UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




Form 10-Q







(Mark One)




x  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For the quarterly period ended September 30, 2010




or




o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934




For the transition period from                                                                                      to




Commission File Number: 001-14949









Implant Sciences Corporation


(Exact name of registrant as specified in our charter)




Massachusetts

(State or other jurisdiction of

incorporation or organization)

04-2837126

(I.R.S. Employer Identification No.)600 Research Drive, Wilmington, Massachusetts

(Address of principal executive offices)

01887

(Zip Code)







(978) 752-1700


(Registrant’s telephone number, including area code)





(Former name, former address and former fiscal year, if changed since last report)







Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.




Yes x  No q




Indicate by check mark whether the registrant has submitted electronically and posted on our corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).     Yes q  No q




Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):




q  Large Accelerated Filer                                                                                                           q  Accelerated Filer




q  Non-accelerated Filer                                                                                                           x  Smaller reporting company




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




As of February 28, 2011, there were 27,901,328 shares of the registrant’s Common Stock outstanding.







IMPLANT SCIENCES CORPORATION







TABLE OF CONTENTS




















PagePART I.
FINANCIAL INFORMATIONItem 1.
Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets at September 30, 2010 (unaudited)

and June 30, 2010
3Condensed Consolidated Statements of Operations for the three months ended

September 30, 2010 and 2009 (unaudited)
4Condensed Consolidated Statements of Cash Flows for the three months ended

September 30, 2010 and 2009 (unaudited)
5Notes to Condensed Consolidated Financial Statements
6-24Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
25-35Item 3.
Quantitative and Qualitative Disclosures About Market Risk
35Item 4T.
Controls and Procedures
35-36PART II.
OTHER INFORMATIONItem 1.
Legal Proceedings
37Item 1A.
Risk Factors
37-38Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
38Item 3.
Defaults Upon Senior Securities
38Item 4.
Submission of Matters to a Vote of Security Holders
38Item 5.
Other Information
38Item 6.
Exhibits
38Signatures
39
























-2-


Implant Sciences CorporationCondensed Consolidated Balance SheetsSeptember 30,


June 30,2010


2010(Unaudited)


(Audited)ASSETSCurrent assets:Cash and cash equivalents

$
-


$
-Restricted cash and investments


1,275,000



1,714,000Accounts receivable-trade, net of allowance of $84,000


465,000



73,000Accounts receivable, unbilled


-



29,000Note receivable


180,000



177,000Inventories


1,170,000



960,000Prepaid expenses and other current assets


491,000



859,000Total current assets


3,581,000



3,812,000Property and equipment, net


125,000



152,000Note receivable


524,000



574,000Restricted cash and investments


312,000



312,000Other non-current assets


107,000



107,000Total assets

$
4,649,000


$
4,957,000LIABILITIES AND STOCKHOLDERS' DEFICITCurrent liabilities:Cash overdraft

$
56,000


$
11,000Senior secured convertible note, net


3,920,000



3,920,000Senior secured note


1,000,000



1,000,000Line of credit


8,702,000



8,143,000Current maturities of long-term debt and obligations under capital lease


16,000



18,000Note payable - related party


-



100,000Payable to Med-Tec


55,000



55,000Accrued expenses


2,675,000



2,668,000Accounts payable


2,816,000



2,974,000Deferred revenue


1,106,000



182,000Note conversion option liability


9,610,000



10,686,000Total current liabilities


29,956,000



29,757,000Long-term liabilities:Long-term debt and obligations under capital lease, net of current maturities


67,000



67,000Warrant derivative liability


247,000



278,000Total long-term liabilities


314,000



345,000Total liabilities


30,270,000



30,102,000Commitments and contingenciesStockholders' deficit:Common stock; $0.10 par value; 50,000,000 shares authorized; 25,897,160 and

24,634,740 at September 30, 2010 and June 30, 2010 shares issued and outstanding, respectively


2,590,000



2,463,000Series F Convertible Preferred Stock, no stated value; 2,000,000 shares

authorized, 1,646,663 shares outstanding (liquidation value $274,000)


274,000



274,000Additional paid-in capital


61,567,000



61,539,000Accumulated deficit


(89,979,000
)


(89,332,000
)Deferred compensation


-



(16,000
)Treasury stock, 10,545 common shares, respectively, at cost


(73,000
)


(73,000
)Total stockholders' deficit


(25,621,000
)


(25,145,000
)Total liabilities and stockholders' deficit

$
4,649,000


$
4,957,000
  The accompanying notes are an integral part of these financial statements.


