charged  to  expense  as
incurred; cost of major additions and betterments are capitalized. When property
and equipment is sold or otherwise disposed of, the cost and related accumulated
depreciation  are eliminated from the accounts and any resulting gains or losses
are reflected in the statement of operations in the period of disposal.

GOODWILL AND INTANGIBLE ASSETS

The Company  accounts for  Goodwill and  Intangible  Assets in  accordance  with
Statement  of  Financial   Accounting  Standards  ("SFAS")  No.  141,  "Business
Combinations"  and SFAS No. 142,  "Goodwill and Other Intangible  Assets." Under
SFAS No. 142,  goodwill and intangibles that are deemed to have indefinite lives
are no longer amortized but,  instead,  are to be reviewed at least annually for
impairment.  Application  of the goodwill  impairment  test  requires  judgment,
including  the   identification   of  reporting  units,   assigning  assets  and
liabilities  to reporting  units,  assigning  goodwill to reporting  units,  and
determining the fair value.  Significant judgments required to estimate the fair
value of  reporting  units  include  estimating  future cash flows,  determining
appropriate discount rates and other assumptions. Changes in these estimates and
assumptions  could  materially  affect the  determination  of fair value  and/or
goodwill  impairment  for each  reporting  unit.  We have  recorded  goodwill in
connection  with the  Company's  acquisitions  described  in Note 5 amounting to
$22,440,412.  The Company's  annual  impairment  review of goodwill  resulted in
goodwill impairment charges totaling $12,929,696 for the year ended December 31,
2005 (Note 5) resulting in $9,510,716  in goodwill at June 30, 2006.  Intangible
assets continue to be amortized over their estimated  useful lives.  The Company
evaluated the carrying amounts of its goodwill and intangible  assets as of June
30, 2006 and determined that impairment charges are not necessary.

LONG LIVED ASSETS

The Company periodically reviews the carrying values of its long lived assets in
accordance  with SFAS 144,  "Long  Lived  Assets"  when  events  or  changes  in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their  realizable  value and records  impairment  charges when
necessary.  The Company's review of the carrying values of its long lived assets
resulted in an impairment  charge of $1,705,455  for the year ended December 31,
2005 (Note 8).

USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS

In preparing  financial  statements in  conformity  with  accounting  principles
generally  accepted in the United  States of America,  management is required to
make estimates and  assumptions  that affect the reported  amounts of assets and
liabilities and the disclosure of contingent  assets and liabilities at the date
of the  financial  statements  and revenue  and  expenses  during the  reporting
period. The Company's significant estimates principally include the valuation of
its  intangible  assets and goodwill  and accrued  liability  for the  Company's
estimate of the fair value of preferred  stock issued upon the settlement of the
creditor and claimant  liabilities  restructuring in June 2006 (Note 16). Actual
results could differ from those estimates.

FAIR VALUE OF FINANCIAL INSTRUMENTS

The  carrying  amounts  reported  in  the  balance  sheet  for  cash,   accounts
receivable,  accounts payable accrued  expenses,  advances from stockholders and
all note obligations  classified as current  liabilities  approximate their fair


                                       10
<PAGE>


values  based on the  short-term  maturity of these  instruments.  The  carrying
amounts of the Company's  convertible and subordinated note  obligations,  stock
repurchase  obligation  and common stock subject to put right  approximate  fair
value as such instruments feature contractual interest rates that are consistent
with  current  market  rates  of  interest  or have  effective  yields  that are
consistent with instruments of similar risk, when taken together with any equity
instruments concurrently issued to holders.

CONVERTIBLE PREFERRED STOCK

The Company accounts for conversion  options  embedded in convertible  preferred
stock in accordance with Statement of Financial  Accounting Standard ("SFAS) No.
133 "Accounting for Derivative  Instruments and Hedging Activities" ("SFAS 133")
and Emerging  Issues Task Force Issue ("EITF") 00-19  "Accounting for Derivative
Financial  Instruments  Indexed to, and Potentially  Settled in, a Company's Own
Stock"  ("EITF  00-19").  SFAS 133  generally  requires  companies  to bifurcate
conversion options embedded in convertible notes and preferred shares from their
host instruments and to account for them as free standing  derivative  financial
instruments in accordance with EITF 00-19. SFAS 133 provides for an exception to
this rule when convertible notes and mandatorily redeemable preferred shares, as
host instruments, are deemed to be conventional as that term is described in the
implementation  guidance  provided in paragraph 61 (k) of Appendix A to SFAS 133
and further clarified in EITF 05-2 "The Meaning of Conventional Convertible Debt
Instrument" in Issue No. 00-19.

SFAS 133  provides  for an  additional  exception to this rule when the economic
characteristics and risks of the embedded derivative  instrument are clearly and
closely  related  to  the  economic   characteristics  and  risks  of  the  host
instrument.

The  Company  determined  that the  conversion  option  embedded in its Series A
Convertible  Preferred  Stock, par value $0.01 per share ("Series A Preferred"),
is not a free standing derivative in accordance with the implementation guidance
provided in paragraph 61 (l) of Appendix A to SFAS 133.

STOCK BASED COMPENSATION

Prior to January 1, 2006, the Company accounted for employee stock  transactions
in  accordance  with  Accounting   Principles   Board  ("APB")  Opinion  No.  25
"Accounting  for Stock Issued to  Employees."  The Company  applied the proforma
disclosure   requirements   of  SFAS  No.  123   "Accounting   for   Stock-Based
Compensation."

Effective  January 1, 2006,  the Company  adopted  SFAS No.  123R  "Share  Based
Payment." This statement is a revision of SFAS Statement No. 123, and supersedes
APB Opinion No. 25, and its related implementation guidance. SFAS 123R addresses
all forms of share based payment  ("SBP") awards  including  shares issued under
employee  stock  purchase  plans,  stock  options,  restricted  stock  and stock
appreciation  rights.  Under SFAS 123R, SBP awards result in a cost that will be
measured at fair value on the awards' grant date,  based on the estimated number
of awards that are expected to vest that will result in a charge to  operations.
The Company adopted the modified  prospective  method with respect to accounting
for its transition to SFAS 123(R) and measured unrecognized compensation cost as
described  in Note 18.  Accordingly,  the Company  recognized  in  salaries  and
related  expense on the  statement of  operations,  $237,424 and $64,089 for the
fair value of stock  options  expected to vest  during the six- and  three-month
periods ended June 30, 2006, respectively.

For the six and three  months  ended June 30,  2005,  the  Company  applied  APB
Opinion No. 25,  "Accounting  for Stock Issued to  Employees." As required under
SFAS  No.  148,  "Accounting  for  Stock-based  Compensation  -  Transition  and
Disclosure,"  the following  table  presents  pro-forma net income and basic and
diluted earnings per share as if the fair value-based method had been applied to
all awards during that period.


                                       11
<PAGE>


                                                      SIX MONTHS    THREE MONTHS
                                                         ENDED          ENDED
                                                       JUNE 30,       JUNE 30,
                                                         2005           2005
                                                     -----------    -----------
Net Loss .........................................   $(7,232,300)   $(5,028,505)
Stock-based employee compensation cost,
   under fair value accounting ...................      (370,556)      (185,278)
                                                     -----------    -----------
Pro-forma net loss under fair value method .......   $(7,602,856)   $(5,213,783)
                                                     ===========    ===========

Net loss per share - basic and diluted ...........   $     (3.93)   $     (2.47)

Per share stock-based employee
   compensation cost, under fair value
   accounting

Pro-forma net loss per share, basic and diluted ..   $     (4.14)   $     (2.56)


The fair  value of all  awards  was  estimated  at the date of grant  using  the
Black-Scholes   option  pricing  model  with  the  following   weighted  average
assumptions:  risk fee interest rate: 3.44% to 4.05%;  expected  dividend yield:
0%; expected option life: 3 to 4 years; volatility: 87% to 125%.


COMMON STOCK PURCHASE WARRANTS

The Company  accounts for the issuance of common stock purchase  warrants issued
with  registration  rights in  accordance  with the  provisions  of EITF  00-19,
"Accounting  for Derivative  Financial  Instruments  Indexed to, and Potentially
Settled in, a Company's Own Stock."

Based on the  provisions  of EITF 00-19,  the Company  classifies  as equity any
contracts that (i) require physical  settlement or net-share  settlement or (ii)
gives the  company a choice of  net-cash  settlement  or  settlement  in its own
shares (physical settlement or net-share settlement).  The Company classifies as
assets  or  liabilities  any  contracts  that (i)  require  net-cash  settlement
(including a requirement  to net cash settle the contract if an event occurs and
if  that  event  is  outside  the  control  of the  company)  or (ii)  give  the
counterparty a choice of net-cash  settlement or settlement in shares  (physical
settlement or net-share settlement).

INCOME TAXES

The Company accounts for income taxes under SFAS No. 109, "Accounting for Income
Taxes."  SFAS No.  109  requires  the  recognition  of  deferred  tax assets and
liabilities  for both the expected  impact of differences  between the financial
statements and tax basis of assets and  liabilities  and for the expected future
tax benefit to be derived from tax loss and tax credit carry forwards.  SFAS No.
109 additionally  requires the establishment of a valuation allowance to reflect
the likelihood of realization of deferred tax assets.

NET LOSS PER SHARE

Basic  net loss  per  common  share  is  computed  by  dividing  net loss by the
weighted-average  number of common shares outstanding during the period. Diluted
net loss per common share also  includes  common stock  equivalents  outstanding
during  the  period if  dilutive.  Diluted  net loss per  common  share has been
computed by dividing net loss by the  weighted-average  number of common  shares
outstanding  without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.

As a result of the  consummation of the Share Exchange  described in Note 2, the
Company  included  40,001 stock options with an exercise price of $.01 per share
that  it  issued  to  certain  employees  during  2002  in  its  calculation  of
weighted-average number of common shares outstanding for all periods presented.

The following table sets forth the computation of basic and diluted earnings per
share:


                                       12
<PAGE>


<TABLE>
<CAPTION>
                                                              Six Months Ended             Three Months Ended
                                                                  June 30,                       June 30,
                                                         --------------------------    --------------------------
Numerator:                                                   2006           2005           2006           2005
                                                         -----------    -----------    -----------    -----------
<S>                                                      <C>            <C>            <C>            <C>
        Net loss .....................................   $(5,896,307)   $(7,232,300)   $(1,496,233)   $(5,028,505)
        Preferred stock dividends ....................      (124,784)          --         (124,784)          --
                                                         -----------    -----------    -----------    -----------
  Numerator for basic and diluted loss per share - net
        loss available to common stockholders, as
        reported .....................................   $(6,021,091)   $(7,232,300)   $(1,621,017)   $(5,028,505)

Denominator:
  Denominator for basic and diluted earnings per
        share - weighted average shares ..............     2,127,543      1,838,106      2,170,653      2,032,823

  Net loss per share available to common
        stockholders - basic and diluted .............   $     (2.83)   $     (3.93)   $     (0.75)   $     (2.47)
</TABLE>


Net loss per  common  share  excludes  the  following  outstanding  options  and
warrants as their effect would be anti-dilutive:

                                                      JUNE 30,
                                            ---------------------------
                                               2006              2005
                                            ---------         ---------
         Options ..................           428,090           197,505
         Warrants .................         1,405,863           235,927
                                            ---------         ---------
                                            1,833,953           433,432
                                            =========         =========

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In December  2004,  the FASB issued SFAS No.  153,  "Exchanges  of  Non-monetary
Assets"  (SFAS  153).  SFAS 153  amends  APB  Opinion  No. 29 to  eliminate  the
exception for non-monetary  exchanges of similar  productive assets and replaces
it with a general  exception  for exchanges of  non-monetary  assets that do not
have commercial  substance.  A non-monetary exchange has commercial substance if
the future cash flows of the entity are  expected to change  significantly  as a
result  of  the  exchange.   The  provisions  of  SFAS  153  are  effective  for
non-monetary  asset exchanges  occurring in fiscal periods  beginning after June
15, 2005.  Earlier  application is permitted for  non-monetary  asset  exchanges
occurring in fiscal periods beginning after December 16, 2004. The provisions of
this  statement  are  intended be applied  prospectively.  The  adoption of this
pronouncement  did  not  have  a  material  effect  on the  Company's  financial
statements.

EITF Issue No. 04-8,  "The Effect of  Contingently  Convertible  Instruments  on
Diluted  Earnings  per Share." The EITF  reached a consensus  that  contingently
convertible  instruments,  such as contingently  convertible debt,  contingently
convertible  preferred  stock,  and other such securities  should be included in
diluted earnings per share (if dilutive)  regardless of whether the market price
trigger has been met. The  consensus  became  effective  for  reporting  periods
ending after December 15, 2004. The adoption of this  pronouncement did not have
a material effect on the Company's financial statements.

In May 2005, the Financial  Accounting Standards Board ("FASB") issued Statement
of  Financial  Accounting  Standards  No.  154,  "Accounting  Changes  and Error
Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3" ("SFAS
154"). This Statement replaces APB Opinion No. 20, Accounting Changes,  and FASB
Statement No. 3, Reporting  Accounting Changes in Interim Financial  Statements,
and changes the requirements for the accounting for and reporting of a change in
accounting  principle.  This  Statement  applies  to all  voluntary  changes  in
accounting  principle.  It also  applies to changes  required  by an  accounting
pronouncement  in the unusual instance that the  pronouncement  does not include
specific  transition   provisions.   When  a  pronouncement   includes  specific
transition provisions, those provisions should be followed.


                                       13
<PAGE>


APB Opinion No. 20 previously required that most voluntary changes in accounting
principle be  recognized  by including in net income of the period of the change
the  cumulative  effect  of  changing  to the  new  accounting  principle.  This
Statement  requires  retrospective   application  to  prior  periods'  financial
statements of changes in accounting  principle,  unless it is  impracticable  to
determine  either the  period-specific  effects or the cumulative  effect of the
change. When it is impracticable to determine the period-specific  effects of an
accounting  change  on one or more  individual  prior  periods  presented,  this
Statement requires that the new accounting  principle be applied to the balances
of assets and  liabilities as of the beginning of the earliest  period for which
retrospective  application is practicable and that a corresponding adjustment be
made  to  the  opening  balance  of  retained  earnings  (or  other  appropriate
components of equity or net assets in the  statement of financial  position) for
that  period  rather  than being  reported  in an income  statement.  When it is
impracticable  to  determine  the  cumulative  effect  of  applying  a change in
accounting principle to all prior periods,  this Statement requires that the new
accounting  principle  be applied as if it were adopted  prospectively  from the
earliest date  practicable.  This Statement is effective for accounting  changes
and  corrections  of errors made in fiscal years  beginning  after  December 15,
2005. The adoption of this  pronouncement  did not have a material effect on the
Company's financial statements.

On  June  29,  2005,  the  EITF  ratified  Issue  No.  05-2,   "The  Meaning  of
`Conventional  Convertible Debt Instrument' in EITF Issue No. 00-19, `Accounting
for Derivative  Financial  Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock.'" EITF Issue 05-2 provides guidance on determining  whether
a convertible debt instrument is  "conventional"  for the purpose of determining
when an issuer is required to bifurcate a conversion  option that is embedded in
convertible  debt in accordance  with SFAS 133.  Issue No. 05-2 is effective for
new  instruments  entered into and  instruments  modified in  reporting  periods
beginning after June 29, 2005. The adoption of this pronouncement did not have a
material effect on the Company's financial statements.

In September 2005, the EITF ratified Issue No. 05-4, "The Effect of a Liquidated
Damages Clause on a Freestanding  Financial Instrument Subject to EITF Issue No.
00-19,   `Accounting  for  Derivative  Financial  Instruments  Indexed  to,  and
Potentially  Settled in, a Company's Own Stock.'" EITF 05-4 provides guidance to
issuers as to how to account for registration  rights agreements that require an
issuer to use its "best efforts" to file a registration statement for the resale
of equity  instruments and have it declared  effective by the end of a specified
grace period and, if applicable,  maintain the effectiveness of the registration
statement  for a  period  of  time or pay a  liquidated  damage  penalty  to the
investor.  The Company is currently in the process of evaluating the effect that
the adoption of this pronouncement may have on its financial statements.

In September 2005, the FASB ratified the Emerging  Issues Task Force's  ("EITF")
Issue No. 05-7,  "Accounting for Modifications to Conversion Options Embedded in
Debt Instruments and Related Issues," which addresses  whether a modification to
a  conversion  option that  changes its fair value  affects the  recognition  of
interest  expense for the associated debt instrument  after the modification and
whether a borrower should recognize a beneficial  conversion feature, not a debt
extinguishment if a debt modification  increases the intrinsic value of the debt
(for example,  the modification  reduces the conversion price of the debt). This
issue is effective for future modifications of debt instruments beginning in the
first interim or annual  reporting period beginning after December 15, 2005. The
adoption of this  pronouncement  did not have a material effect on the Company's
financial statements.

In September 2005, the FASB also ratified the EITF's Issue No. 05-8, "Income Tax
Consequences of Issuing Convertible Debt with a Beneficial  Conversion Feature,"
which  discusses  whether the  issuance of  convertible  debt with a  beneficial
conversion  feature  results in a basis  difference  arising from the  intrinsic
value of the  beneficial  conversion  feature on the  commitment  date (which is
recorded in the stockholders'  equity for book purposes,  but as a liability for
income tax purposes),  and, if so, whether that basis  difference is a temporary
difference  under FASB  Statement No. 109,  "Accounting  for Income Taxes." This
Issue should be applied by retrospective  application  pursuant to Statement 154
to all  instruments  with a beneficial  conversion  feature  accounted for under
Issue 00-27  included in financial  statements for reporting  periods  beginning
after  December 15,  2005.  The  adoption of this  pronouncement  did not have a
material effect on the Company's financial statements.

In February 2006, the FASB issued SFAS No. 155,  "Accounting  for Certain Hybrid
Financial  Instruments - an amendment of FASB  Statements No. 133 and 150." SFAS
No. 155 (a) permits fair value remeasurement for any


                                       14
<PAGE>


hybrid financial  instrument that contains an embedded derivative that otherwise
would  require  bifurcation,  (b)  clarifies  that certain  instruments  are not
subject to the  requirements  of SFAS 133,  (c)  establishes  a  requirement  to
evaluate  interests in securitized  financial assets to identify  interests that
may contain an embedded derivative requiring bifurcation, (d) clarifies what may
be an  embedded  derivative  for certain  concentrations  of credit risk and (e)
amends SFAS 140 to eliminate  certain  prohibitions  related to derivatives on a
qualifying  special-purpose  entity.  SFAS 155 is  applicable to new or modified
financial instruments in fiscal years beginning after September 15, 2006, though
the provisions related to fair value accounting for hybrid financial instruments
can also be applied to existing instruments. Early adoption, as of the beginning
of an entity's  fiscal  year,  is also  permitted,  provided  interim  financial
statements have not yet been issued.  We are currently  evaluating the potential
impact,  if any,  that the  adoption  of SFAS 155 will have on our  consolidated
financial statements.