-3-




Implant Sciences CorporationCondensed Consolidated Statements of Operations(Unaudited)For the Three Months EndedSeptember 30,2010


2009Revenues:Security products

$
1,004,000


$
1,635,000Government contracts and services


-



185,0001,004,000



1,820,000Cost of revenues


636,000



979,000Gross margin


368,000



841,000Operating expenses:Research and development


470,000



595,000Selling, general and administrative


1,148,000



1,227,0001,618,000



1,822,000Loss from operations


(1,250,000
)


(981,000
)Other income (expense), net:Interest income


12,000



18,000Interest expense


(516,000
)


(767,000
)Change in fair value of warrant derivative liability


31,000



7,000Change in fair value of note conversion option liability


1,076,000



376,000Total other income (expense), net


603,000



(366,000
)Loss from continuing operations


(647,000
)


(1,347,000
)Preferred distribution, deemed dividends and accretion


-



(329,000
)Loss from continuing operations applicable to common shareholders


(647,000
)


(1,676,000
)Net loss from discontinued operations


-



(20,000
)Net loss applicable to common shareholders

$
(647,000
)

$
(1,696,000
)Net loss

$
(647,000
)

$
(1,367,000
)Loss per share from continuing operations, basic and diluted

$
(0.03
)

$
(0.09
)Loss per share from continuing operations applicable to common

shareholders, basic and diluted

$
(0.03
)

$
(0.11
)Loss per share from discontinued operations, basic and diluted

$
-


$
(0.00
)Loss per share applicable to common shareholders,

basic and diluted

$
(0.03
)

$
(0.11
)Net loss per share, basic and diluted

$
(0.03
)

$
(0.09
)Weighted average shares used in computing net loss

per common share, basic and diluted


25,878,335



15,424,195







The accompanying notes are an integral part of these financial statements.




-4-


Implant Sciences CorporationCondensed Consolidated Statements of Cash Flows(Unaudited)For The Three Months Ended September 30,2010


2009Cash flows from operating activities:Net loss

$
(647,000
)

$
(1,367,000
)Less:  Net loss from discontinued operations


-



(20,000
)Loss from continuing operations


(647,000
)


(1,347,000
)Adjustments to reconcile net loss from continuing operations to net cash flows:Depreciation and amortization


26,000



34,000Bad debt expense


-



3,000Share-based compensation expense


65,000



43,000Debt discount amortization


-



625,000Loss on disposal of equipment


2,000



-Fair value of warrants issued to non-employees


(6,000
)


1,000Common stock issued to consultants


8,000



-Change in fair value of warrant derivative liability


(31,000
)


(7,000
)Change in fair value of note conversion option liability


(1,076,000
)


(376,000
)Changes in assets and liabilities:Accounts receivable


55,000



(326,000
)Inventories


(210,000
)


157,000Prepaid expenses and other current assets


368,000



208,000Cash overdraft


45,000



(6,000
)Accounts payable


(157,000
)


(1,100,000
)Accrued expenses


7,000



(28,000
)Deferred revenue


924,000



(410,000
)Net cash used in operating activities of continuing operations


(627,000
)


(2,529,000
)Net cash provided by operating activities of discontinued operations


-



16,000Net cash used in operating activities


(627,000
)


(2,513,000
)Cash flows from investing activities:Purchases of property and equipment


-



(3,000
)Transfer to restricted funds, net


21,000



(25,000
)Payments received on note receivable


47,000



45,000Net cash provided by investing activities of continuing operations


68,000



17,000Net cash used in investing activities of discontinued operations


-



-Net cash provided by investing activities


68,000



17,000Cash flows from financing activities:Proceeds from common stock issued in connection with exercise

of stock options and employee stock purchase plan


2,000



-Proceeds from the issuance of senior secured promissory note


-



1,000,000Principal repayments of long-term debt and capital lease obligations


(2,000
)


(5,000
)Net borrowings on line of credit


559,000



1,833,000Net cash provided by financing activities of continuing operations


559,000



2,828,000Net cash used in discontinued operations


-



-Net cash provided by financing activities


559,000



2,828,000Net change in cash and cash equivalents


-



332,000Cash and cash equivalents at beginning of period


-



-Cash and cash equivalents at end of period

$
-


$
332,000Supplemental Disclosure of Cash Flow Information:Interest paid

$
356,000


$
20,000Non-cash Investing and Financing Activity:Series F convertible preferred stock beneficial conversion feature

$
-


$
329,000Conversion of convertible promissory note - related party


100,000



-Fair value of Series F convertible preferred stock


-



274,000







The accompanying notes are an integral part of these financial statements.









-5-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


1.
Description of Business




Implant Sciences Corporation provides systems and sensors for the homeland security market and related industries.  We have developed and acquired technologies using ion mobility spectrometry to develop a product line for use in trace explosives detection.  We currently market and sell our existing trace explosives detector products while continuing to make significant investments in developing the next generation of these products.




Sale of Accurel




In May 2007, as part of our strategic initiative to focus on our security business, we sold substantially all of the assets of our wholly owned semiconductor wafer analytical services subsidiary, Accurel Systems International Corporation, to Evans Analytical Group LLC in exchange for cash of $12,705,000, of which $1,000,000 was placed in escrow.




In February 2008, Evans filed suit against us and against John Traub, a former officer of the Company and of Accurel, requesting rescission of the acquisition agreement, plus damages, based on claims of misrepresentation and fraud.  In March 2008, Evans filed a claims notice with the escrow agent prohibiting release of any portion of the escrowed funds pending resolution of the lawsuit.  In March 2009, we announced the settlement of this litigation and the mutual release by the Company and Evans of all claims related to the sale of Accurel.  In settling this litigation, we agreed to pay Evans damages in the amount of approximately $5,700,000 by releasing to Evans approximately $700,000 that had been held in escrow since the time of the closing and issuing to Evans 1,000,000 shares of Series E Convertible Preferred Stock having an aggregate liquidation preference of $5,000,000.




Mr. Traub had demanded that we indemnify him in connection with the Evans litigation. We refused to do so, and our insurer, Carolina Casualty Company, refused to advance Mr. Traub’s litigation expenses. In April 2009, Mr. Traub filed suit for breach of contract and indemnification against us and our insurer, demanding payment of his defense costs and indemnification with respect to the Evans litigation. In June 2010, we resolved the litigation with Evans and Traub, resulting in the cancellation of 1,000,000 shares of Series E Convertible Preferred Stock (see Note 15).




Sale of Core




In November 2008, as part of our strategic initiative to focus on our security business, we sold substantially all of the assets of our wholly owned semiconductor wafer processing subsidiary, C Acquisition Corp., which had operated under the name Core Systems, to Core Systems Incorporated, an entity newly formed by the subsidiary’s general manager and certain other investors, for $3,000,000 plus the assumption of certain liabilities.




CorNova




We had partnered with CorNova, Inc., a privately-held, development stage company focused on the development of a next-generation drug-eluting stent, and were issued 1,500,000 shares of CorNova’s common stock representing a 15% ownership interest. In December 2008, we transferred our entire interest in 1,500,000 shares of the common stock of CorNova, Inc. to DMRJ Group LLC in lieu of commitment fees, closing fees and other transaction related fees in connection with our issuance of the senior secured convertible promissory note (See Note 12).




-6-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Liquidity, Going Concern and Management’s Plans




Despite our current sales, expense and cash flow projections and the cash available from our line of credit with DMRJ Group LLC, we require additional capital in the third quarter of fiscal 2011 to repay our senior secured convertible promissory note, secured promissory note and line of credit, each of which mature on March 31, 2011, to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.