In March 2006,  the FASB issued  Statement  of  Financial  Accounting  Standards
("SFAS") No. 156,  Accounting for Servicing of Financial  Assets (SFAS No. 156).
SFAS No. 156 amends SFAS No. 140  "Accounting  for  Transfers  and  Servicing of
Financial Assets and  Extinguishments of Liabilities," to require all separately
recognized  servicing assets and servicing  liabilities to be initially measured
at  fair  value,  if  practicable.  SFAS  No.  156  also  permits  servicers  to
subsequently  measure each separate class of servicing assets and liabilities at
fair value rather than at the lower of cost or market.  For those companies that
elect to measure their servicing assets and liabilities at fair value,  SFAS No.
156 requires  the  difference  between the carrying  value and fair value at the
date of adoption to be recognized as a cumulative  effect adjustment to retained
earnings as of the  beginning  of the fiscal year in which the election is made.
SFAS No. 156 is effective for the first fiscal year  beginning  after  September
15, 2006. We are currently  evaluating  the potential  impact,  if any, that the
adoption of SFAS 156 will have on our consolidated financial statements.

Other  accounting  standards  that have been  issued or  proposed by the FASB or
other standards-setting  bodies that do not require adoption until a future date
are not  expected  to  have a  material  impact  on the  consolidated  financial
statements upon adoption.


NOTE 5 - BUSINESS COMBINATIONS

On February 25, 2005, the Company acquired  Complete  Security  Solutions,  Inc.
("CSSI") and LucidLine,  Inc.  ("LucidLine")  in separate  merger  transactions.
Additionally,  on March 30, 2005, the Company acquired Entelagent Software Corp.
("Entelagent") in a merger transaction. The Company accounted for these business
combinations  in  accordance  with the  provisions of SFAS 141  "Accounting  for
Business Combinations."

In connection with these three merger  transactions,  the Company paid, $200,000
in cash, 496,667 shares of common stock with a fair market value of $12,665,000,
subordinated  promissory notes in the aggregate  principal amount of $4,500,000,
warrants to purchase  up to 75,001  shares of common  stock which were valued at
$1,912,500.   Direct  expenses   incurred  by  the  Company  to  complete  these
transactions  amounted  to  $912,663.  The  total  purchase  price for the three
companies amounted to $20,190,133.

The allocation of the purchase price was based upon a valuation  study performed
by an independent outside appraisal firm. The purchase price allocation resulted
in the allocation of $3,101,000 to intangible  assets,  including  $2,570,000 to
developed  technology  and  $190,000 to  in-process  research  and  development.
Additionally,  the  purchase  price  allocation  resulted in the  allocation  of
$22,440,412 to goodwill.

The Company  performed its annual  impairment test of goodwill at its designated
valuation date of December 31, 2005 in accordance  with SFAS 142. As a result of
these tests, the Company determined that the recoverable amount of goodwill with
respect  to its  business  amounted  to  $9,510,716.  Accordingly,  the  Company
recorded a goodwill  impairment charge in the amount of $12,929,696 for the year
ended  December  31,  2005.  Additionally,   after  reevaluating  the  resources
available to the Company, the strategic direction of the business as well as the
revised  business  plans and  financial  projections,  the  Company,  during the
quarter ended December 31, 2005, recorded a $1,705,455 charge for the impairment
of  the  developed  technology  assets  acquired  in  the  CSSI  and  Entelagent
acquisitions.  The  remaining  amount  of  goodwill  and  intangible  assets  is
presented net of such impairment charges recorded during the year ended December
31, 2005.


                                       15
<PAGE>


On April 18, 2006,  the Company  entered into a Stock  Purchase  Agreement  with
Walnut Valley,  Inc.  pursuant to which the Company sold all of the  outstanding
shares  of  LucidLine,  Inc.  As a  result,  LucidLine  has  been  treated  as a
discontinued operation in these financial statements (Note 19).


NOTE 6 - OTHER CURRENT ASSETS

Other current assets consist of the following:

                                                              JUNE 30,
                                                                2006
                                                             ----------
         Employee receivables ...........................    $   23,517
         Prepaid expenses ...............................        52,417
         Deposits .......................................        30,639
         Other current assets ...........................       125,000
                                                             ----------
           Other current assets .........................    $  231,573
                                                             ==========


NOTE 7 - PROPERTY AND EQUIPMENT

                                                              JUNE 30,
                                                               2006
                                                            ----------
         Computers ......................................   $  147,524
         Furniture and Fixtures .........................       31,962
         Leasehold improvements .........................        4,490
                                                            ----------
             sub-total ..................................      183,976
         less: accumulated depreciation .................      (58,368)
                                                            ----------
             Property and equipment, net ................   $  125,608
                                                            ==========


Depreciation  expense  amounted to $26,751 and $13,753 for the six months  ended
June 30, 2006 and 2005, respectively.


NOTE 8 - INTANGIBLE ASSETS

The  components  of  intangible  assets as of June 30, 2006 are set forth in the
following table:

                                                             JUNE 30,
                                                               2006
                                                           -----------
         Developed technology .......................      $ 2,570,000
         Customer relationships .....................          180,000
         Trademarks and tradenames ..................          161,000
         In-process research and development ........          807,917
                                                           -----------
                                                             3,718,917
         Amortization and impairment charge .........       (2,319,299)
                                                           -----------
            Intangible assets, net ..................      $ 1,399,618
                                                           ===========


During the year ended  December  31,  2005,  the Company  recorded a  $1,705,455
charge for the  impairment of the developed  technology  assets  acquired in the
CSSI and Entelagent acquisitions (Note 5).

The Company  classifies  amortization of developed  technology as a component of
cost of sales and  amortization  of customer  relationship  and  trademarks  and
tradenames as a component of general and administrative expense.



                                       16
<PAGE>


Amortization  expense amounted to $116,669 and $178,545 for the six months ended
June 30, 2006 and 2005,  respectively.  Included in these amounts is $55,044 and
$147,731 for the six months ended June 30, 2006 and 2005, respectively, which is
classified as cost of sales.


NOTE 9 - DEMAND NOTES PAYABLE

Through  December 31, 2004, the Company borrowed an aggregate amount of $695,000
from several unrelated  parties.  At June 30, 2006, all but one note was settled
in the creditor and claimant liabilities restructuring.  The outstanding balance
on this note  amounts  to  $135,000.  This note is  payable  on demand and bears
interest at the rate of 10% per annum. Interest expense on the notes amounted to
$20,750 and $35,750  for the six months  ended June 30, 2006 and June 30,  2005,
respectively.

Other demand notes at June 30, 2006 total $312,556 and is associated with a note
payable to Lok Technology which is secured by Entelagent's  accounts  receivable
and bears  interest at 15% per annum.  Interest on this demand note  amounted to
$23,442 for the six months  ended June 30, 2006 and $0 for six months ended June
30, 2005. As described in Note 15, on May 4, 2006, the Company became aware of a
complaint  that  Lok  Technologies,  Inc.  had  filed in the  Superior  Court of
Californian,  County of Santa  Clara on or about  March  30,  2006  against  the
Company, Entelagent Software Corp. and unnamed defendants.

As of June 30,  2006,  $608,500  of the Demand  Notes have been  surrendered  as
payment for Series A-1  Preferred  stock as part of the  creditor  and  claimant
liabilities restructuring (Note 16).


NOTE 10 - BRIDGE NOTES PAYABLE

INTERIM BRIDGE FINANCING I

On February 28, 2005, the Company completed a $3,500,000 financing (the "Interim
Bridge Financing I") through the issuance of 10% Senior  Convertible  Promissory
Notes (the "Bridge I Notes") and warrants to purchase up to 58,348 shares of the
Company's  common stock  ("Bridge I  Warrants").  The warrants  have a term of 5
years and an exercise price of $21.00 per share. The aggregate fair value of the
Bridge I Warrants amounts to $1,487,500.  Prior to final maturity,  the Bridge I
Notes may be  converted  into  securities  that would be  issuable  at the first
closing of a subsequent  financing  by the  Company,  for such number of offered
securities that could be purchased for the principal amount being converted. The
Bridge I Notes  had an  initial  term of 120 days  (due on June 28,  2005)  with
interest at a  contractual  rate of 10% per annum and featured an option for the
Company to extend the term for an additional 60 days to August 27, 2005.

In accordance with APB 14, "Accounting for Convertible Debt and Debt Issued with
Stock Purchase  Warrants," the Company  allocated  $2,456,140 of the proceeds to
the Bridge I Notes and  $1,043,860  of proceeds  to the Bridge I  Warrants.  The
difference  between  the  carrying  amount  of the  Bridge  I  Notes  and  their
contractual redemption amount was accreted as interest expense to June 28, 2005,
their earliest date of redemption.

On June 28, 2005, the Company elected to extend the contractual maturity date of
the Bridge I Notes for an  additional  60 days to August 27, 2005,  which caused
the  contractual  interest rate to increase to 12% per annum.  In addition,  the
Company was  required to issue the 58,348  additional  warrants  (the  "Bridge I
Extension  Warrants") to purchase such number of shares of common stock equal to
1/60 of a share for each $1.00 of  principal  amount  outstanding.  The Bridge I
Extension  Warrants  have a term of 5 years and an exercise  price of $21.00 per
share.

The  Company  did not redeem the  Bridge I Notes on August  27,  2005 and,  as a
result, the notes  automatically  became convertible into 0.128 shares of common
stock for each $1 of principal then  outstanding in accordance with the original
note agreement. Accordingly, the Company recorded a charge of $3,500,000 in 2005
based  upon  the  intrinsic  value of this  conversion  option  measured  at the
original  issuance date of the note in accordance  with EITF 00-27.  The Company
has agreed to file with the SEC, a registration  statement for the resale of the
restricted  shares of the Company's  common stock  issuable upon exercise of the
conversion  option that would be issued in this  transaction,  on a best efforts
basis.


                                       17
<PAGE>


Contractual  interest  expense on the Bridge I Notes  amounted to  $113,883  and
$116,667 for the six months ended June 30, 2006 and 2005,  respectively,  and is
included as a component  of interest  expense in the  accompanying  statement of
operations.

As of June 30, 2006,  $3,155,025 of the Bridge I Notes have been  surrendered as
payment for Series A-1  Preferred  stock as part of the  creditor  and  claimant
liabilities restructuring (Note 16).

INTERIM BRIDGE FINANCING II

On June 6, 2005,  the Company  completed a $2,543,000  financing  (the  "Interim
Bridge  Financing  II")  through  the  issuance  of (i) 10%  Junior  Convertible
Promissory  Notes (the  "Bridge II Notes")  and (ii)  warrants to purchase up to
42,388  shares of common stock (the "Bridge II  Warrants").  The warrants have a
term of 5 years and an exercise  price of $18.00 per share.  The aggregate  fair
value of the Bridge II Warrants  amounts to  $673,895.  Prior to  maturity,  the
Junior Convertible Promissory Notes may be converted into the securities offered
by the Company at the first  closing of a subsequent  financing for the Company,
for such number of offered  securities  as could be purchased  for the principal
amount being converted.

In accordance with APB 14, the Company  allocated  $2,010,277 of the proceeds to
the Bridge II Notes and  $532,723  of proceeds  to the Bridge II  Warrants.  The
difference  between  the  carrying  amount  of the  Bridge  II Notes  and  their
contractual  redemption  amount is being accreted as interest expense to October
3, 2005, their earliest date of redemption.

The  Bridge II Notes  have an  initial  term of 120 days (due on  various  dates
beginning  October 3, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an  additional  60 days to various  dates
beginning  December 2, 2005.  Upon the  extension  of the  maturity  date of the
Bridge II Notes, the contractual  interest rate would increase to 12% per annum,
and the Company  would be required to issue  warrants  (the "Bridge II Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to 1/60th of a share for each $1.00 of principal then outstanding. The Bridge II
Extension  Warrants  issuable upon  extension of the maturity date of the Junior
Convertible  Promissory notes feature a term of 5 years and an exercise price of
$18.00 per share. In addition, if the Bridge II Notes are not paid in full on or
before the  extended  maturity  date,  each note becomes  convertible  into .128
shares  of  the  Company's  common  stock  for  each  $1.00  of  principal  then
outstanding.  The  intrinsic  value of this  conversion  option  measured at the
issuance  date of the notes  amounts to  $2,543,000  and would be  recognized as
interest  expense in accordance with EITF 00-27.  The Company has agreed to file
with the SEC, a registration  statement for the resale of the restricted  shares
of its common stock issuable upon exercise of the  conversion  option that would
be issuable in this transaction, on a best efforts basis.

The Company sold these  securities to seven accredited  investors  introduced by
Laidlaw,  placement  agent in the  Interim  Bridge  Financing  II.  The  Company
incurred  $386,027 of fees in connection with this transaction  including a cash
fee of $305,160  and  $80,867  for the fair value of warrants to purchase  4,243
shares of the Company's common stock at an exercise price of $18.00 per share.

The Company  elected to extend the due dates of these notes by an  additional 60
days to various dates beginning  December 2, 2005. In addition,  the Company was
required to issue Bridge II Extension  Warrants to purchase 42,388 shares of the
Company's  common  stock . The Bridge II  Extension  Warrants  have at term of 5
years and an exercise price of $18.00 per share.

The  Company  did not redeem the Bridge II Notes on  December  2, 2005 and, as a
result, the notes  automatically  became convertible into 0.128 shares of common
stock for each $1 of principal then  outstanding in accordance with the original
note agreement.  Accordingly,  the Company recorded a charge of $2,543,000 based
upon the  intrinsic  value of this  conversion  option  measured at the original
issuance date of the note in accordance with EITF 00-27.  The Company has agreed
to file with the SEC, a registration  statement for the resale of the restricted
shares of the Company's  common stock  issuable upon exercise of the  conversion
option that would be issued in this transaction, on a best efforts basis.


                                       18
<PAGE>


Contractual  interest  expense on the Bridge II Notes  amounted to $111,146  and
$21,192  for the six months  ended June 30, 2006 and 2005,  respectively  and is
included as a component  of interest  expense in the  accompanying  statement of
operations.

As of June 30, 2006,  $2,343,000 of the Bridge II Notes have been surrendered as
payment for Series A-1  Preferred  stock as part of the  creditor  and  claimant
liabilities restructuring (Note 16).

INTERIM BRIDGE FINANCING III

Beginning on July 1, 2005, and continuing through December 31, 2005, the Company
completed,  through 12 separate fundings,  a $5,234,000  financing (the "Interim
Bridge  Financing  III")  through  the  issuance  of (i) 10% Junior  Convertible
Promissory  Notes (the  "Bridge III Notes") and (ii)  warrants to purchase up to
87,235 shares of common stock (the "Bridge III  Warrants").  The warrants have a
term of 5 years and an exercise  price of $18.00 per share.  Prior to  maturity,
the Junior  Convertible  Promissory  Notes may be converted  into the securities
offered by the Company at the first  closing of a subsequent  financing  for the
Company,  for such number of offered  securities  as could be purchased  for the
principal amount being converted.

In accordance with APB 14, the Company  allocated  $4,645,544 of the proceeds to
the Bridge III Notes and  $587,595 of proceeds to the Bridge III  Warrants.  The
difference  between  the  carrying  amount  of the  Bridge  III  Notes and their
contractual  redemption  amount is being accreted as interest expense to various
dates from November 1, 2005, their earliest date of redemption. Accretion of the
aforementioned discount amounted to $20,909 for the three months ended March 31,
2006 and is  included as a component  of  interest  expense in the  accompanying
statement of operations.

The  Bridge III Notes  have an  initial  term of 120 days (due on various  dates
beginning October 28, 2005) with interest at 10% per annum and feature an option
for the Company to extend the term for an  additional  60 days to various  dates
beginning  December 28,  2005.  Upon the  extension of the maturity  date of the
Bridge III Notes, the contractual interest rate would increase to 12% per annum,
and the Company  would be required to issue  warrants (the "Bridge III Extension
Warrants") to purchase such number of shares of the Company's common stock equal
to 1/60th of a share for each $1.00 of principal  then  outstanding.  The Bridge
III  Extension  Warrants  issuable  upon  extension of the maturity  date of the
Junior  Convertible  Promissory  Notes feature a term of 5 years and an exercise
price of $18.00 per share. In addition,  if the Bridge III Notes are not paid in
full on or before the extended maturity date, each note becomes convertible into
0.128 shares of the  Company's  common  stock for each $1.00 of  principal  then
outstanding.  The  intrinsic  value of this  conversion  option  measured at the
issuance  date of the notes  amounts to  $5,234,000  and would be  recognized as
interest  expense in accordance with EITF 00-27.  The Company has agreed to file
with the SEC, a registration  statement for the resale of the restricted  shares
of its common stock issuable upon exercise of the  conversion  option that would
be issuable in this transaction, on a best efforts basis.

Beginning on October 29,  2005,  the Company  elected to extend the  contractual
maturity  date of the  various  Bridge  III Notes for an  additional  60 days to
various dates beginning December 28, 2005, which caused the contractual interest
rate to increase  to 12% per annum.  In  addition,  during the three month ended
March 31, 2006,  the Company was required to issue  39,917  additional  warrants
(the "Bridge III Extension Warrants"). The aggregate fair value of the warrants,
which  amounted to $48,129 was  recorded  as a deferred  financing  cost and was
being  amortized over the 60-day  extension  period or until March 27, 2006 when
the Bridge III Notes were  surrendered  as payment for the Series A-1  Preferred
stock under the creditor and claimant liabilities restructuring.  The Bridge III
Extension  Warrants  have a term of 5 years and an exercise  price of $18.00 per
share.

The Company did not redeem Bridge III Notes on  contractual  maturity dates that
occurred  through  January  12,  2006 (the date of the Series A-1  creditor  and
claimant  liabilities  restructuring).  As a  result,  $3,400,000  of the  Notes
automatically  became  convertible into 0.128 shares of common stock for each $1
of principal then  outstanding in accordance  with the original note  agreement.
This amounts to a total of 70,400  shares during the three months ended of March
31, 2006.  Accordingly,  the Company recorded a charge of $550,000, in the three
months ended March 31, 2006,  based upon the intrinsic  value of this conversion
option  measured at the original  issuance date of the notes in accordance  with
EITF 00-27. With the surrender of the Bridge III Notes in payment for Series A-1
Preferred stock under the creditor and claimant liabilities restructuring, these
conversion options are no longer exercisable and have been cancelled.


                                       19
<PAGE>


As of March 31,  2006,  all of the  Bridge III Notes  have been  surrendered  as
payment for Series A-1  Preferred  stock as part of the  creditor  and  claimant
liabilities restructuring (Note 16).

Contractual interest expense on the Bridge III Notes amounted to $153,036 and $0
for the six months ended June 30, 2006 and 2005,  respectively,  and is included
as a component of interest expense in the accompanying statement of operations.

The Company sold these securities to Apex, Northwestern,  and Advanced Equities.
Funding  for the Bridge III Notes  included  the  conversion  of  $1,650,000  of
stockholder advances made during the period March 30, 2005 to June 30, 2005 into
Bridge III Notes.

2006 BRIDGE NOTES

On January 18, 2006, the Company completed a financing of approximately $540,000
in  additional  gross  funds (the "2006  Bridge  Note  Financing")  through  the
issuance of Subordinated  Convertible Promissory Notes (the "2006 Bridge Notes")
in the amount of  $720,001.  The 2006 Bridge Note  agreement  provided for these
notes to automatically convert into the same securities (consisting of shares of
Series A Preferred Stock and warrants to purchase shares of the Company's common
stock)  offered  by the  Company  in  connection  with its  Series  A  Preferred
Financing (as defined  below).  On March 27, 2006 (the date of the first closing
of the Series A Preferred Financing),  the 2006 Bridge Notes were converted into
7.2 Units in the Series A Preferred  Financing  described  below.  The  $180,000
difference between the gross proceeds received upon the original issuance of the
notes and the redemption  amount was recorded as an original  issuance  discount
that was fully expensed during the six months ended June 30, 2006.

Additionally,  the  Company  paid  Laidlaw & Company  (UK)  Ltd.  (Laidlaw),  as
placement  agent in the  transaction,  a fee of $54,000 in conjunction  with the
2006 Bridge Note  Financing.  This fee was fully  amortized  and  recognized  as
interest expense during the six months ended June 30, 2006.


NOTE 11 - RELATED PARTY TRANSACTIONS

EXPENSE REIMBURSEMENTS DUE TO OFFICERS AND STOCKHOLDERS

Certain  stockholders  and  officers  of the Company  have paid  expenses on the
Company's behalf since its inception,  of which $130,201 remains  outstanding at
June 30, 2006. The amounts payable to such officers and  stockholders are due on
demand.  The balance due under these arrangements is included in the liabilities
that the  Company  has  offered  to  settle  under  the  creditor  and  claimant
liabilities restructuring described in Note 16.

NOTES PAYABLE TO OFFICERS AND STOCKHOLDERS

Notes payable to officers and stockholders  amount to $90,000,  bear interest at
10% per annum and are due on demand. Interest expense on these notes amounted to
$6,475 for the six months ended June 30, 2006. As of June 30, 2006,  $145,712 of
the original notes which  amounted to $235,712 have been  surrendered as payment
for Series A-1 Preferred stock as part of the creditor and claimant  liabilities
restructuring  (Note 16).  Subsequent to June 30, 2006, the remaining $90,000 of
this amount has been surrendered as payment for Series A-1 Preferred stock under
the creditor and claimant liabilities restructuring.

CONSULTING AGREEMENT PAYABLE

On June 8, 2005,  the Company  negotiated  a  settlement  regarding a consulting
agreement  payable with a related party.  The terms of the settlement  agreement
terminated the prior agreement and reduced the remaining  payments due under the
contract  to  $150,000  including  a  $50,000  payment  that was  made  upon the
execution of the agreement and two additional  $50,000 payments including one to
be made upon the completion of a follow-on-financing  by the Company and one not
later than September 30, 2005.  The $150,000  reduction in payments was recorded
as a


                                       20
<PAGE>


reduction of general and  administrative  expense  during the quarter ended June
30, 2005.  Additionally,  the settlement  agreement terminated an obligation for
the Company to issue 3,334  shares of  unrestricted  stock.  The stock  issuable
under this  commitment  was  recorded in 2004 as common  stock issued in lieu of
cash for services in the amount of $78,900. The rescission of the stock issuable
under this arrangement resulted in an additional reduction of $78,900 in general
and administrative expenses during the year ended December, 31, 2005.

The payment due on September 30, 2005 was not made by the Company.  The $100,000
balance due under this  arrangement  has been  surrendered as payment for Series
A-1 Preferred  stock under the creditor and claimant  liabilities  restructuring
described in Note 16.

NOTES PAYABLE (TO CREDITORS OF ACQUIRED BUSINESS)

The notes issued to creditors of Entelagent (in connection  with the acquisition
described  in Note 5) include  $554,202  that is payable to related  parties for
settlements  of accrued  payroll,  notes payable and other  payables that remain
outstanding  at June 30, 2006.  The original  amount of these notes  amounted to
$2,602,913.  Aggregate  interest  expense on these notes amounted to $77,370 and
$51,842  for the six months  ended  June 30,  2006 and 2005,  respectively.  The
balance due under these  notes is included in the  liabilities  that the Company
has offered to settle under the creditor and claimant liabilities  restructuring
described in Note 16.

During the six months ended June 30, 2006,  $1,795,930  of the notes  payable to
creditors  of  acquired  business  was  surrendered  as  payment  for Series A-1
Preferred stock under the creditor and claimant liabilities restructuring.


NOTE 12 - OTHER CURRENT LIABILITIES

Other current liabilities principally consist of $439,769 of accrued payroll and
sales tax  liabilities  and estimated  penalties that the Company assumed in its
acquisition   of   Entelagent   (Note  5).  The  balance   consists  of  various
miscellaneous other current liabilities.


NOTE 13 - DEFERRED REVENUE

Deferred  revenue at June 30, 2006  includes  (1) $128,093 for the fair value of
remaining  service  obligations  on  maintenance  and support  contracts and (2)
$370,687  for  contracts  on which the revenue  recognition  is  deferred  until
contract  deliverables have been completed.  Included in the contracts for which
revenue  recognition  has been deferred is one contract  with contract  value of
$272,610 for which no revenue has been  recognized  and for which the revenue is
expected to be recorded  during 2006. Also included is a down payment of $53,202
received on a contract  in the amount of  $266,009  for which no revenue has yet
been reported and for which revenue is expected to be recognized during 2006 and
2007 and the  non-cancelable  portion  of a $716,965  contract  in the amount of
$89,750 less the revenue already recognized of $44,875.


NOTE 14 - ACCOMMODATION AGREEMENT

In November 2002, the Company entered into a financing  arrangement with a third
party financial institution (the "Lender"),  pursuant to which the Company would
borrow $950,000 under a note to be collateralized by the pledge of 31,667 shares
of registered  stock from five different  stockholders.  In connection with this
arrangement,  the Company  executed a series of  Accommodation  Agreements  with
these stockholders  wherein each stockholder  pledged their shares in return for
the right to receive on or before  November  17,  2003 the return of the pledged
shares,  or replacement  shares in the event of foreclosure,  and one additional
share of common stock for every four shares pledged as compensation. The Company
also  agreed  to use  "best  efforts"  to  register  these  shares  with  the US
Securities and Exchange Commission 12 months from the date of issue.

In December 2002, the Company received  approximately $450,000 of proceeds under
the note and  provided  the  Lender the  pledged  shares.  Since  that date,  no
additional proceeds were provided by the Lender and repeated


                                       21
<PAGE>


attempts were made by the Company to secure the additional proceeds. The Company
has  effectively  accounted  for the  Lender's  failure to fund the facility and
return the pledged shares as a foreclosure on the loan collateral.  Accordingly,
the Company recorded a $1,047,728 loss during the year ended December 31, 2002.

On March  13,  2003,  the  Company  issued  40,000  replacement  shares  with an
aggregate fair value of $3,708,000 to the  stockholders who pledged their shares
under  the  Accommodation  Agreements.  Accordingly,  the  Company  recorded  an
additional  loss of $2,210,272  during the year ended  December 31, 2003 for the
difference  between the loss the Company recorded upon the Lender's  foreclosure
of the collateral and the aggregate fair value of the replacement shares.

In  addition,  the  Accommodation  Agreements  provided for the Company to pay a
penalty  in the  event of its  failure  to cause  the  replacement  shares to be
registered  on or before March 31, 2003.  As a result,  the Company has recorded
stock based  penalties for the fair value of 15,000  shares per quarter  through
December 31, 2005.

The total stock-based  penalties  associated with the  Accommodation  Agreements
from April 2003 to December  31, 2005 were  $3,318,975.  An aggregate of 165,000
shares were issuable through  December 31, 2005 under the stock-based  penalties
associated with the Accommodation Agreements.

On March 27, 2006, the Company  entered into an agreement to release and resolve
all  outstanding  claims  between the parties  under the  creditor  and claimant
liabilities restructuring (Note 16).

STOCK PLEDGE ARRANGEMENT

In April 2004, a stockholder  of the Company  entered into a one-year stock loan
financing  arrangement ("Stock Financing Facility") with a third party financial
institution (the "Lender I"),  pursuant to which such  stockholder  committed to
obtain financing for the Company under a credit facility  collateralized  by the
pledge of 22,834  shares of  registered  stock (the  "Pledged  Stock")  that was
pledged by a second stockholder (the "Pledging Stockholder"). In connection with
this  arrangement,  the Company  executed an  accommodation  agreement  with the
Pledging Stockholder  committing to issue 22,834 shares of restricted stock (the
"Replacement Stock") on April 2, 2005 (the "Termination Date") in the event of a
loss of the Pledged Stock, plus a premium of 6,850 shares (the "Premium Shares")
for entering  into the  agreement.  The Company  also agreed to register  10,000
shares of restricted  stock held by the Pledging  Stockholder (the "Held Stock")
within thirty days of the  agreement  and to use its best efforts  register with
the SEC,  both the  Replacement  Stock and Premium  Stock  within 12 months from
their date of issue.

The  Company  received  $40,012 of funds but was unable to recover  the  Pledged
Stock on the Termination Date. In addition, due to a delay in registering all of
the  shares  under  this  arrangement,  the  Company  entered  into a  secondary
agreement  with  the  Pledging  Stockholder  providing  for:  (1) the  immediate
issuance of the Replacement  Shares and Premium Shares;  (2) registration of the
Replacement Shares,  Premium Shares and Held Shares; (3) the retroactive accrual
of a penalty  from May 2, 2004  through the date the  registration  statement is
filed  payable in such  number of shares  that is equal to 15% of the Held Stock
(prorated  for each  fraction of a year);  and (4) the accrual of an  additional
penalty from April 2, 2005 through the date the registration  statement is filed
equal to 15% of the  Replacement  Stock and  Premium  Stock  (prorated  for each
fraction of a year).

The Company  recorded a charge of $406,205 for the fair value of the Replacement
Stock and Premium Stock (29,684 shares) issued to the Pledging Stockholder under
this arrangement. Such charge, net of $40,012 of advances received, is presented
as a loss on collateralized  financing arrangement in the accompanying statement
of  operations.  The Company also recorded  charges of $5,246 and $62,102 during
the six months ended June 30, 2006 and 2005,  respectively for the fair value of
2,952 and 2,853  shares  issuable  during the six months ended June 30, 2006 and
2005,  respectively  to the Pledging  Stockholder as penalties for the delays in
registering the stock. The charges associated with the penalties are included in
stock  based  penalties  under  accommodation  agreements  in  the  accompanying
statements of operations.


                                       22
<PAGE>


NOTE 15 - COMMITMENTS AND CONTINGENCIES

SEC INVESTIGATION

Pursuant  to  Section  20(a)  of the  Securities  Act and  Section  21(a) of the
Securities Exchange Act, the staff of the SEC (the "Staff"), issued an order (In
the Matter of Patron Systems, Inc. - Order Directing a Private Investigation and
Designating  Officers to Take  Testimony  (C-03739-A,  February 12,  2004)) (the
"Order")  that a  private  investigation  (the "SEC  Investigation")  be made to
determine whether certain actions of, among others, the Company,  certain of its
officers  and  directors  and  others  violated  Section  5(a)  and  5(c) of the
Securities Act and/or Section 10 and Rule 10b-5  promulgated  under the Exchange
Act.  Generally,  the Order  provides,  among  other  things,  that the Staff is
investigating (i) the legality of two (2) separate Registration Statements filed
by the Company on Form S-8,  filed on December 20, 2002 and on April 2, 2003, as
amended on April 9, 2003 (collectively, the "Registration Statements"), covering
the  resale  of, in the  aggregate,  145,834  shares of common  stock  issued to
various  consultants  of the Company,  and (ii) whether in  connection  with the
purchase or sale of shares of common  stock,  certain  officers and directors of
the Company and others (a) sold common  stock in  violation  of Section 5 of the
Securities Act and/or, (b) made misrepresentations  and/or omissions of material
facts and/or  employed  fraudulent  devices in  connection  with such  purchases
and/or sales  relating to certain of the  Company's  press  releases  regarding,
among  other  items,   proposed  mergers  and   acquisitions   that  were  never
consummated.  If the SEC brings an action  against the Company,  it could result
in,  among  other  items,  a  civil  injunctive   order  or  an   administrative
cease-and-desist  order being  entered  against the Company,  in addition to the
imposition of a  significant  civil  penalty.  Moreover,  the SEC  Investigation
and/or a subsequent SEC action could affect  adversely the Company's  ability to
have its common stock become  listed on a stock  exchange  and/or  quoted on the
NASD Bulletin  Board or NASDAQ,  the Company  being able to sell its  securities
and/or  have its  securities  registered  with the SEC and/or in various  states
and/or the Company's ability to implement its business plan. The Company's legal
counsel  representing  the Company in such matters has indicated  that while the
SEC  Investigation  is ongoing and the Company has not  received  correspondence
from the SEC  indicating  that the matter is  officially  closed,  the Staff has
indicated  that it does not intend to request  additional  information  from the
Company and that,  at this time,  it does not intend to  recommend  that the SEC
bring an enforcement action against the Company, its officers and directors.

LEGAL PROCEEDINGS

Sherleigh  Associates Inc. Profit Sharing Plan  ("Sherleigh")  filed a complaint
against the  Company,  Patrick  Allin,  former  Chief  Executive  Officer of the
Company, and Robert E. Yaw, the Company's non-executive Chairman, on February 3,
2004, in the United States District Court for the Southern  District of New York
(the "Court")  alleging common law fraud.  The complaint  alleged that Sherleigh
was fraudulently  induced into purchasing  33,334 shares of Company common stock
in reliance upon certain of the  Company's  press  releases and allegedly  false
statements by Mr. Allin and Mr. Yaw,  concerning the Company's  plans to acquire
two target companies,  TrustWave  Corporation  (currently a strategic partner of
the Company) and  Entelagent  (a current  subsidiary  of the  Company),  and its
financing arrangements regarding those acquisitions. Sherleigh sought rescission
of its  purchase  agreement  and  return  of its  $2,000,000  purchase  price or
compensatory  damages to be proven at trial. Mr. Allin entered into a settlement
agreement  with  Sherleigh  and is  requesting  that the  Court  include  in its
dismissal  order a finding that the  settlement is reasonable  and a prohibition
against any claims by the Company or Mr. Yaw against Mr. Allin for  contribution
or indemnification  with respect to Sherleigh's  claims. The Company has opposed
Mr.  Allin's  request.  The Court has not yet issued  any ruling on Mr.  Allin's
request.  Discovery  has been  completed,  but no trial date has been set by the
Court.  On April 24, 2006, the Company and the Sherleigh  Associates Inc. Profit
Sharing Plan entered into a final and binding  settlement  of all claims as part
of the creditor and claimant liabilities restructuring (Note 16).

On January 5, 2006,  Mark P. Gertz,  Trustee in  bankruptcy  for Arter & Hadden,
LLP,  filed an Adversary  Complaint  for Recovery of Assets of the Estate in the
United  States  Bankruptcy  Court  Northern  District of Ohio Eastern  Division,
against  the  Company as  successor  in merger to  Entelagent.  Mr.  Gertz seeks
$32,278.18 plus interest  accruing at the statutory rate since July 15, 2003 for
services  rendered  by Arter & Hadden,  LLP to  Entelagent.  The Company and Mr.
Gertz have agreed to a settlement  through mediation in the amount of $32,500 in
13  installments  of $2,500.  The Company is awaiting  final  documents from Mr.
Gertz.


                                       23
<PAGE>


On May 4, 2006,  Patron  became  aware that Lok  Technologies,  Inc. had filed a
complaint on or about March 30, 2006 against the  Company,  Entelagent  Software
Corp.  and unnamed  defendants in the Superior  Court of  California,  County of
Santa Clara alleging  breach of contract,  breach of duty of good faith and fair
dealing and unjust enrichment and seeking damages, interest, disgorgement of any
unjust  enrichment,  attorneys fees and cost. Prior to receipt of this notice of
litigation,  the Company  had  recorded a liability  of  $320,000  plus  accrued
interest of $159,432. The Company believes that it has defenses to these claims.
The Company cannot  provide any assurance  that the ultimate  settlement of this
claim will not have a material adverse affect on its financial condition.


NOTE 16 - CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING

On January 12, 2006, the Company issued a Stock Subscription  Agreement & Mutual
Release ("the Original Release") to each creditor and claimant ("Subscriber") of
the Company for purposes of entering  into a final and binding  settlement  with
respect to any and all claims,  liabilities,  demands,  causes of action, costs,
expenses,  attorneys fees, damages,  indemnities,  and obligations of every kind
and  nature  that  the  creditor  and/or  claimant  may have  with  the  Company
("Subscriber Claims").  Under terms of this agreement,  the Company sells to the
Subscriber and the Subscriber purchases from the Company shares ("Stock") of its
Series A-1 Preferred stock at a price of $0.80 per share. The aggregate purchase
price is equivalent to the value of the Subscriber  Claims being settled through
this  settlement  and release.  Subscriber  is deemed to have paid for the Stock
through the settlement and release of Subscriber Claims.  Each share of Stock is
automatically  convertible into 1/3 share of the Company's common stock upon the
effectiveness  of an amendment to the  Company's  certificate  of  incorporation
which provides for a sufficient number of authorized but unissued and unreserved
shares of the Company's  common stock to permit the conversion of all issued and
outstanding  shares of Series A-1  Preferred.  If the requisite  agreements  and
approvals are obtained, the Company anticipates issuing the Series A-1 Preferred
shares  following the final  determination  of the claims and  acceptance by the
Company of each  claimant  submitted  Stock  Subscription  Agreement  and Mutual
Release through countersignature thereof.

The Original  Release also  provided that in the event that (a) a bona fide sale
or (series of related  sales) by the Company of equity  interests in the Company
in  an  amount  equal  to  or  in  excess  of  $3,000,000  or  (b)  any  merger,
consolidation,     recapitalization,      reclassification,     reincorporation,
reorganization,  share exchange,  sale of all or substantially all of the assets
of the Company or comparable transaction,  is not consummated on or before March
31, 2006 (the "Termination  Date"),  the Stock  Subscription  Agreement & Mutual
Release shall terminate and be null and void, the Series A-1 Preferred issued to
Subscriber  shall be cancelled  and the  Subscriber  Claims shall remain in full
force and effect on their terms.  Each Subscriber agrees not to transfer or sell
any portion of the Stock until the next business day after the Termination Date,
subject  to (i) an  effective  registration  under  the  Securities  Act or in a
transaction  which is otherwise in compliance  with the Securities  Act, (ii) an
effective  registration  under any applicable state  securities  statute or in a
transaction otherwise in compliance with any applicable state securities statue,
and (iii) evidence of compliance  with the applicable  securities  laws of other
jurisdictions.

As  described  below under the Private  Placement  Series A Preferred  Stock and
Warrants,  on March 3, 2006 the  investors  in the Series A Preferred  Financing
modified  the  terms of their  financing  arrangement  to  provide  funds to the
Company prior to the 100%  completion  of the creditor and claimant  liabilities
restructuring.  This modification provides for the establishment of a restricted
cash escrow agent and establishes a methodology to disburse funds to the Company
to cover payroll,  rent and other operating costs,  including  eligible payables
not otherwise subject to the creditor and claimant liabilities restructuring, on
a bi-monthly  basis. As described below, the Company  completed the sale of $4.8
million in equity securities under the Series A Preferred Financing on March 27,
2006  thereby  eliminating  the  provision  for  automatic  termination  of this
arrangement.