In addition, while we strive to bring new products to market, we are subject to a number of risks similar to the risks faced by other technology-based companies, including risks related to: (a) our dependence on key individuals and collaborative research partners; (b) competition from substitute products and larger companies; (c) our ability to develop and market commercially usable products and obtain regulatory approval for our products under development; and (d) our ability to obtain substantial additional financing necessary to adequately fund the development, commercialization and marketing of our products.  For the three months ended September 30, 2010, we reported a loss from continuing operations of $647,000 and used $627,000 in cash from operations.  As of September 30, 2010, we had an accumulated deficit of approximately $89,979,000 and a working capital deficit of $26,375,000.  Management continually evaluates plans to reduce our operating expenses and increase our cash flow from operations.  Failure to achieve our projections may require us to seek additional financing or discontinue operations.




Based on current sales, operating expense and cash flow projections, and the cash available from our line of credit, management believes there are plans in place to sustain operations through March 31, 2011 and, if we are successful in refinancing our obligations to DMRJ, for the near future.  If we are successful in refinancing these obligations, there can still be no assurances that sales will materialize as forecasted, management will be successful in executing its business plan, and/or any capital we raise will be sufficient to fund operations indefinitely.  Management will therefore continue to closely monitor and attempt to control our costs and actively seek the needed capital through government grants and awards, strategic alliances, private financing sources, and through our lending institutions.  Future expenditures for research and product development are discretionary and can be adjusted, as can certain selling, general and administrative expenses, based on the availability of cash.  Our financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.




We have suffered recurring losses from operations.  Our consolidated financial statements have been presented on the basis that it is a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.




There can be no assurances that our forecasted results will be achieved or that we will be able to raise additional capital necessary to operate our business.  These conditions raise substantial doubt about our ability to continue as a going concern.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.




We have experienced a reduction in security revenue in the three-month period ended September 30, 2010 as compared with the comparable prior year period, relating to a decline in unit sales of our trace explosives products.  Security product sales tend to have a long sale cycle, and are often subject to export controls.  In an effort to identify new opportunities and stimulate sales, we hired additional sales personnel in the fourth quarter of fiscal 2010.  However, there can be no assurance that these efforts will increase revenue.




We have a history of being active in submitting proposals for government sponsored grants and contracts and successful in being awarded grants and contracts from government agencies. However, we have experienced a decline in government contract revenue and for the three months ended September 30, 2010 we recorded no revenues from government contracts, due to the expiration of several contracts and our inability to secure new contracts.  Management will continue to pursue these grants and contracts to support our research and development efforts primarily in the areas of trace explosives detection.




-7-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





In December 2008, we entered into a note and warrant purchase agreement with DMRJ Group LLC, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  Thereafter, we entered into a series of amendments, waivers and modifications of our facility with DMRJ.  As of the most recent amendments and modifications, entered into on September 30, 2010, we have a $10,000,000 line of credit with DMRJ and the maturity of all of our indebtedness to DMRJ has been extended until March 31, 2011 (see Note 12). For the three months ended September 30, 2010, we recorded non-cash benefits of $31,000 and $1,076,000, in our statement of operations, to record the change in fair value of the warrant derivative liability and note conversion option liability, respectively.  For the three months ended September 30, 2009, we recorded non-cash benefits of $7,000 and $376,000, in our statement of operations, to record the change in fair value of the warrant derivative liability and note conversion option liability, respectively (see Notes 13 and 14).We expect to record recurring non-cash adjustments to earnings in subsequent reporting periods, as a result of changes in fair value of the warrant and the conversion option which will be subject to, among other factors, changes from time to time in the price of our common stock.




The failure to refinance or otherwise negotiate further extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.




We are currently expending significant resources to develop the next generation of our current products and to develop new products.  We require additional funding to continue the advancement of the commercial development and manufacturing of the explosives detection system.  We will attempt to obtain such financing by: (i) government grants, (ii) private financing, or (iii) strategic partnerships.  However, there can be no assurance that we will be successful in our attempts to raise such additional financing.