The Company has committed to file with the Securities  and Exchange  Commission,
as soon as  practicable  and in any  event no later  than 120 days from the date
that the  Company  countersigns  each Stock  Subscription  Agreement  and Mutual
Release, a registration statement ("Registration Statement") covering the resale
of the Stock and cause such  Registration  Statement to become effective as soon
as practicable  thereafter and in any event no later than 180 days from the date
that the  Company  countersigns  each Stock  Subscription  Agreement  and Mutual
Release.  The  Company  shall  keep  the  Registration   Statement  continuously
effective under the Securities Act until the earlier of (i)


                                       24
<PAGE>


the  date  when  all  shares  of  the  Stock  have  been  sold  pursuant  to the
Registration Statement or an exemption from the registration requirements of the
Securities  Act, and (ii) two years from the effective date of the  Registration
Statement.

Through  July  21,  2006,  the  Company  issued  additional  Stock  Subscription
Agreements & Mutual  Releases ("the  Additional  Release") to several  creditors
that had not signed the January 12, 2006 Original Release by April 30, 2006. The
terms of the  Additional  Release  are  predominantly  the same as the  Original
Release  with  the  exception  of  the  120  day   requirement  for  filing  the
Registration Statement.

As of July 21, 2006, creditors representing  $29,592,756 of the Company's claims
outstanding,  which includes amounts settled under the accommodation  agreement,
have  indicated  their  acceptance  of the  Company's  proposal  by signing  and
returning to the Company the Stock  Subscription  Agreement and Mutual  Release.
Additionally,  the Company has settled $382,584 of claims for $12,140. The total
of all claims settled represents 94% of the total Company claims. The Company is
currently  unable  to  provide  assurance  that  the  acceptance  of the  claims
settlement  will  actually  improve  the  Company's  ability to fund the further
development of its business plan or improve its operations.

LOSS (GAIN) ASSOCIATED WITH SETTLEMENT AGREEMENTS

During the six months  ended June 30, 2006 as part of the  creditor and claimant
liabilities  restructuring,  the  Company  settled  a  number  of  disputed  and
unresolved  payables and outstanding  claims.  Included among the claims settled
was a claim associated with  Accommodation  Agreements (Note 14).  Settlement of
this matter resulted in a gain of approximately  $3,022,000 which was offset by,
among others,  settlement losses associated with the Sherleigh Associates Profit
Sharing Plan complaint ($1,850,000), loss on the settlement of Richard Linting's
lawsuit  against  the  Company  ($1,129,000)  and a  loss  associated  with  the
reinstatement and subsequent settlement of the claim associated with the lawsuit
brought by Marie Graul against the Company ($931,377).

During the six months ended June 30, 2005, the Company entered into a settlement
agreement  with Cook  Associates to settle all claims related to a lawsuit filed
by Cook Associates  filed against the Company.  This settlement  resulted in the
Company recognizing a gain on settlement of $389,103.


NOTE 17 - SERIES A AND SERIES A-1 PREFERRED STOCK

On March 1, 2006,  the  Company  filed with the  Delaware  Secretary  of State a
Certificate of Designation of  Preferences,  Rights and  Limitations of Series A
Convertible   Preferred  Stock  and  Series  A-1  Convertible   Preferred  Stock
designating  the rights,  preferences and privileges of 2,160 shares of Series A
Convertible  Preferred  Stock and  50,000,000  shares of Series A-1  Convertible
Preferred Stock.

SERIES A PREFERRED STOCK

The Series A  Preferred  Stock has a stated  value of $5,000  per share,  has no
maturity date,  carries a dividend of 10% per annum, with such dividend accruing
on a cumulative basis. The dividend is payable only (i) at such time as declared
payable  by the  Board  of  Directors  of the  Company  or (ii) in the  event of
liquidation,   as  part  of  the  liquidation  preference  amount  ("Liquidation
Preference  Amount").  Accrued  but unpaid  dividends  on the Series A Preferred
amount to $124,784 at June 30, 2006.

The Series A Preferred is convertible,  at the option of the holder, into shares
of the Company's  common stock  ("Conversion  Shares") at an initial  conversion
price ("Initial  Conversion Price") of $2.40 per share based on the stated value
of the Series A Preferred,  subject to adjustment  for stock splits,  dividends,
recapitalizations,  reclassifications, payments made to Common Stock holders and
other similar  events and for issuances of additional  securities at prices more
favorable  than the conversion  price at the date of such issuance.  The Company
evaluated  the  conversion  option at the  commitment  date of the  financing in
accordance with APB 14 and EITF 00-27 and determined  that conversion  price was
not beneficial.



                                       25
<PAGE>


The Series A Preferred is mandatorily  convertible  into shares of the Company's
common stock at the Initial  Conversion Price, which is subject to adjustment as
described above, on the date that: (i) there shall be an effective  registration
statement covering the resale of the Conversion Shares, (ii) the average closing
price of the Company's common stock, for a period of 20 consecutive trading days
is at least 250% of the then applicable  Conversion Price, and (iii) the average
daily  trading  volume of the  Company's  common stock for the same period is at
least 8,334 shares.

The  potential  adjustment  to the  conversion  price that would  occur upon the
completion of a subsequent  financing  transaction  on terms more favorable than
that of the  Series  A  Preferred  (if  any) is  considered  to be a  contingent
conversion  price in accordance with EITF 00-27.  Accordingly,  such adjustments
would be measured and accounted for at the effective time of such adjustment, if
any.

The Series A Preferred Liquidation Preference Amount is equal to 125% of the sum
of: (i) the stated  value of any then  unconverted  shares of Series A Preferred
and (ii) any accrued and unpaid dividends thereon. An event of liquidation means
any liquidation,  dissolution or winding up of the Company, whether voluntary or
involuntary,  as well as any change of control of the Company which includes the
sale by the  Company  of  either  (x)  substantially  all its  assets or (y) the
portion of its assets which comprises its core business technology,  products or
services.

SERIES A-1 PREFERRED STOCK

The Series A-1  Preferred  Stock has a stated  value of $0.80 per share,  has no
maturity  date,  carries a  non-cumulative  dividend of 5% per annum,  with such
dividend  payable  only (i) at such  time as  declared  payable  by the Board of
Directors  of the  Company or (ii) in the event of  liquidation,  as part of the
liquidation  preference amount ("Series A-1 Liquidation Preference Amount"). The
Series A-1 Liquidation  Preference Amount is equal to the sum of: (i) the stated
value of any then  unconverted  shares  of  Series  A-1  Preferred  and (ii) any
accrued  and  unpaid  dividends  thereon.  An event  of  liquidation  means  any
liquidation,  dissolution  or winding up of the  Company,  whether  voluntary or
involuntary,  as well as any change of control of the Company which includes the
sale by the  Company  of  either  (x)  substantially  all its  assets or (y) the
portion of its assets which comprises its core business technology,  products or
services.

The Series A-1 Preferred is not  convertible  at the option of the holder.  Each
share of Series A-1 Preferred  automatically  converts into the Company's common
stock, at a conversion price of $2.40 per share based on the stated value of the
Series A-1 Preferred,  upon the  effectiveness  of an amendment to the Company's
certificate  of  incorporation   which  provides  for  a  sufficient  number  of
authorized  shares to permit  the  exercise  or  conversion  of all  issued  and
outstanding shares of Series A Preferred,  Series A-1 Preferred and all options,
warrants and other rights to acquire shares of the Company's common stock.

Through June 30, 2006,  the Company has issued  36,388,907  shares of Series A-1
Preferred Stock which are convertible, upon the effectiveness of an amendment to
the Company's Second Amended and Restated Certificate of Incorporation to affect
a 1-for-30  reverse stock split,  into 12,129,674  shares of the Company's newly
split common stock.

PRIVATE PLACEMENT OF SERIES A PREFERRED STOCK AND WARRANTS

In  January  2006,  the  Company  initiated  a  proposed  $5,400,000   financing
transaction (the "Series A Preferred  Financing") which would, for each $100,000
Unit  purchased,  result in the  issuance of (i) 20 shares of Series A Preferred
Stock and (ii) warrants ("Investor Warrants") to purchase 13,888.9 shares of the
Company's common stock.  The minimum amount of the Series A Preferred  Financing
is $3,000,000  ("Minimum  Amount") and the maximum  amount is  $5,400,000.  Apex
agreed to  purchase up to  $1,500,000  which will all be  available  to fund the
Minimum  Amount,  provided  however,  in the event that the  Series A  Preferred
Financing is  over-subscribed  as to the Minimum Amount,  then for each $1.00 of
such over  subscription  up to  $250,000,  the Apex funding  commitment  will be
reduced on a dollar for dollar basis,  down to a minimum  amount of  $1,250,000.
Additionally,  holders of the 2006 Bridge  Notes were  mandatorily  obligated to
exchange  their 2006 Bridge Notes for Units in the Series A Preferred  Financing
upon consummation of the Series A Preferred Financing at the face value of their
2006 Bridge  Notes.  The  issuance of Units to the holders of 2006 Bridge  Notes
counts toward satisfying the Minimum Amount.


                                       26
<PAGE>


The Investor  Warrants have a term of 5 years and an exercise price of $3.00 per
share.  Each  Investor  Warrant  will  entitle  the holder  thereof to  purchase
13,888.9 shares of the Company's common stock (the "Warrant Shares"), subject to
anti-dilution provisions similar to those of the conversion rights of the Series
A Preferred.  The Company is obligated to include the Conversion  Shares and the
Warrant Shares in the Registration  Statement which the Company has committed to
file in  connection  with the creditor and  claimant  liabilities  restructuring
described  above.  The  Conversion  Shares and the Warrant Shares will also have
piggyback registration rights.

In  connection  with the Series A  Preferred  Financing,  the  Company  retained
Laidlaw as its  non-exclusive  placement  agent  ("Series A Preferred  Placement
Agent").  Laidlaw  shall  receive,  in its role as Series A Preferred  Placement
Agent,  (i) a cash fee equal to 10% of all gross  proceeds,  excluding  the Apex
proceeds, delivered at each Closing and (ii) a warrant (the "Agent Warrants") to
purchase  the  Company's  common  stock  equal to 10%  times  the sum of (x) the
Conversion  Shares  to be  issued  upon  conversion  of the  shares  of Series A
Preferred  issued at each Closing and (y) the number of shares of the  Company's
common stock  reserved for issuance  upon the exercise of the Investor  Warrants
issued at each closing.  The Agent  Warrants shall have a term of 5 years and an
exercise  price of $0.10 per  share.  Additionally,  the  Company  shall pay the
Series A  Preferred  Placement  Agent a  non-accountable  expense  allowance  of
$25,000.

On March 3, 2006, the investors in the Series A Preferred  Financing agreed to a
modification of the terms of this financing arrangement to waive the requirement
for 100% completion of the creditor and claimant  liabilities  restructuring for
release of the net  proceeds  of the Series A  Preferred  Financing  in order to
allow the Company to proceed with its business plan and to protect the investors
in the Series A  Preferred  Financing.  The  modifications  provide  for the net
proceeds  of the Series A Preferred  Financing  to be  deposited  with an escrow
agent whereby funds will be released to the Company to cover  payroll,  rent and
other operating costs,  including eligible payables not otherwise subject to the
creditor and claimant liabilities restructuring, on a bi-monthly basis.

As of March 27, 2006, the Company  consummated the Series A Preferred  Financing
with the closing of funds totaling $4,465,501,  resulting in the issuance of 893
shares of Series A Preferred Stock and 620,233 common stock purchase warrants to
the  purchasers  of the Series A Preferred  Stock.  This amount is  comprised on
$720,001  associated with the conversion of the Bridge Notes,  $895,000 provided
by Apex and  $2,850,500  from parties  made  available by the Series A Preferred
Placement Agent.  The Company has also issued to Laidlaw  5,950,837 common stock
purchase warrants, the "Agent Warrants", as Series A Preferred Placement Agent.

On April 3, 2006,  the  Company  consummated  an  additional  Series A Preferred
Financing with the closing of funds totaling $355,000, resulting in the issuance
of 71 shares of  Series A  Preferred  Stock and  49,306  common  stock  purchase
warrants.

The 964 shares of Series A Preferred Stock  outstanding as of April 3, 2006 will
be  convertible,  as  described  above and  following  the  effectiveness  of an
amendment  to  the  Company's   Second  Amended  and  Restated   Certificate  of
Incorporation to affect a 1-for-30 reverse stock split, into 2,008,567 shares of
the Company's newly split common stock. Additionally,  upon the effectiveness of
the 1-for-30 reverse stock split, the 20,085,446  common stock purchase warrants
issued to holders  of the  Series A  Preferred  Stock  will be  exercisable  for
669,539  shares of the  Company's  newly split  common  stock and the  5,950,837
common stock purchase warrants issued to Laidlaw as Series A Preferred Placement
Agent will be exercisable for 198,375 shares of the Company's newly split common
stock.

In order to affect the  availability  of these funds to the Company prior to the
completion of the creditor and claimant liabilities restructuring,  the Company,
on March 27, 2006, entered into a post-closing  restricted cash escrow agreement
("Post-Closing  Escrow Agreement") with an escrow agent ("Escrow Agent").  As of
March 27,  2006,  the  Escrow  Agent was  provided  $2,183,026  in net  offering
proceeds.   The  escrow   agent  is  holding  the  funds  and  making   periodic
disbursements  to the Company on or after the 15th of each calendar month and on
or after the last day of each calendar month. The Company is required to provide
a detailed schedule of the mid-month, month-end and maximum monthly disbursement
amounts to substantiate  its request for a release of any funds.  The Company is
currently unable to provide  assurance that the securing of additional  funding,
the completion of the creditor and claimant  liabilities  restructuring  program
and the  acceptance  by  individual  creditors  of the  claims  settlement  will
actually  improve the Company's  ability to fund the further  development of its
business plan or improve its operations.


                                       27
<PAGE>


NOTE 18 - STOCKHOLDERS' EQUITY

ADDITIONAL SHARES ISSUED UNDER ANTI-DILUTION PROVISION

Effective April 1, 2006, the Company issued 251,175 shares of common stock under
the provisions of an anti-dilution  agreement associated with private placements
of common stock that occurred in March, August and September 2004.

ISSUANCE OF COMMON STOCK PURCHASE WARRANTS

On January 28, 2006 the Company  issued  warrants for 20,000 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $20,316.

On February 13, 2006 the Company  issued  warrants for 6,000 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $6,634.

On February 21, 2006 the Company  issued  warrants for 1,250 shares at an $18.00
per share exercise price to Apex in connection with the Interim Bridge Financing
III financing. The aggregate fair value of these warrants amounted to $1,382.

On March 1, 2006 the Company  issued  warrants for 6,417 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $10,029.

On March 17, 2006 the Company issued  warrants for 3,750 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $5,861.

On March 22, 2006 the Company issued  warrants for 2,500 shares at an $18.00 per
share exercise price to Apex in connection with the Interim Bridge Financing III
financing. The aggregate fair value of these warrants amounted to $3,907.

On March 27, 2006 the Company issued  warrants for 620,233 shares at a $3.00 per
share  exercise  price to the  investors in the Series A Preferred  Financing in
connection  with the Series A  Preferred  Financing.  Additionally,  the Company
issued  198,375  common stock  purchase  warrants at a $3.00 per share  exercise
price to Laidlaw as placement agent in the Series A Preferred Financing.

On April 3, 2006 the Company  issued  warrants for 49,306  shares at a $3.00 per
share exercise price to Apex in connection with their investment in the Series A
Preferred Financing.

ISSUANCE OF EMPLOYEE STOCK OPTIONS

During the six months ended June 30, 2006,  the Company  issued stock options to
employees to purchase  99,575 shares.  These options include a grant to purchase
73,371  shares at $1.65 per share,  with a fair value of  $96,850,  to the Chief
Operating Officer of the Company,  Mr. Braden Waverley,  upon the signing of his
employment agreement with the Company. Additionally, the Company granted options
to purchase 26,204 shares at $1.65 per share,  with a fair value of $34,589,  to
Mr. Martin T. Johnson,  the Company's Chief Financial Officer,  upon the signing
of his employment agreement with the Company.


                                       28
<PAGE>


The fair  value of the  unvested  portion of stock  options at June 30,  2006 is
$706,601 with a weighted-average remaining vesting period of 3.3 years.

SHARE-BASED COMPENSATION ARRANGEMENTS

The Company,  since its  inception  has granted  non-qualified  stock options to
various employees and non-employees at the discretion of the Board of Directors.
Substantially all options granted to date have exercise prices equal to the fair
value of underlying  stock at the date of grant and terms of ten years.  Vesting
periods range from fully vested at the date of grant to four years.

As described  in Note 4, the fair value of all awards was  estimated at the date
of grant using the Black-Scholes  option pricing model.  Assumptions relating to
the  estimated  fair value of stock  options that the Company  granted  prior to
January 1, 2006 that were accounted for and recorded  under the intrinsic  value
method prescribed under APB 25 are also described in Note 4.

On February 16, 2006, the Company issued an aggregate of 99,575 stock options to
two newly hired  executives  upon signing  their  employment  agreements.  These
options  are  exercisable  at $1.65 per share and have a term of ten years.  The
aggregate fair value of these options amounts to $131,439.  Assumptions relating
to the  estimated  fair  value of these  stock  options,  which the  Company  is
accounting for in accordance with SFAS 123(R) are as follows: risk-free interest
rate of 4.45%;  expected  dividend yield zero percent;  expected  option life of
four years; and current volatility of 125%.

The risk-free  rate is based on the U.S.  Treasury  yield curve in effect at the
time of grant. The Company has not paid dividends to date and does not expect to
pay  dividends  in the  foreseeable  future due to its  substantial  accumulated
deficit and limited capital  resources.  Accordingly,  expected dividends yields
are currently zero.  Historical  cancellations  and forfeitures of stock options
granted  through  December  31,  2004  have  been  insignificant.  However,  the
Company's operations and the nature of its business changed substantially during
2005 with the  acquisition  of  businesses  and the  recruitment  of a new Chief
Operating Officer in 2006.  Accordingly,  the Company considers more recent data
relating to employee turnover rates to be indicative of future vesting. Based on
available  data, the Company has assumed that  approximately  84% of outstanding
options will vest annually.  Deferred  compensation  relating to options granted
through  December  31, 2005 has been  adjusted to reflect  this  assumption.  No
options have been  exercised to date.  The Company  will  prospectively  monitor
employee  terminations,  exercises  and other  factors  that  could  affect  its
expectations  relating to the vesting of options in future periods.  The Company
will adjust its assumptions  relating to its  expectations of future vesting and
the terms of options at such times that  additional  data indicates that changes
in these assumptions are necessary.  Expected volatility is principally based on
the historical volatility of the Company's stock.

A summary  of option  activity  for the six  months  ended  June 30,  2006 is as
follows:

---------------------------------- ------------- ------------- --------------
                                                                 WEIGHTED-
                                                   WEIGHTED-      AVERAGE
                                                   AVERAGE       REMAINING
                                                   EXERCISE     CONTRACTUAL
             OPTIONS                  SHARES        PRICE          TERM
---------------------------------- ------------- ------------- --------------
Outstanding at January 1, 2006          428,022     $21.09       7.2 years
---------------------------------- ------------- ------------- --------------
Granted                                  99,575     $ 1.65       9.6 years
---------------------------------- ------------- ------------- --------------
Exercised                                  --         --             --
---------------------------------- ------------- ------------- --------------
Forfeited or expired                    (59,506)    $10.20       9.1 years
---------------------------------- ------------- ------------- --------------
Outstanding at June 30, 2006            468,091     $18.34       7.5 years
---------------------------------- ------------- ------------- --------------
Exercisable at June 30, 2006            319,886     $22.54       6.2 years
---------------------------------- ------------- ------------- --------------

At June 30, 2006,  the  aggregate  intrinsic  value of options  outstanding  and
options exercisable,  based on the June 30, 2006 split adjusted closing price of
the  Company  common  stock ($.90 per share)  amounted  to $40,000 and  $24,000,
respectively.   In  addition  the  table  includes   156,670  fully  vested  and
non-forfeitable  stock  options  outstanding  that it  issued  to  non-employees
through  December 31, 2005.  As of June 30, 2006,  these options have a weighted
average


                                       29
<PAGE>


exercise price of $17.39,  weighted average  remaining  contractual term of 6.65
years and an aggregate  intrinsic  value  $5,731,105.  The Company did not enter
into any stock based compensation arrangements with non-employees during the six
months ended June 30, 2006.  Stock based  compensation  expense to non-employees
amounted  to  $952,875  during the six months  ended  June 30,  2005,  including
$472,500  relating to stock options and $480,375 relating to issuances of common
stock for  services.  All  non-employee  stock  based  compensation  awards were
accounted for in accordance with the provisions of EITF 96-18.

A summary of the status of the Company's  non-vested shares as of June 30, 2006,
and changes during the six months ended June 30, 2006 is presented below:

--------------------------------- ----------------- -------------------------
                                                        WEIGHTED-AVERAGE
       NON-VESTED SHARES               SHARES        GRANT DATE FAIR VALUE
--------------------------------- ----------------- -------------------------
Non-vested at January 1, 2006         149,680                $8.12
--------------------------------- ----------------- -------------------------
Granted                                99,575                $1.32
--------------------------------- ----------------- -------------------------
Vested                                (41,546)               $3.80
--------------------------------- ----------------- -------------------------
Forfeited                             (59,506)               $8.10
--------------------------------- ----------------- -------------------------
Non-vested at June 30, 2006           148,203                $4.42
--------------------------------- ----------------- -------------------------

The  weighted-average  grant-date  fair value of options  granted during the six
months  ended June 30,  2006  amounted  to $1.32 per share.  The Company did not
grant any stock  options to  employees  or  non-employees  during the six months
ended June 30, 2005.  There have also not been any exercises of stock options to
date.

As of June 30, 2006,  there was  $1,108,922 of  unrecognized  compensation  cost
related to non-vested share-based compensation arrangements including $1,014,724
for the fair value of stock options that the Company  accounted for under APB 25
through  December 31, 2005 and $94,198 for option  granted during the six months
ended June 30, 2006 that that the Company is accounting  for in accordance  with
SFAS 123(R).  These costs are expected to be recognized over a  weighted-average
period of 3.3 years.

The total fair value of options vested during the six months ended June 30, 2006
amounted to $157,746.  The Company did not modify any stock  options  granted to
employees or non employees under share based payment arrangements.  In addition,
the  Company  did  not   capitalize  the  cost   associated   with  stock  based
compensation.


NOTE 19 - DISCONTINUED OPERATIONS/ SALE OF LUCIDLINE

During the three months ended March 31,  2006,  the Company  undertook a plan to
streamline  its  business.  As a result,  the  Company  redirected  its focus on
providing  enterprise  level  software  and service  solutions  and is no longer
providing internet access,  backup and retrieval  services through LucidLine,  a
former wholly-owned subsidiary acquired in 2005.

On April 18, 2006,  the Company  entered into a Stock  Purchase  Agreement  with
Walnut Valley, Inc. pursuant to which the Company sold, effective April 1, 2006,
all of the  outstanding  shares of LucidLine,  Inc. to Walnut  Valley,  Inc. for
$50,000  including  $25,000  in cash and a $25,000  Promissory  Note The loss on
discontinued operations for the six months ended June 30, 2006 and June 30, 2005
amounted to $104,962  and  $850,874,  respectively.  During the six months ended
June 30,  2006,  the  Company  recorded a $75,920  loss on the  disposal  of its
investment in LucidLine.


NOTE 20 - SUBSEQUENT EVENTS

RATIFICATION OF AGREEMENT WITH STUBBS, ALDERTON & MARKILES, LLP

On July 12,  2006,  the Board of  Directors  ratified,  approved and adopted the
indemnification and escrow agreements that the Company has entered into with its
legal counsel,  Stubbs,  Alderton & Markiles,  LLP.  Accordingly,  cash that was
previously held in escrow for general working  capital  purposes,  including the
repayment of outstanding obligations,  under the Company's merger agreement with
Entelagent and the Series A Preferred Stock Financing documents was used to fund
general operating activities.


                                       30
<PAGE>


STOCK OPTION GRANT

On July  12,  2006,  the  Board  of  Directors  approved  the  grant  of  40,339
non-qualified  stock  options  to 11  individuals.  The  strike  price for these
options was $1.35,  the closing price for the Company's common stock on the date
of grant, July 12, 2006.

ANNUAL MEETING OF STOCKHOLDERS

On July 20,  2006,  the Company  held its annual  meeting of  stockholders.  The
stockholders approved the election of three directors: Mr. Robert Cross to serve
until the annual meeting of  stockholders  in 2007; Mr. Braden Waverley to serve
until the annual meeting of  stockholders  in 2008; and Mr. George  Middlemas to
serve  until the  annual  meeting of  stockholders  in 2009.  Additionally,  the
stockholders  approved the three other  proposals made as part of the 2006 proxy
statement  including  the  adoption  of the  Patron  Systems,  Inc.  2006  Stock
Incentive  Plan which  provides for the grant of up to 5.6 million stock options
and the approval of an amendment to the Second Amended and Restated  Certificate
of Incorporation,  as amended,  to provide for a 1-for-30 reverse stock split of
the Company's issued and outstanding common stock.

COMPLETION OF THE CREDITOR AND CLAIMANT LIABILITIES RESTRUCTURING PROGRAM

On July 21,  2006,  the Board of  Directors  authorized  the  completion  of the
Creditor and Claimant  Liabilities  Restructuring  program.  Under this program,
claims totaling  $29,592,756  have been settled for 36,990,946  shares of Series
A-1  Preferred  Stock.  Additionally,  the Company has settled  claims  totaling
$382,584  for $12,140.  The total of all claims  settled  represents  94% of the
eligible claims.


                                       31
<PAGE>


ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS


                      PATRON SYSTEMS, INC. AND SUBSIDIARIES

           MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                            AND RESULTS OF OPERATIONS
                                  JUNE 30, 2006

The following  discussion and analysis  should be read in  conjunction  with the
Annual Report on Form 10-KSB,  including the consolidated  financial statements,
and the related notes  thereto,  for the year ended  December 31, 2005 of Patron
Systems,  Inc.  and  subsidiaries  (collectively  referred to as  "Patron,"  the
"Company," "we," "us," or "our").  Except for historical  information  contained
herein, the matters discussed below are forward-looking statements made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995.  Such  statements  involve  risks and  uncertainties,  including,  but not
limited to, economic,  governmental,  political,  competitive and  technological
factors affecting our operations,  markets,  products,  prices and other factors
discussed  elsewhere  in this  report  and  other  reports  filed by us with the
Securities and Exchange Commission  ("SEC").  These factors may cause results to
differ  materially  from the statements made in this report or otherwise made by
or on our behalf.

OVERVIEW

On February 25, 2005,  we  consummated  the  acquisitions  of Complete  Security
Solutions,  Inc.  ("CSSI") and  LucidLine,  Inc.  ("LucidLine")  pursuant to the
filings of Agreements  and Plans of Merger with the  Secretaries of State of the
States of  Delaware  and  Illinois,  respectively.  On  February  28,  2005,  we
consummated a private placement with accredited  investors in the amount of $3.5
million.  On March 30,  2005,  we  consummated  the  acquisition  of  Entelagent
Software Corp. ("Entelagent") pursuant to the filing of an Agreement and Plan of
Merger with the  Secretary of State of the State of  California.  From March 31,
2005 to December 31,  2005,  we borrowed  $3,300,000  from a  stockholder,  Apex
Investment  Fund V, LP.  During the three  months  ended  September  30, 2005 we
raised  approximately  $3,600,000  in  additional  gross  funds in five  capital
financing  transactions,  which includes converting  $1,650,000 in advances from
stockholders  into Bridge  Notes.  Net  proceeds  from all of these  transaction
amounted to $3,594,000, which were used principally to fund operations and repay
certain  liabilities.  We discuss these  transactions  in further detail in this
report. During the six months ended June 30, 2006, we raised $4,640,501 of gross
proceeds  ($4,301,450  net  proceeds  after the  payment of certain  transaction
expenses) in the Series A Preferred  Stock  Financing.  The  proceeds  from this
transaction were used to fund operations.

Our strategic  mission is to solve a set of  enterprise-level  customer problems
associated with electronic  message  management,  whether in the form of e-mail,
eforms or instant messaging. Our software and services solutions are designed to
help our  customers  create,  manage and apply  complex  rule sets that  support
business policies,  enhance work flow processes,  enforce regulatory compliance,
and reduce the time,  cost and  overhead  of  message  management.  Our suite of
products  addresses  e-mail  policy  management,   e-mail  retention   policies,
archiving and eDiscovery,  proactive e-mail  supervision,  and the protection of
messages  and their  attachments  in motion  and at rest.  Our  eforms  solution
enables customers to quickly and easily create forms, capture, share, and manage
data in an industry standard format.

We currently offer software solutions that fit into overall corporate compliance
and data protection initiatives by automatically finding, archiving and applying
persistent  protection  to sensitive  data - beyond  authentication  - whenever,
wherever and however sensitive data is shared, accessed and stored. Additionally
we offer software solutions that support real-time secure  collection,  delivery
and  sharing  of  field-based  report  information.  This  software  allows  law
enforcement  and  public-safety  agencies  to have  real-time  access  to  field
reporting  data  for  use  inside  a  department  or  in a  multi-jurisdictional
information sharing system.


                                       32
<PAGE>


CRITICAL ACCOUNTING POLICIES

The  preparation of financial  statements and related  disclosures in conformity
with  accounting  principles  generally  accepted in the United States  requires
management to make estimates and assumptions that affect the amounts reported in
the  Condensed   Consolidated   Financial  Statements  and  Notes  thereto.  Our
application  of accounting  policies  affects these  estimates and  assumptions.
Actual results could differ from these estimates under different  assumptions or
conditions.

REVENUE RECOGNITION

We derive revenues from the following  sources:  (1) sales of computer software,
which includes new software  licenses and software  updates and product  support
revenues and (2) services, which include internet access, back-up, retrieval and
restoration services and professional consulting services.

We apply the revenue  recognition  principles set forth under AICPA Statement of
Position ("SOP") 97-2 "Software Revenue Recognition" and Securities and Exchange
Commission Staff  Accounting  Bulletin  ("SAB") 104 "Revenue  Recognition"  with
respect  to all  of  our  revenue.  Accordingly,  we  record  revenue  when  (i)
persuasive evidence of an arrangement exists, (ii) delivery has occurred,  (iii)
the vendor's fee is fixed or determinable, and (iv) collectability is probable.

We generate  revenues  through  sales of software  licenses  and annual  support
subscription  agreements which include access to technical  support and software
updates (if and when  available).  Software  license revenues are generated from
licensing the rights to use our products directly to end-users and through third
party service providers.

Revenues from software license agreements are generally recognized upon delivery
of  software to the  customer.  All of our  software  sales are  supported  by a
written  contract  or other  evidence  of sale  transaction  such as a  customer
purchase order.  These forms of evidence  clearly  indicate the selling price to
the  customer,  shipping  terms,  payment  terms  (generally 30 days) and refund
policy,  if any. The selling  prices of these products are fixed at the time the
sale is consummated.

Revenue from post contract customer support arrangements or undelivered elements
are deferred and  recognized at the time of delivery or over the period in which
the services are performed based on vendor specific  objective  evidence of fair
value for such  undelivered  elements.  Vendor  specific  objective  evidence is
typically  based on the price charged when an element is sold  separately or, if
an element is not sold  separately,  on the price  established  by an authorized
level of management,  if it is probable that the price, once  established,  will
not change before market introduction.  We use the residual method prescribed in
SOP 98-9 "Modification of SOP 97-2, Software Revenue Recognition With Respect to
Certain  Transactions"  to allocate  revenues to delivered  elements once it has
established vendor-specific evidence for such undelivered elements.

We provide internet access and back-up, retrieval and restoration services under
contractual  arrangements  with  terms  ranging  from 1 year to 5  years.  These
contracts are billed  monthly,  in advance,  based on the  contractually  stated
rates.  At the inception of a contract,  we may activate the customer's  account
for a  contractual  fee  that it  amortizes  over the  term of the  contract  in
accordance  with  Emerging  Issues  Task Force  Issue  ("EITF")  00-21  "Revenue
Arrangements   with   Multiple   Deliverables."   Our  standard   contracts  are
automatically  renewable by the customer  unless  terminated  on 30 days written
notice.  Early  termination  of  the  contract  generally  results  in an  early
termination  fee equal to the lesser of six  months of service or the  remaining
term of the contract.

Professional  consulting  services  are  billed  based on the number of hours of
consultant  services provided and the hourly billing rates. We recognize revenue
under these arrangements as the service is performed.

Revenue from the resale of third-party  hardware and software is recognized upon
delivery  provided  there are no  further  obligations  to install or modify the
hardware or software. Revenue from the sales of hardware/software is recorded at
the gross amount of the sale when the contract  satisfies  the  requirements  of
EITF 99-19 "Reporting Revenue Gross as a Principal versus Net as Agent."


                                       33
<PAGE>


BUSINESS COMBINATIONS

In accordance  with business  combination  accounting,  we allocate the purchase
price of acquired  companies  to the tangible and  intangible  assets  acquired,
liabilities  assumed,  as well as in-process  research and development  based on
their  estimated  fair values.  We have engaged a third-party  appraisal firm to
assist  management in determining the fair values of certain assets acquired and
liabilities  assumed.  Such a valuation requires  management to make significant
estimates and assumptions, especially with respect to intangible assets.

Management makes estimates of fair value based upon  assumptions  believed to be
reasonable.  These estimates are based on historical  experience and information
obtained from the management of the acquired  companies.  Critical  estimates in
valuing certain of the intangible  assets include but are not limited to: future
expected  cash  flows  from  license  sales,  maintenance  agreements,  customer
contracts and acquired  developed  technologies;  expected  costs to develop the
in-process  research and development  into  commercially  viable  products;  the
acquired  company's brand awareness and market position,  as well as assumptions
about the  period of time the  acquired  brand will  continue  to be used in the
combined  company's product  portfolio;  and discount rates. These estimates are
inherently  uncertain  and  unpredictable.  Assumptions  may  be  incomplete  or
inaccurate,  and  unanticipated  events and  circumstances  may occur  which may
affect  the  accuracy  or  validity  of such  assumptions,  estimates  or actual
results.

GOODWILL AND INTANGIBLE ASSETS

We account for Goodwill and  Intangible  Assets in accordance  with Statement of
Financial  Accounting  Standards ("SFAS") No. 141,  "Business  Combinations" and
SFAS No.  142,  "Goodwill  and Other  Intangible  Assets."  Under SFAS No.  142,
goodwill and intangibles  that are deemed to have indefinite lives are no longer
amortized but,  instead,  are to be reviewed at least  annually for  impairment.
Application of the goodwill  impairment  test requires  judgment,  including the
identification of reporting units, assigning assets and liabilities to reporting
units,  assigning  goodwill to reporting  units, and determining the fair value.
Significant  judgments  required to estimate the fair value of  reporting  units
include estimating future cash flows, determining appropriate discount rates and
other  assumptions.  Changes in these estimates and assumptions could materially
affect the  determination  of fair value  and/or  goodwill  impairment  for each
reporting  unit.  We have  recorded  goodwill in  connection  with the Company's
acquisitions described in Note 5 amounting to $22,440,412.  The Company's annual
impairment  review of  goodwill  identified  that  goodwill  impairment  charges
totaling  $12,929,696  were necessary for the year ended December 31, 2005 (Note
5).  Intangible  assets  continue to be amortized  over their  estimated  useful
lives.

LONG LIVED ASSETS

The Company periodically reviews the carrying values of its long lived assets in
accordance  with SFAS 144,  "Long  Lived  Assets"  when  events  or  changes  in
circumstances would indicate that it is more likely than not that their carrying
values may exceed their  realizable  value and records  impairment  charges when
necessary.  The Company  determined that an impairment  charge of $1,705,455 was
necessary for the year ended December 31, 2005 (Note 8).

INCOME TAXES

We account for income  taxes  pursuant to SFAS No.  109,  Accounting  for Income
Taxes. Deferred taxes arise from temporary  differences,  primarily attributable
to the use of the cash  method  for tax  purposes  and  accrual  method for book
purposes  and net  operating  loss  carry-forwards.  The  Company  reserves  for
deferred tax assets when more likely than not, the benefit of the asset will not
be realized in the future.

NET LOSS PER SHARE

Basic  net loss  per  common  share  is  computed  by  dividing  net loss by the
weighted-average  number of common shares outstanding during the period. Diluted
net loss per common share also  includes  common stock  equivalents  outstanding
during  the  period if  dilutive.  Diluted  net loss per  common  share has been
computed by dividing net loss by the  weighted-average  number of common  shares
outstanding  without an assumed increase in common shares outstanding for common
stock equivalents; as such common stock equivalents are anti-dilutive.


                                       34
<PAGE>


USE OF ESTIMATES IN PREPARING FINANCIAL STATEMENTS

In preparing  financial  statements in  conformity  with  accounting  principles
generally  accepted in the United  States of America,  management is required to
make estimates and  assumptions  that affect the reported  amounts of assets and
liabilities and the disclosure of contingent  assets and liabilities at the date
of the  financial  statements  and revenue  and  expenses  during the  reporting
period. Actual results could differ from those estimates.

STOCK BASED COMPENSATION

Prior to January 1, 2006, the Company accounted for employee stock  transactions
in  accordance  with  Accounting   Principles   Board  ("APB")  Opinion  No.  25
"Accounting for Stock Issued to Employees." The Company has adopted the proforma
disclosure   requirements   of  SFAS  No.  123   "Accounting   for   Stock-Based
Compensation."

Effective  January 1, 2006,  the Company  adopted  SFAS No.  123R  "Share  Based
Payment". This statement is a revision of SFAS Statement No. 123, and supersedes
APB Opinion No. 25, and its related implementation guidance. SFAS 123R addresses
all forms of share based payment  ("SBP") awards  including  shares issued under
employee  stock  purchase  plans,  stock  options  restricted  stock  and  stock
appreciation  rights.  Under SFAS 123R, SBP awards result in a cost that will be
measured at fair value on the awards' grant date,  based on the estimated number
of awards that are expected to vest that will result in a charge to operations.

NON-EMPLOYEE STOCK BASED COMPENSATION

We record the cost of stock  based  compensation  awards  that we have issued to
non-employees  for services at either the fair value of the services rendered or
the instruments issued in exchange for such services,  whichever is more readily
determinable,  using the  measurement  date  guidelines  enumerated  in Emerging
Issues Task Force ("EITF") Issue 96-18,  "Accounting for Equity Instruments That
Are  Issued to Other  Than  Employees  for  Acquiring,  or in  Conjunction  with
Selling, Goods or Services."


                              RESULTS OF OPERATIONS

THREE  MONTHS  ENDED JUNE 30, 2006  COMPARED TO THE THREE  MONTHS ENDED JUNE 30,
2005.

For the three months ended June 30, 2006, our consolidated  revenues amounted to
$318,960  compared  to $84,413 for the three  months  ended June 30,  2005.  The
increase is principally the result of growth of our business,  principally  with
the FormStream  product,  since the  combinations  were consummated with CSSI in
February 2005 and Entelagent in March 2005.

Cost of Sales for the three  months  ended  June 30,  2006  amounted  to $27,522
compared to $128,501 for the three  months  ended June 30,  2005.  Cost of sales
during  the three  months  ended  June 30,  2006 and June 30,  2005 is  entirely
associated with the  amortization of developed  technology that we acquired from
CSSI and Entelagent.

Operating  expenses  amounted to $1,625,104  for the three months ended June 30,
2006 as compared to  $2,534,373  for the three  months  ended June 30,  2005,  a
reduction  of  $909,269.   The   reduction   in  operating   expenses   includes
approximately $159,000 for increased salaries associated with an increase in the
number of employees from acquired businesses,  approximately $64,000 of employee
stock option  compensation  expense,  an increase of  approximately  $263,000 in
general and  administrative  expense,  approximately  $17,000 reduction in gains
associated with the settlement of outstanding  litigation under the creditor and
claimant  liabilities  restructuring  and  other  settlement  agreements  and an
increase of approximately  $2,000 associated with a stock-based  penalty under a
collateralized  financing  arrangement.   These  increases  were  offset  by  an
approximately  $444,000 reduction in expense associated with the amortization of
stock-based compensation arrangements, approximately $284,000 reduction in legal
and  professional  fees  associated with the work performed in 2005 to bring the
Company's  SEC filings into  compliance  and expenses  associated  with the 2005
acquisitions,  an expense reduction of $366,000 associated with a 2005 loss on a
collateralized financing arrangement, a $320,000 reduction in expense associated
with 2005 penalties under stock-based accommodation agreements and approximately
$348,000  reduction  in  expense  associated  with  a  penalty  provision  of an
Accommodation Agreement.


                                       35
<PAGE>


Our  consolidated  loss from operations for the three months ended June 30, 2006
amounted to $1,333,666  compared to a loss of $2,578,461  for the same period in
2005. Our loss was reduced as a result of the  reductions in operating  expenses
and the increased revenues discussed above.

Interest expense during the three months ended June 30, 2006 amounted to $88,421
as  compared  to  $1,701,547  for the three  months  ended  June 30,  2005.  The
reduction is principally related to the issuance, in the three months ended June
30, 2005,  of the Bridge II Notes and the  associated  amortization  of deferred
financing costs and the accretion of debt discounts incurred with that financing
not being  incurred in the three months ended June 30, 2006.  Additionally,  the
interest  expense  associated  with the  outstanding  Acquisition  Notes and the
Bridge I Notes in the three  months  ended June 30,  2005 was  reduced  with the
exchange of a substantial  portion of these notes for Series A-1 Preferred Stock
as of March 31, 2006. Non-cash interest relating to the amortization of deferred
financing  costs and the  accretion  of debt  discounts  during the three months
ended June 30, 2006 amounted to  approximately $0 compared to $1,473,140 in same
period  in 2005.  Amortization  of  deferred  finance  charges  which  have been
classified  as interest  expense was $0 in the three  months ended June 30, 2006
compared to $557,065 in the same  period in 2005.  Accretion  of debt  discounts
during the three  months ended June 30, 2006 were  approximately  $0 compared to
$916,075 in the same period in 2005.  Interest income,  was $1,961 and $0 in the
three  months  ended  June 30,  2006 and  2005,  respectively.  Interest  income
represents the interest earned on cash balances.

During the three months ended June 30, 2006,  the Company  accrued  dividends on
its Series A Preferred of $124,784.

For the three  months  ended June 30,  2006,  the net loss  available  to common
stockholders  was $1,621,017 or $(0.75) per share on 2,170,653  weighted average
common  shares   outstanding   compared  to  a  net  loss  available  to  common
stockholders  of $5,028,505 or $(2.47) per share on 2,032,823  weighted  average
common shares outstanding for the three months ended June 30, 2005.

SIX MONTHS ENDED JUNE 30, 2006 COMPARED TO THE SIX MONTHS ENDED JUNE 30, 2005.

For the six months ended June 30, 2006, our  consolidated  revenues  amounted to
$580,745  compared  to $90,843  for the six  months  ended  June 30,  2005.  The
increase is principally the result of growth of our business,  principally  with
the FormStream  product,  since the  combinations  were consummated with CSSI in
February 2005 and Entelagent in March 2005.

Cost of Sales  for the six  months  ended  June 30,  2006  amounted  to  $84,941
compared  to  $149,734  for the six months  ended June 30,  2005.  Cost of sales
during the six months ended June 30, 2006 and June 30, 2005 includes $27,522 and
$19,230, respectively,  associated with the amortization of developed technology
that we acquired from CSSI and Entelagent.

Operating expenses amounted to $4,509,130 for the six months ended June 30, 2006
as compared to $4,145,250 for the six months ended June 30, 2005, an increase of
$363,880. The increase in operating expenses includes  approximately  $1,134,000
for  salaries  associated  with an  increase  in the  number of  employees  from
acquired   businesses,   approximately   $237,000  of  employee   stock   option
compensation   expense,   approximately   $233,000  for   increased   legal  and
professional  fees that we incurred  principally in connection with the year-end
financial  audit,  the negotiation and settlement of various legal matters under
the   creditor   and  claimant   liabilities   restructuring   program  and  the
implementation of the Series A Preferred Stock private placement,  approximately
$23,000 for amortization of acquired intangible assets,  approximately  $876,000
in charges  associated with the settlement of outstanding  litigation  under the
creditor  and  claimant  liabilities   restructuring  and  approximately  $5,000
associated  with  a  stock-based   penalty  under  a  collateralized   financing
arrangement.  These increases were partially offset by an approximately $953,000
reduction  in  expense   associated   with  the   amortization   of  stock-based
compensation arrangements,  a reduction of approximately $136,000 in general and
administrative  expense, an expense reduction of $366,000 associated with a 2005
loss  on a  collateralized  financing  arrangement  and  approximately  $689,000
reduction in expense  associated  with a penalty  provision of an  Accommodation
Agreement.


                                       36
<PAGE>


Our  consolidated  loss from  operations  for the six months ended June 30, 2006
amounted to $4,013,326  compared to a loss of $4,204,141  for the same period in
2005.  Our loss  increased as a result of the  increases  in operating  expenses
discussed above.

Interest  expense  during  the six  months  ended  June  30,  2006  amounted  to
$1,703,935 as compared to $2,196,535 for the six months ended June 30, 2005. The
reduction is due to the issuance of Series A Preferred  stock and its associated
amortization of deferred financing costs and the accretion of debt discounts and
the intrinsic value of the conversion option for bridge note holders being lower
in total  during the six months  ended June 30,  2006 than the  amortization  of
deferred financing costs and the accretion of debt discounts incurred during the
six months ended June 30, 2005.  Offsetting  this  reduction was the increase in
interest  expense due to the increased level of total debt financing  during the
six months  ended June 30, 2006 than  during the same  period in 2005.  Non-cash
interest  relating  to the  amortization  of  deferred  financing  costs and the
accretion of debt  discounts  during the six months ended June 30, 2006 amounted
to  approximately  $303,038  compared to $1,887,625 in same period in 2005.  The
intrinsic value of the conversion option for bridge note holders, which has been
classified  as interest  expense  amounted to $550,000  for the six months ended
June 30,  2006  compared  to $0 in the same  period  in  2005.  Amortization  of
deferred  finance  charges which have been  classified  as interest  expense was
approximately  $282,129  in the six  months  ended  June 30,  2006  compared  to
$710,585 in the same period in 2005.  Accretion of debt discounts during the six
months ended June 30, 2006 were approximately  $20,909 compared to $1,177,040 in
the same  period in 2005.  Interest  income,  was $1,961 and  $19,250 in the six
months ended June 30, 2006 and 2005,  respectively.  Interest income  represents
the  interest  earned  from  loans  that  we  made to  Entelagent  prior  to our
acquisition  of that business on March 30, 2005 and interest on cash balances in
the six months ended June 30, 2006.

During the six months ended June 30, 2006, the Company accrued  dividends on its
Series A Preferred of $124,784.

For the six  months  ended  June 30,  2006,  the net loss  available  to  common
stockholders  was $6,021,091 or $(2.83) per share on 2,127,543  weighted average
common  shares   outstanding   compared  to  a  net  loss  available  to  common
stockholders  of $7,232,300 or $(3.93) per share on 1,838,106  weighted  average
common shares outstanding for the six months ended June 30, 2005.


LIQUIDITY AND CAPITAL RESOURCES

We incurred a net loss of  $5,896,307  for the six months  ended June 30,  2006,
which  includes  $1,857,670  of  non-cash  charges  including  non-cash  charges
associated  with the fair  value of common  stock we issued as  penalties  under
certain  registration  rights  agreements  ($5,246),  fair value of a conversion
option in connection with bridge note holders  ($550,000),  accretion related to
warrants  issued in conjunction  with notes payable  ($20,909),  amortization of
deferred  financing  costs  ($282,129),  amortization  of deferred  compensation
($7,500), loss on disposal of discontinued operation ($75,920), loss on issuance
of  preferred  stock in  settlement  of debt  ($486,597),  non-cash  increase in
interest   payable  to  a  former   stockholder   ($48,400),   depreciation  and
amortization  ($143,420),  and a charge  for  stock  option  based  compensation
($237,424).  We also used  $511,691 of our  restricted  cash  escrowed to settle
liabilities assumed.  Including the amounts above, we used net cash flows in our
operating  activities of  $3,956,439  during the six months ended June 30, 2006.
Our working capital deficiency at June 30, 2006 amounts to $4,375,799 and we are
continuing  to  experience  shortages  in working  capital.  We are  involved in
litigation and are being investigated by the Securities and Exchange  Commission
with  respect  to  certain  of our  press  releases  and our use of form  S-8 to
register  shares of common stock that we issued to certain  consultants in prior
periods.  Our legal counsel  representing  us in such matters has indicated that
while the SEC  Investigation is ongoing and we have not received  correspondence
from the SEC  indicating  that the matter is  officially  closed,  the Staff has
indicated that it does not intend to request additional  information from us and
that,  at this  time,  it does not  intend  to  recommend  that the SEC bring an
enforcement action against us, our officers or directors.  We cannot provide any
assurance  that the outcome of these  matters  will not have a material  adverse
affect on our ability to sustain the business.  These matters raise  substantial
doubt about our ability to continue as a going concern.

We expect to continue  incurring  losses for the  foreseeable  future due to the
inherent uncertainty that is related to establishing the commercial  feasibility
of  technological  products  and  developing  a  presence  in new  markets.  The
Company's ability to successfully integrate the acquired businesses described in
Note 5 is critical to the  realization  of its business plan. The Company raised
$4,640,501 of gross proceeds ($4,301,450 net proceeds after the payment


                                       37
<PAGE>


of certain transaction expenses) in financing transactions during the six months
ended June 30, 2006.  The Company used  $3,956,439 of these proceeds to fund its
operations and a net of $407,643 in investing  activities,  principally  for the
purchase and development of software technology.  Additionally, the Company made
$125,000 in legal  payments  associated  with the  settlement  of  accommodation
agreements  and  incurred  $54,000 in  deferred  financing  costs.  The  Company
received $50,000 in proceeds from the disposition of discontinued operations and
received $55,000 in proceeds in connection with a financing settlement.

We are currently in the process of attempting  to raise  additional  capital and
have  taken  certain  steps to  conserve  our  liquidity  while we  continue  to
integrate  the acquired  businesses.  Although we believe that we have access to
capital resources,  we have not secured any commitments for additional financing
at this time nor can we provide any assurance  that we will be successful in our
efforts to raise  additional  capital and/or  successfully  execute our business
plan.  In an effort to  secure  additional  financing,  we  completed  a program
pursuant to which we offered our creditors and claimants an agreement to receive
shares of our  capital  stock for amounts  owed to the holders of the  Company's
indebtedness  (including  lenders,   past-due  trade  accounts,  and  employees,
consultants and other service providers with claims for fees, wages or expenses)
(Note 16).

OFF-BALANCE SHEET ARRANGEMENTS

At June 30, 2006, we did not have any relationships with unconsolidated entities
or financial  partnerships,  such as entities  often  referred to as  structured
finance,  variable interest or special purpose  entities,  which would have been
established for the purpose of facilitating  off-balance  sheet  arrangements or
other contractually  narrow or limited purposes.  As such, we are not exposed to
any  financing,  liquidity,  market or credit  risk that  could  arise if we had
engaged in such relationships.


CAUTIONARY STATEMENTS AND RISK FACTORS

The risks noted below and  elsewhere  in this report and in other  documents  we
file  with the SEC are risks  and  uncertainties  that  could  cause our  actual
results   to  differ   materially   from  the   results   contemplated   by  the
forward-looking  statements contained in this report and other public statements
we make.

RISKS RELATED TO OUR COMMON STOCK

THERE IS SUBSTANTIAL DOUBT ABOUT OUR ABILITY TO CONTINUE AS A GOING CONCERN.

We  currently  have a number of  obligations  that we are unable to meet without
generating  additional  revenues  or  raising  additional  capital.  We are also
subject to  substantial  litigation  and an  investigation  by the SEC described
elsewhere herein. If we cannot generate  additional revenues or raise additional
capital in the near future,  we may become  insolvent.  As of June 30, 2006, our
cash balance was $195,432 and we had a working  capital  deficit of  $4,375,799.
This raises  substantial doubt about our ability to continue as a going concern.
Historically,  we have  funded  our  capital  requirements  with debt and equity
financing.  Our ability to obtain additional equity or debt financing depends on
a  number  of  factors  including  our  financial  performance  and the  overall
conditions in our industry.  If we are not able to raise additional financing or
if such financing is not available on acceptable terms, we may liquidate assets,
seek or be  forced  into  bankruptcy,  and/or  continue  operations  but  suffer
material harm to our  operations and financial  condition.  These measures could
have a material adverse affect on our ability to continue as a going concern.

We have  restructured  approximately 94% of our previously  outstanding  claims,
liabilities,  demands,  causes of  action,  costs,  expenses,  attorneys'  fees,
damages,  indemnities,  and  obligations  of every kind and nature that  certain
creditors  and  claimants  had with the  Company  pursuant to our  creditor  and
claimant liabilities restructuring described in Note 16. We are currently unable
to provide  assurance that the acceptance of the claims settlement will actually
improve our  ability to fund the further  development  of our  business  plan or
improve its operations.

INVESTORS MAY NOT BE ABLE TO ADEQUATELY  EVALUATE OUR BUSINESS AND PROSPECTS DUE
TO OUR  LIMITED  OPERATING  HISTORY,  LACK  OF  REVENUES  AND  LACK  OF  PRODUCT
OFFERINGS.


                                       38
<PAGE>


We are at an early stage of executing  our business  plan and have no history of
offering information security capabilities.  We were incorporated in Delaware in
2002. Significant business operations only began with the acquisitions completed
in  February  and March  2005.  As a result of our  limited  history,  it may be
difficult to plan operating  expenses or forecast our revenues  accurately.  Our
assumptions about customer or network requirements may be wrong. The revenue and
income  potential of these  products is unproven,  and the markets  addressed by
these  products are volatile.  If such products are not  successful,  our actual
operating  results  could be below  our  expectations  and the  expectations  of
investors and market analysts,  which would likely cause the price of our common
stock to decline.

We  generated  no revenue  from  operations  before  December  31, 2004 and only
limited  revenues  in the year  ended  December  31,  2005.  We have  relied  on
financing   generated   from  our  capital   raising   activities  to  fund  the
implementation  of our business plan. We have incurred  operating and net losses
and negative  cash flows from  operations  since our  inception.  As of June 30,
2006, we had an  accumulated  deficit of  approximately  $90.3  million.  We may
continue to incur  operating  and net losses,  due in part to  implementing  our
acquisitions  strategy,  engaging in financing  activities  and expansion of our
personnel and our business  development  capabilities.  We will continue to seek
financing for the acquisition of other acquisition  targets that we may identify
in the future.  We continue to believe that we will secure financing in the near
future, but there can be no assurance of our success. If we are unable to obtain
the  necessary  funding,  it will  materially  adversely  affect our  ability to
execute our business plan and to continue our operations.

In addition, we may not be able to achieve or maintain profitability,  and, even
if we do  achieve  profitability,  the  level  of any  profitability  cannot  be
predicted and may vary significantly from quarter to quarter.

THERE CAN BE NO GUARANTY  THAT A MARKET WILL  DEVELOP FOR THE PRODUCTS WE INTEND
TO OFFER.

We currently have a limited offering of products.  We intend to acquire products
through the acquisition of existing businesses. There is no guarantee,  however,
that a market will develop for Internet security solutions of the type we intend
to  offer.  We cannot  predict  the size of the  market  for  Internet  security
solutions,  the rate at which the  market  will  grow,  or  whether  our  target
customers will accept our acquired products.

OUR  OPERATING  RESULTS  MAY  FLUCTUATE  SIGNIFICANTLY,   WHICH  MAY  RESULT  IN
VOLATILITY OR HAVE AN ADVERSE EFFECT ON THE MARKET PRICE OF OUR COMMON STOCK.

The  market  prices  of the  securities  of  technology-related  companies  have
historically  been  volatile and may continue to be volatile.  Thus,  the market
price of our common stock is likely to be subject to wide  fluctuations.  If our
revenues do not grow or grow more slowly than we  anticipate,  if  operating  or
capital   expenditures   exceed   our   expectations   and   cannot  be  reduced
appropriately,  or if some other event adversely affects us, the market price of
our common stock could decline.  Only a small public market currently exists for
our common stock and the number of shares eligible for sale in the public market
is currently  very limited,  but is expected to increase.  Sales of  substantial
shares in the future would depress the price of our common  stock.  In addition,
we currently do not receive any stock market research coverage by any recognized
stock  market  research  or  trading  firm and our  shares are not traded on any
national  securities  exchange.  A larger and more active  market for our common
stock may not develop.

Because of our limited  operations  history  and lack of assets and  revenues to
date, our common stock is believed to be currently  trading on speculation  that
we will be successful in implementing  our  acquisition  and growth  strategies.
There can be no assurance  that such  success  will be achieved.  The failure to
implement our acquisitions  and growth  strategies would likely adversely affect
the  market  price  of  our  common  stock.  In  addition,  if  the  market  for
technology-related stocks or the stock market in general experiences a continued
or greater loss in investor  confidence or otherwise  fails, the market price of
our common stock could decline for reasons unrelated to our business, results of
operations  and financial  condition.  The market price of our common stock also
might decline in reaction to events that affect other  companies in our industry
even if these events do not directly  affect us.  General  political or economic
conditions, such as an outbreak of war, a recession or interest rate or currency
rate  fluctuations,  could also cause the  market  price of our common  stock to
decline.  Our  common  stock  has  experienced,  and is likely  to  continue  to
experience, these fluctuations in price, regardless of our performance.


                                       39
<PAGE>


WE ARE  CURRENTLY  SUBJECT TO AN SEC  INVESTIGATION  WHICH COULD HAVE AN ADVERSE
AFFECT ON OUR BUSINESS AND RESULTS OF OPERATIONS.

Pursuant  to  Section  20(a)  of the  Securities  Act and  Section  21(a) of the
Securities  Exchange Act of 1934, as amended (the "Exchange  Act"), the staff of
the SEC (the "Staff"),  issued an order (In the Matter of Patron Systems, Inc. -
Order  Directing  a  Private  Investigation  and  Designating  Officers  to Take
Testimony  (C-03739-A,   February  12,  2004))  (the  "Order")  that  a  private
investigation (the "SEC  Investigation") be made to determine whether certain of
our actions and certain of the actions of our officers and  directors and others
(as described below) violated Section 5(a) and 5(c) of the Securities Act and/or
Section 10 and Rule 10b-5  promulgated  under the Exchange Act.  Generally,  the
Order  provides,  among other things,  that the Staff is  investigating  (i) the
legality of two (2) separate  Registration  Statements  filed by us on Form S-8,
filed on  December  20,  2002 and on April 2, 2003,  as amended on April 9, 2003
(collectively,  the "Registration  Statements"),  covering the resale of, in the
aggregate,   4,375,000   shares  of  common  stock  issued  to  various  of  our
consultants,  and (ii) whether in connection with the purchase or sale of shares
of common stock,  certain of our officers,  directors and others (a) sold common
stock  in  violation  of  Section  5 of the  Securities  Act  and/or,  (b)  made
misrepresentations and/or omissions of material facts and/or employed fraudulent
devices in connection  with such  purchases  and/or sales relating to certain of
our  press  releases  regarding,   among  other  items,   proposed  mergers  and
acquisitions  that were never  consummated.  If the SEC brings an action against
us, it could  result in,  among  other  items,  a civil  injunctive  order or an
administrative  cease-and-desist  order being entered against us, in addition to
the imposition of a significant civil penalty.  Moreover,  the SEC Investigation
and/or a subsequent  SEC action could affect  adversely  our ability to have our
common stock listed on a stock exchange  and/or quoted on the OTC Bulletin Board
or  NASDAQ,  our  ability  to sell our  securities  and/or  have our  securities
registered with the SEC and/or in various states and/or our ability to implement
our business plan. The Company's legal counsel  representing the Company in such
matters  has  indicated  that while the SEC  Investigation  is  ongoing  and the
Company has not received  correspondence from the SEC indicating that the matter
is officially closed, the Staff has indicated that it does not intend to request
additional  information  from the  Company and that,  at this time,  it does not
intend  to  recommend  that the SEC  bring an  enforcement  action  against  the
Company, its officers and directors. There can be no assurance that the SEC will
accept the Staff's  recommendation not to bring an enforcement action against us
or that  the  Staff  will  not  elect  at some  future  time to seek  additional
information from the Company with respect to these matters.

FUTURE SALES OF SHARES BY EXISTING  STOCKHOLDERS  COULD CAUSE OUR STOCK PRICE TO
DECLINE.

If our  existing  or  future  stockholders  sell,  or  are  perceived  to  sell,
substantial  amounts of our common stock in the public market,  the market price
of our common stock could  decline.  As of August 3, 2006,  there were 2,131,496
shares  of  common  stock  outstanding,  of which  213,746  shares  were held by
directors,  executive  officers  and  other  affiliates,  the sale of which  are
subject to volume limitations under Rule 144, various vesting agreements and our
quarterly  and  other  "blackout"  periods.   Furthermore,   shares  subject  to
outstanding  options and warrants and shares  reserved for future issuance under
our stock option plan will become  eligible for sale in the public market to the
extent  permitted by the provisions of various vesting  agreements,  the lock-up
agreements and Rule 144 under the Securities Act.

THE  UNPREDICTABILITY  OF AN ACQUIRED COMPANY'S  QUARTERLY RESULTS MAY CAUSE THE
TRADING PRICE OF OUR COMMON STOCK TO DECLINE.

The quarterly  revenues and  operating  results of companies we may acquire will
likely continue to vary in the future due to a number of factors,  many of which
are outside of our control.  Any of these  factors  could cause the price of our
common stock to decline. The primary factors that may affect future revenues and
future operating results include the following:

         o        the demand for our subsidiaries' current product offerings and
                  our future products;

         o        the length of sales cycles;

         o        the timing of recognizing revenues;

         o        new product introductions by us or our competitors;


                                       40
<PAGE>


         o        changes in our pricing policies or the pricing policies of our
                  competitors;

         o        variations in sales channels, product costs or mix of products
                  sold;

         o        our ability to develop,  introduce and ship in a timely manner
                  new  products  and  product  enhancements  that meet  customer
                  requirements;

         o        our ability to obtain  sufficient  supplies of sole or limited
                  source components for our products;

         o        variations in the prices of the components we purchase;

         o        our  ability to attain and  maintain  production  volumes  and
                  quality  levels for our products at  reasonable  prices at our
                  third-party manufacturers;

         o        our ability to manage our customer base and credit risk and to
                  collect our accounts receivable; and

         o        the  financial  strength  of  our  value-added  resellers  and
                  distributors.

Our  operating  expenses are largely  based on  anticipated  revenues and a high
percentage  of our  expenses  are,  and will  continue to be, fixed in the short
term. As a result,  lower than  anticipated  revenues for any reason could cause
significant  variations  in our  operating  results from quarter to quarter and,
because of our rapidly growing operating  expenses,  could result in substantial
operating losses.

OUR  COMMON  STOCK  IS  SUBJECT  TO THE  SEC'S  PENNY  STOCK  RULES.  THEREFORE,
BROKER-DEALERS MAY EXPERIENCE DIFFICULTY IN COMPLETING CUSTOMER TRANSACTIONS AND
TRADING ACTIVITY IN OUR SECURITIES MAY BE ADVERSELY AFFECTED.

If at any time a company has net tangible  assets of  $5,000,000 or less and the
common  stock has a market price per share of less than $5.00,  transactions  in
the common stock may be subject to the "penny stock" rules promulgated under the
Exchange Act. Under these rules, broker-dealers who recommend such securities to
persons other than institutional accredited investors must:

         o        make a  special  written  suitability  determination  for  the
                  purchaser;

         o        receive the  purchaser's  written  agreement to a  transaction
                  prior to sale;

         o        provide the purchaser  with risk  disclosure  documents  which
                  identify  certain risks  associated  with  investing in "penny
                  stocks" and which describe the market for these "penny stocks"
                  as well as a purchaser's legal remedies; and

         o        obtain a signed and dated  acknowledgment  from the  purchaser
                  demonstrating  that the  purchaser  has actually  received the
                  required risk  disclosure  document  before a transaction in a
                  "penny stock" can be completed.

If our common stock becomes subject to these rules,  broker-dealers  may find it
difficult  to  effectuate  customer  transactions  and  trading  activity in our
securities  may be  adversely  affected.  As a result,  the market  price of our
securities may be depressed, and stockholders may find it more difficult to sell
their shares of our common stock.

RISKS RELATED TO OUR BUSINESS

WE MAY BE UNABLE TO SUCCESSFULLY INTEGRATE ACQUIRED BUSINESSES.

Our business plan is dependent upon the acquisition and integration of companies
that have previously operated independently.  To date we have experienced delays
in  implementing  our business  plan as a result of limited  capital  resources,
which have had a material adverse effect on our business.  Further delays in the
process of integrating  could cause an interruption  of, or loss of momentum in,
the activities of our business and the loss of key  personnel.  The diversion of
management's attention and any delays or difficulties  encountered in connection
with our integration of acquired  operations could have an adverse effect on our
business, results of operations, financial condition or prospects.

WE CURRENTLY DO NOT HAVE SUFFICIENT  REVENUES TO SUPPORT OUR BUSINESS ACTIVITIES
AND IF OPERATING LOSSES CONTINUE,  WILL BE REQUIRED TO OBTAIN ADDITIONAL CAPITAL
THROUGH FINANCINGS WHICH WE MAY NOT BE ABLE TO SECURE.

To achieve our intended growth, we will require substantial  additional capital.
We have  encountered  difficulty  and delays in raising  capital to date and the
market   environment  for  development  stage  companies,   like  ours,  remains


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<PAGE>


particularly challenging. There can be no assurance that funds will be available
when  needed or on  acceptable  terms.  Technology  companies  in  general  have
experienced  difficulty in recent years in accessing  capital.  Our inability to
obtain  additional  financing  may require us to delay,  scale back or eliminate
certain of our growth  plans which could have a material  and adverse  effect on
our business,  financial condition or results of operations or could cause us to
cease  operations.  Even if we are able to  obtain  additional  financing,  such
financing  could be  structured  as  equity  financing  that  would  dilute  the
ownership percentage of any investor in our securities.

DOWNTURNS IN THE INTERNET  INFRASTRUCTURE,  NETWORK SECURITY AND RELATED MARKETS
MAY DECREASE OUR REVENUES AND MARGINS.

The  market  for our  current  products  and other  products  we intend to offer
depends on economic  conditions  affecting the broader Internet  infrastructure,
network  security  and related  markets.  Downturns  in these  markets may cause
enterprises  and  carriers to delay or cancel  security  projects,  reduce their
overall or security-specific  information technology budgets or reduce or cancel
orders for our current  products and other products we intend to offer.  In this
environment, customers such as distributors,  value-added resellers and carriers
may  experience  financial  difficulty,  cease  operations and fail to budget or
reduce  budgets for the  purchase of our current  products or other  products we
intend to offer.  This,  in turn,  may lead to longer  sales  cycles,  delays in
purchase  decisions,  payment  and  collection,  and may  also  result  in price
pressures,  causing us to realize  lower  revenues,  gross margins and operating
margins.  In  addition,   general  economic   uncertainty  caused  by  potential
hostilities involving the United States,  terrorist  activities,  the decline in
specific markets such as the service  provider market in the United States,  and
the general  decline in capital  spending in the information  technology  sector
make it difficult to predict changes in the purchase and network requirements of
our potential  customers and the markets we intend to serve. We believe that, in
light of these events, some businesses may curtail or eliminate capital spending
on  information  technology.  A decline in capital  spending  in the  markets we
intend to serve may  adversely  affect our future  revenues,  gross  margins and
operating margins and make it necessary for us to gain significant  market share
from our future  competitors in order to achieve our financial goals and achieve
profitability.

COMPETITION MAY DECREASE OUR PROJECTED REVENUES, MARKET SHARE AND MARGINS.

The market for network security  products is highly  competitive,  and we expect
competition  to intensify in the future.  Competitors  may gain market share and
introduce new competitive  products for the same markets and customers we intend
to serve with our products.  These products may have better  performance,  lower
prices and broader  acceptance than the products we currently offer or intend to
offer.

Many of our potential competitors have longer operating histories,  greater name
recognition,   large  customer  bases  and  significantly   greater   financial,
technical,  sales, marketing and other resources than we have. In addition, some
of our  potential  competitors  currently  combine  their  products  with  other
companies'  networking and security products.  These potential  competitors also
often combine their sales and marketing  efforts.  Such activities may result in
reduced  prices,  lower gross and operating  margins and longer sales cycles for
the  products  we  currently  offer and  intend to offer.  If any of our  larger
potential  competitors were to commit greater  technical,  sales,  marketing and
other  resources to the markets we intend to serve,  or reduce  prices for their
products over a sustained  period of time, our ability to successfully  sell the
products  we intend to offer,  increase  revenue or meet our or market  analysts
expectations could be adversely affected.

FAILURE TO ADDRESS  EVOLVING  STANDARDS  IN THE NETWORK  SECURITY  INDUSTRY  AND
SUCCESSFULLY  DEVELOP AND INTRODUCE NEW PRODUCTS OR PRODUCT  ENHANCEMENTS  WOULD
CAUSE OUR REVENUES TO DECLINE.

The market for network security products is characterized by rapid technological
change, frequent new product introductions, changes in customer requirements and
evolving   industry   standards.   We  expect  to  introduce  our  products  and
enhancements  to existing  products to address  current  and  evolving  customer
requirements and broader networking trends and  vulnerabilities.  We also expect
to develop products with strategic partners and incorporate third-party advanced
security  capabilities  into  our  intended  product  offerings.  Some of  these
products and enhancements  may require us to develop new hardware  architectures
that involve complex and time consuming processes. In developing and introducing
our  intended  product  offerings,  we have  made,  and will  continue  to make,


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<PAGE>


assumptions with respect to which features,  security  standards and performance
criteria will be required by our potential customers.  If we implement features,
security  standards  and  performance  criteria  that are  different  from those
required by our potential  customers,  market acceptance of our intended product
offerings may be significantly reduced or delayed,  which would harm our ability
to penetrate existing or new markets.

Furthermore,  we may not be able to develop new products or product enhancements
in a timely  manner,  or at all. Any failure to develop or  introduce  these new
products and product  enhancements  might cause our existing products to be less
competitive, may adversely affect our ability to sell solutions to address large
customer  deployments  and, as a  consequence,  our  revenues  may be  adversely
affected.  In addition,  the introduction of products embodying new technologies
could render existing  products we intend to offer obsolete,  which would have a
direct,  adverse  effect on our market  share and  revenues.  Any failure of our
future products or product enhancements to achieve market acceptance could cause
our revenues to decline and our operating  results to be below our  expectations
and the expectations of investors and market analysts,  which would likely cause
the price of our common stock to decline.

WE HAVE EXPERIENCED ISSUES WITH OUR FINANCIAL  SYSTEMS,  CONTROLS AND OPERATIONS
THAT COULD HARM OUR FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

Our ability to sell our intended  product  offerings  and implement our business
plan successfully in a volatile and growing market requires effective management
and financial systems and a system of financial processes and controls.  Through
the quarter  ended  December 31, 2005,  our Chief  Executive  Officer and Acting
Chief Financial Officer  evaluated the effectiveness of our disclosure  controls
and  procedures  in  accordance  with  Exchange  Act Rules  13a-15 or 15d-15 and
identified material weakness in our internal controls. These material weaknesses
affected  our ability to timely file our  reports  with the SEC and  communicate
critical  information to management that was needed to make business  decisions.
Although  we have taken steps to correct  these  previous  deficiencies  and are
currently in compliance with the SEC's reporting  requirements,  we have limited
capital  resources  and are still at risk for the loss of key  personnel  in our
finance department.  The loss of key personnel in our finance department, or any
other  conditions  that could disrupt our operations in this area,  could have a
material  adverse affect on our ability to communicate  critical  information to
management and our investors,  raise capital and/or maintain compliance with our
SEC reporting  obligations.  These  circumstances,  if they arise,  could have a
material adverse affect on our business.

We have  limited  management  resources to date and are still  establishing  our
management and financial systems.  Growth, to the extent it occurs, is likely to
place a considerable strain on our management resources,  systems, processes and
controls.  To address  these  issues,  we will need to  continue  to improve our
financial and managerial  controls,  reporting systems and procedures,  and will
need to continue to expand, train and manage our work force worldwide. If we are
unable to maintain an adequate level of financial processes and controls, we may
not be able to accurately report our financial performance on a timely basis and
our business and stock price would be harmed.

IF OUR FUTURE  PRODUCTS DO NOT  INTEROPERATE  WITH OUR END CUSTOMERS'  NETWORKS,
INSTALLATIONS WOULD BE DELAYED OR CANCELLED,  WHICH COULD  SIGNIFICANTLY  REDUCE
OUR ANTICIPATED REVENUES.

Future  products will be designed to interface with our end customers'  existing
networks,  each of which have  different  specifications  and  utilize  multiple
protocol standards. Many end customers' networks contain multiple generations of
products  that  have  been  added  over time as these  networks  have  grown and
evolved.  Our future products must  interoperate with all of the products within
these  networks  as well as with  future  products  that might be added to these
networks in order to meet end customers' requirements.  If we find errors in the
existing  software used in our end customers'  networks,  we may elect to modify
our  software  to fix or  overcome  these  errors  so  that  our  products  will
interoperate and scale with their existing software and hardware.  If our future
products do not  interoperate  with those  within our end  customers'  networks,
installations  could be delayed or orders for our products  could be  cancelled,
which could significantly reduce our anticipated revenues.

AS A PUBLIC  COMPANY,  WE MAY  INCUR  INCREASED  COSTS AS A RESULT  OF  RECENTLY
ENACTED AND  PROPOSED  CHANGES IN LAWS AND  REGULATIONS  RELATING  TO  CORPORATE
GOVERNANCE MATTERS AND PUBLIC DISCLOSURE.


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<PAGE>


Recently  enacted and  proposed  changes in the laws and  regulations  affecting
public companies, including the provisions of the Sarbanes-Oxley Act of 2002 and
rules adopted or proposed by the SEC will result in increased costs for us as we
evaluate the  implications of these laws,  regulations and standards and respond
to their  requirements.  These laws and regulations could make it more difficult
or more costly for us to obtain certain types of insurance,  including  director
and officer liability  insurance,  and we may be forced to accept reduced policy
limits and  coverage or incur  substantially  higher costs to obtain the same or
similar  coverage.  The impact of these events could also make it more difficult
for us to  attract  and  retain  qualified  persons  to  serve  on our  board of
directors,  board  committees or as executive  officers.  We cannot estimate the
amount or timing of additional  costs we may incur as a result of these laws and
regulations.

WE DEPEND ON OUR KEY PERSONNEL TO MANAGE OUR BUSINESS  EFFECTIVELY  IN A RAPIDLY
CHANGING  MARKET,  AND IF WE ARE UNABLE TO HIRE  ADDITIONAL  PERSONNEL OR RETAIN
EXISTING  PERSONNEL,  OUR  ABILITY TO EXECUTE  OUR  BUSINESS  STRATEGY  WOULD BE
IMPAIRED.

Our  future  success  depends  upon  the  continued  services  of our  executive
officers. The loss of the services of any of our key employees, the inability to
attract  or  retain  qualified  personnel  in the  future,  or  delays in hiring
required  personnel,  could  delay the  development  and  introduction  of,  and
negatively impact our ability to sell, our intended product offerings.

WE MIGHT HAVE TO DEFEND  LAWSUITS OR PAY DAMAGES IN CONNECTION  WITH ANY ALLEGED
OR ACTUAL FAILURE OF OUR PRODUCTS AND SERVICES.

Because our intended product  offerings and services provide and monitor network
security and may protect valuable information,  we could face claims for product
liability,  tort or breach of  warranty.  Anyone who  circumvents  our  security
measures could misappropriate the confidential  information or other property of
end  customers  using our  products,  or  interrupt  their  operations.  If that
happens,  affected  end  customers  or others may sue us.  Defending  a lawsuit,
regardless of its merit, could be costly and could divert management  attention.
Our business  liability  insurance coverage may be inadequate or future coverage
may be unavailable on acceptable terms or at all.

WE COULD BECOME SUBJECT TO LITIGATION  REGARDING  INTELLECTUAL  PROPERTY  RIGHTS
THAT COULD BE COSTLY AND RESULT IN THE LOSS OF SIGNIFICANT RIGHTS.

In recent  years,  there has been  significant  litigation  in the United States
involving patents and other intellectual  property rights. We may become a party
to litigation in the future to protect our intellectual  property or as a result
of an alleged infringement of another party's intellectual property.  Claims for
alleged infringement and any resulting lawsuit, if successful,  could subject us
to significant liability for damages and invalidation of our proprietary rights.
These lawsuits,  regardless of their success, would likely be time-consuming and
expensive  to  resolve  and would  divert  management  time and  attention.  Any
potential intellectual property litigation could also force us to do one or more
of the following:

         o        stop or delay  selling,  incorporating  or using products that
                  use the challenged intellectual property; and/or

         o        obtain from the owner of the infringed  intellectual  property
                  right a license to sell or use the relevant technology,  which
                  license might not be available on reasonable  terms or at all;
                  or redesign the products that use that technology.

If we are forced to take any of these  actions,  our business might be seriously
harmed.  Our insurance may not cover potential claims of this type or may not be
adequate to indemnify us for all liability that could be imposed.

OUR INABILITY TO OBTAIN ANY THIRD-PARTY LICENSE REQUIRED TO DEVELOP NEW PRODUCTS
AND PRODUCT  ENHANCEMENTS  COULD REQUIRE US TO OBTAIN  SUBSTITUTE  TECHNOLOGY OF
LOWER QUALITY OR PERFORMANCE STANDARDS OR AT GREATER COST, WHICH COULD SERIOUSLY
HARM OUR BUSINESS, FINANCIAL CONDITION AND RESULTS OF OPERATIONS.


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<PAGE>


From time to time, we may be required to license  technology  from third parties
to develop new products or product enhancements. Third-party licenses may not be
available to us on  commercially  reasonable  terms or at all. Our  inability to
obtain any  third-party  license  required  to develop  new  products or product
enhancements  could require us to obtain substitute  technology of lower quality
or  performance  standards or at greater cost,  which could  seriously  harm our
business, financial condition and results of operations.

GOVERNMENTAL  REGULATIONS  AFFECTING  THE  IMPORT OR EXPORT  OF  PRODUCTS  COULD
NEGATIVELY AFFECT OUR REVENUES.

Governmental  regulation  of imports  or  exports or failure to obtain  required
export approval of our encryption  technologies could harm our international and
domestic sales.  The United States and various foreign  governments have imposed
controls,  export license  requirements and restrictions on the import or export
of some technologies,  especially encryption technology.  In addition, from time
to time, governmental agencies have proposed additional regulation of encryption
technology,  such as requiring the escrow and  governmental  recovery of private
encryption keys.

In particular,  in light of recent terrorist  activity,  governments could enact
additional regulation or restrictions on the use, import or export of encryption
technology.  Additional  regulation  of  encryption  technology  could  delay or
prevent the  acceptance and use of encryption  products and public  networks for
secure  communications.  This might  decrease  demand for our  intended  product
offerings and services.  In addition,  some foreign  competitors  are subject to
less stringent controls on exporting their encryption technologies. As a result,
they may be able to compete  more  effectively  than we can in the  domestic and
international network security market.

MANAGEMENT COULD INVEST OR SPEND OUR CASH OR CASH EQUIVALENTS AND INVESTMENTS IN
WAYS THAT MIGHT NOT ENHANCE OUR RESULTS OF OPERATIONS OR MARKET SHARE.

We have  made no  specific  allocations  of our  cash  or cash  equivalents  and
investments.  Consequently,  management  will  retain a  significant  amount  of
discretion over the application of our cash or cash  equivalents and investments
and could spend the proceeds in ways that do not improve our  operating  results
or increase our market share. In addition, these proceeds may not be invested to
yield a favorable rate of return.


ITEM 3. CONTROLS AND PROCEDURES

Members of our  management,  including  our Chief  Executive  Officer  and Chief
Financial  Officer,  evaluated the effectiveness of our disclosure  controls and
procedures,  as defined by  paragraph  (e) of  Exchange  Act Rules  13(a)-15  or
15(d)-15 for the fiscal  quarter ended June 30, 2006, the period covered by this
report.  Based  on that  evaluation,  our  Chief  Executive  Officer  and  Chief
Financial  Officer  concluded that, as of June 30, 2006 our disclosure  controls
and procedures were not effective.

DISCLOSURE CONTROLS AND INTERNAL CONTROLS

Disclosure  controls and procedures are controls and other  procedures  that are
designed  with  the  objective  of  ensuring  that  information  required  to be
disclosed in our reports  filed under the  Securities  Exchange Act of 1934,  as
amended,  such as this Report, is recorded,  processed,  summarized and reported
within the time  periods  specified  in the SEC's  rules and  forms.  Disclosure
controls and  procedures  are also  designed with the objective of ensuring that
such  information is accumulated and  communicated to our management,  including
our Chief Executive  Officer and Chief  Financial  Officer,  as appropriate,  to
allow timely decisions  regarding  required  disclosure.  Internal  controls are
procedures  which  are  designed  with the  objective  of  providing  reasonable
assurance that our transactions are properly  authorized,  recorded and reported
and our assets are safeguarded  against  unauthorized or improper use, to permit
the  preparation  of our  financial  statements  in  conformity  with  generally
accepted accounting principles.


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<PAGE>


Our company is not an "accelerated filer" (as defined in the Securities Exchange
Act) and is not  required  to deliver  management's  report on control  over our
financial  reporting  until our year ended December 31, 2007.  Nevertheless,  we
identified  certain matters that constitute  material weakness (as defined under
the Public Company  Accounting  Oversight Board Auditing  Standard No. 2) in our
internal controls over financial reporting.

In previous  periods,  we reported that we had identified  certain  matters that
constituted  material  weakness (as defined under the Public Company  Accounting
Oversight Board Auditing Standard No. 2) in our internal controls over financial
reporting.  The material  weaknesses that we identified related to the fact that
that our overall financial  reporting structure and current staffing levels were
not   sufficient  to  support  the   complexity   of  our  financial   reporting
requirements,  we lacked the  expertise  we needed to apply  complex  accounting
principles  relating to our business  combinations  and  participation in equity
transactions and lacked the structure we need to ensure the timely filing of our
tax returns.

Prior to the  second  quarter  2005,  we did not have  any full  time  employees
including a Principal  Accounting Officer assigned to perform any duties related
to our financial reporting  obligations.  Accordingly we were unable,  until the
second quarter of 2005, to record,  process and summarize all of the information
that we needed to close our books and records on a timely  basis and deliver our
reports  to the  Securities  and  Exchange  Commission  within  the time  frames
required under the Commission's rules.

During the third  quarter of 2005,  under the  direction of our Chief  Executive
Officer,  we engaged the services of an outside financial  reporting  specialist
who,  together with our full time personnel,  undertook the process of forming a
system of  internal  controls.  We have since  hired  personnel  and  instituted
various  procedures  that have  enabled  us to  record,  process  and  summarize
transactions  within the time frames  required to timely file our reports  under
the  Commission's  rules.  These  improvements  have  enabled us to resolve  all
previous  delinquencies  relating  to the  filing of our  annual  and  quarterly
reports with the SEC as of the quarter ended June 30, 2005. We also resolved the
delinquent  filing of our Forms 8-K/A from the acquisitions of CSSI,  Entelagent
and LucidLine in December  2005. We also assigned a key member of the accounting
department  with the task of filing  previously  delinquent  tax returns and are
undertaking  a structure  to ensure that our tax returns in the future are filed
on a timely basis.  We have completed  filing all delinquent tax returns through
the year ended December 31, 2004.  This member of our  accounting  department is
also working with an outside  specialist  to ensure that our tax returns for the
year ended December 31, 2005 are filed in a timely manner.

Although the improvements we have made in our financial reporting processes have
enabled us to (a) bring the Company  into  compliance  with the SEC's  reporting
requirement,  (b) better  plan  transactions  that  involve the  application  of
complex accounting principles and (c) improve our ability to comply with our tax
reporting  obligations,  additional  time is still required to test and document
our  internal  and  disclosure  control  processes  to  ensure  their  operating
effectiveness.

We believe that the changes we have made in our financial  reporting  procedures
have enabled us to substantially  reduce previous financial reporting risks that
existed as a result of our limited resources.  We are continuing to evaluate our
risks and resources.  We will seek to make  additional  changes in our financial
reporting  systems and procedures  wherever  necessary and appropriate to ensure
their effectiveness in future periods.


PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Sherleigh  Associates Inc. Profit Sharing Plan  ("Sherleigh")  filed a complaint
against the  Company,  Patrick  Allin,  former  Chief  Executive  Officer of the
Company, and Robert E. Yaw, the Company's non-executive Chairman, on February 3,
2004, in the United States District Court for the Southern  District of New York
(the "Court")  alleging common law fraud.  The complaint  alleged that Sherleigh
was  fraudulently  induced into  purchasing  1,000,000  shares of Company common
stock in reliance  upon certain of the  Company's  press  releases and allegedly
false  statements by Mr. Allin and Mr. Yaw,  concerning  the Company's  plans to
acquire  two target  companies,  TrustWave  Corporation  (currently  a strategic
partner of the Company) and  Entelagent  (a current  subsidiary of the Company),
and its financing  arrangements  regarding those acquisitions.  Sherleigh sought
rescission of its purchase agreement and return of its $2,000,000 purchase price
or  compensatory  damages  to be proven  at  trial.  Mr.  Allin  entered  into a


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<PAGE>


settlement  agreement with Sherleigh and is requesting that the Court include in
its  dismissal  order  a  finding  that  the  settlement  is  reasonable  and  a
prohibition  against any claims by the Company or Mr. Yaw against Mr.  Allin for
contribution or indemnification  with respect to Sherleigh's claims. The Company
has opposed Mr. Allin's request.  The Court has not yet issued any ruling on Mr.
Allin's request. Discovery has been completed, but no trial date has been set by
the Court.  On April 24, 2006,  the Company and the  Sherleigh  Associates  Inc.
Profit Sharing Plan entered into a final and binding settlement of all claims as
part of the creditor and claimant liabilities restructuring.

In settlement  of the Sherleigh  Claims,  Sherleigh  purchased  from the Company
2,312,500 shares of the Series A-1 Preferred Stock for a purchase price of $0.80
per share or $1,850,000. The aggregate purchase price is equivalent to the value
of the  Sherleigh  Claims  being  settled,  which  is  being  paid  through  the
settlement and release of the Sherleigh Claims.

On May 4,  2006,  we  became  aware  that Lok  Technologies,  Inc.  had  filed a
complaint on or about March 30, 2006 against us,  Entelagent  Software Corp. and
unnamed  defendants in the Superior Court of  California,  County of Santa Clara
alleging  breach of contract,  breach of duty of good faith and fair dealing and
unjust enrichment  related to a license agreement and certain  promissory notes,
and seeking damages, interest, disgorgement of any unjust enrichment, attorneys'
fees and cost in an amount to be  provided.  Prior to receipt of this  notice of
litigation,  we had  recorded a liability of $320,000  plus accrued  interest of
$159,432.  We believe that we have defenses to these claims.  The Company cannot
provide any assurance that the ultimate resolution of this claim will not have a
material adverse affect on its financial condition.

Pursuant  to  Section  20(a)  of the  Securities  Act and  Section  21(a) of the
Securities Exchange Act, the staff of the SEC (the "Staff"), issued an order (In
the Matter of Patron Systems, Inc. - Order Directing a Private Investigation and
Designating  Officers to Take  Testimony  (C-03739-A,  February 12,  2004)) (the
"Order")  that a  private  investigation  (the "SEC  Investigation")  be made to
determine whether certain actions of, among others, the Company,  certain of its
officers  and  directors  and  others  violated  Section  5(a)  and  5(c) of the
Securities Act and/or Section 10 and Rule 10b-5  promulgated  under the Exchange
Act.  Generally,  the Order  provides,  among  other  things,  that the Staff is
investigating (i) the legality of two (2) separate Registration Statements filed
by the Company on Form S-8,  filed on December 20, 2002 and on April 2, 2003, as
amended on April 9, 2003 (collectively, the "Registration Statements"), covering
the resale of, in the  aggregate,  4,375,000  shares of common  stock  issued to
various  consultants  of the Company,  and (ii) whether in  connection  with the
purchase or sale of shares of common  stock,  certain  officers and directors of
the Company and others (a) sold common  stock in  violation  of Section 5 of the
Securities Act and/or, (b) made misrepresentations  and/or omissions of material
facts and/or  employed  fraudulent  devices in  connection  with such  purchases
and/or sales  relating to certain of the  Company's  press  releases  regarding,
among  other  items,   proposed  mergers  and   acquisitions   that  were  never
consummated.  If the SEC brings an action  against the Company,  it could result
in,  among  other  items,  a  civil  injunctive   order  or  an   administrative
cease-and-desist  order being  entered  against the Company,  in addition to the
imposition of a  significant  civil  penalty.  Moreover,  the SEC  Investigation
and/or a subsequent SEC action could affect  adversely the Company's  ability to
have its common stock become  listed on a stock  exchange  and/or  quoted on the
NASD Bulletin  Board or NASDAQ,  the Company  being able to sell its  securities
and/or  have its  securities  registered  with the SEC and/or in various  states
and/or the Company's ability to implement its business plan. The Company's legal
counsel  representing  the Company in such matters has indicated  that while the
SEC  Investigation  is ongoing and the Company has not  received  correspondence
from the SEC  indicating  that the matter is  officially  closed,  the Staff has
indicated  that it does not intend to request  additional  information  from the
Company and that,  at this time,  it does not intend to  recommend  that the SEC
bring an enforcement action against the Company, its officers and directors.


                                       47
<PAGE>


ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

The  following  unregistered  securities  have been sold by us during the period
from April 1, 2006 to June 30, 2006:

<TABLE>
<CAPTION>
                  TITLE AND AMOUNT OF SECURITIES       NAME OF          NAME OR CLASS OF
DATE OF GRANT       GRANTED/EXERCISE PRICE IF         PRINCIPAL       PERSONS WHO RECEIVED      CONSIDERATION
                            APPLICABLE               UNDERWRITER           SECURITIES             RECEIVED
-------------       --------------------------        ----------      ---------------------     -------------
<S>              <C>                                     <C>         <C>                        <C>
 April 2006       1,591,003/Series A-1 Preferred         None        Creditors and Claimants    $1,272,802 in
                               Stock                                  in the Company's Debt       cancelled
                                                                          Restructuring           debt(1)

 April 2006         71/Series A Preferred Stock          None        Apex Investment Fund V,    $355,000(2)
                                                                               L.P.
  June 2006       1,346,575/Series A-1 Preferred         None           Arco van Nieuwland      $1,077,260 in
                               Stock                                                              cancelled
                                                                                                  debt(3)

  June 2006      31,250/Series A-1 Preferred Stock       None             John V. Bivona        $25,000 in
                                                                                                  cancelled
                                                                                                  debt(4)

  June 2006            251,175/Common Stock              None              9 Investors           $0.00(5)
</TABLE>


The following  unregistered  derivative  securities  (options and warrants) have
been issued by us during the period from April 1, 2006 to June 30, 2006:



<TABLE>
<CAPTION>
                  TITLE AND AMOUNT OF SECURITIES       NAME OF          NAME OR CLASS OF
DATE OF GRANT       GRANTED/EXERCISE PRICE IF         PRINCIPAL       PERSONS WHO RECEIVED      CONSIDERATION
                            APPLICABLE               UNDERWRITER           SECURITIES             RECEIVED
-------------       --------------------------        ----------      ---------------------     -------------
<S>              <C>                                     <C>         <C>                        <C>
   April 2006    49,306/Common Stock Purchase            None        Apex Investment Fund V,    $0.00(6)
                             Warrants                                          L.P.
</TABLE>

The above unregistered  securities were issued pursuant to an exemption from the
registration  requirements  of the  Securities  Act  under  Section  4(2) of the
Securities Act.


ITEM 6. EXHIBITS

See attached Exhibit Index.


----------
(1)      On April 30, 2006, we issued  1,591,003  shares of Series A-1 Preferred
         Stock in consideration  for $1,272,802 of debt  cancellation and claims
         settlement under the Creditor and Claimant Liabilities Restructuring.

(2)      On April 3, 2006,  we issued 71 shares of Series A  Preferred  Stock in
         consideration for $355,000 from Apex Investment Fund V, L.P.

(3)      On June 3, 2006,  we issued  1,346,575  shares of Series A-1  Preferred
         Stock in consideration  for $1,077,260 of debt  cancellation and claims
         settlement under the Creditor and Claimant Liabilities Restructuring.

(4)      On June 29, 2006, we issued 31,250 shares of Series A-1 Preferred Stock
         in consideration for $25,000 of debt cancellation and claims settlement
         under the Creditor and Claimant Liabilities Restructuring.

(5)      On June 30,  2006,  we  issued  251,175  shares  of  Common  Stock to 9
         investors as an anti-dilution  adjustment to their share purchases made
         directly  from the Company  during the March 2004 and  August/September
         2004 periods.

(6)      On April 3, 2006, we issued warrants to purchase up to 49,306 shares of
         our common  stock to Apex  Investment  Fund V, L.P. who invested in our
         Series A Preferred Stock private placement. The warrants have a term of
         5 years and an exercise price of $3.00 per share.


                                       48
<PAGE>


                                   SIGNATURES

In accordance with the  requirements of the Exchange Act, the registrant  caused
this  report to be  signed on its  behalf  by the  undersigned,  thereunto  duly
authorized.


Date: August 11, 2006                   PATRON SYSTEMS, INC.
                                        (Registrant)


                                        /s/ Robert Cross
                                        ----------------------------------------
                                        By:    Robert Cross
                                        Its:   Chief Executive Officer


                                        /s/ Martin T. Johnson
                                        ----------------------------------------
                                        By:    Martin T. Johnson
                                        Its:   Chief Financial Officer


                                       49
<PAGE>


                                  EXHIBIT INDEX

EXHIBIT
NUMBER                             DESCRIPTION OF EXHIBIT
-------        -----------------------------------------------------------------
3.1            Certificate   of  Amendment   of  Second   Amended  and  Restated
               Certificate of Incorporation of Patron Systems, Inc. Incorporated
               by  reference  to Appendix B to the  Definitive  Proxy  Statement
               filed with the  Securities  and Exchange  Commission  on June 19,
               2006.

10.1           Stock  Purchase  Agreement  dated April 18, 2006  between  Patron
               Systems, Inc. and Walnut Valley, Inc.

10.2           Patron Systems,  Inc. 2006 Stock Incentive Plan.  Incorporated by
               reference to Appendix A to the Definitive  Proxy  Statement filed
               with the  Securities  and Exchange  Commission  on June 19, 2006.

31.1           Certification   of  Principal   Executive   Officer  pursuant  to
               Securities  Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
               pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2           Certification   of  Principal   Financial   Officer  pursuant  to
               Securities  Exchange Act Rules 13a-14(a) and 15d-14(a) as adopted
               pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1           Certification  of  Principal  Executive  Officer  pursuant  to 18
               U.S.C.  Section 1350,  as adopted  pursuant to Section 906 of the
               Sarbanes-Oxley Act of 2002.

32.2           Certification  of  Principal  Financial  Officer  pursuant  to 18
               U.S.C.  Section 1350,  as adopted  pursuant to Section 906 of the
               Sarbanes-Oxley Act of 2002.


                                       50