We require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; the hiring of additional personnel, and acquiring capital equipment.




2.
Interim Financial Statements and Basis of Presentation




The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”).  In the opinion of management, the accompanying condensed consolidated financial statements include all adjustments (consisting only of normal recurring adjustments), which we consider necessary for a fair presentation of the financial position at such date and of the operating results and cash flows for the periods presented.  All intercompany balances and transactions have been eliminated in consolidation. The results of operations and cash flows for the three months ended September 30, 2010 may not necessarily be indicative of results that may be expected for any succeeding quarter or for the entire fiscal year.  The information contained in this Form 10-Q should be read in conjunction with our audited financial statements, included in our Form 10-K, as of and for the year ended June 30, 2010.




The balance sheet at June 30, 2010 has been derived from our audited consolidated financial statements at that date, but does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.




The accompanying condensed consolidated financial statements include our operations in Massachusetts and California.




-8-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







As a result of our decision to dispose of the medical business unit, the operating results of the medical business unit are presented in the accompanying condensed consolidated statements of operations as discontinued operations for the three months ended September 30, 2009.




Additionally, the following notes to the condensed consolidated financial statements include disclosures related to our continuing operations unless specifically identified as disclosures related to discontinued operations.




The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and judgments, which are evaluated on an ongoing basis, that affect the amounts reported in our condensed consolidated financial statements and accompanying notes.  Management bases our estimates on historical experience and on various other assumptions that it believes are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the amounts of revenues and expenses that are not readily apparent from other sources.  Actual results could differ from those estimates and judgments.  In particular, significant estimates and judgments include those related to revenue recognition, allowance for doubtful accounts, useful lives of property and equipment, inventory reserves, valuation for goodwill and acquired intangible assets.




Significant accounting policies are described in Note 2 to the financial statements included in Item 7 of our Form 10-K, as of June 30, 2010.




We have evaluated subsequent events after the balance sheet date through the date of filing of these financial statements with the SEC, for appropriate accounting and disclosure.




3.
Fair Value Measurement




The three level fair value hierarchy to classify the inputs used in measuring fair value are as follows:




Level 1 inputs to the valuation methodology are based on quoted prices (unadjusted) in active markets for identical assets or liabilities;




Level 2 inputs to the valuation methodology are based are inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly; and




Level 3 inputs to the valuation methodology are based on unobservable inputs that reflect our own assumptions that market participants would use in pricing the asset or liability.




Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.


Our financial instruments at September 30, 2010 include cash equivalents, restricted cash, accounts receivable, note receivable, accounts payable and senior secured convertible promissory note. The carrying amounts of cash and cash equivalents, restricted cash, receivables and accounts payable are representative of their respective fair values because of the short-term maturities or expected settlement dates of these instruments. The fair value of debt, as included in Note 12, is based on the fair value of similar instruments. These instruments are short-term in nature and there is no known trading market for our debt.




The following table provides the fair value measurements of assets and liabilities as of September 30, 2010:


Fair Value Measurements as of September 30, 2010Description

Carrying Value

at

Sept. 30, 2010


Quoted Prices in Active

Markets for Identical

Assets

Level 1


Significant Other

Observable

Inputs

Level 2


Significant

Unobservable

Inputs

Level 3Note conversion option liability

$
9,610,000


$
-


$
-


$
9,610,000Warrant derivative liability


247,000



-



-



247,000Senior secured convertible promissory note


3,920,000



-



-



3,920,000Senior secured promissory note


1,000,000



-



-



1,000,000


-9-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







The following table summarizes the changes in the fair value of our Level 3 financial liabilities that are measured at fair value for each reporting period:




Note Conversion Option Liability

Three Months Ended September 30,


Warrant Derivative Liability

Three Months Ended September 30,2010


2009


2010


2009Balance at July 1,

$
10,686,000


$
1,183,000


$
278,000


$
61,000Net change in fair value of financial instrument


(1,076,000
)


(376,000
)


(31,000
)


(7,000
)Balance at September 30,

$
9,610,000


$
807,000


$
247,000


$
54,000


There were no changes in the fair value of our senior secured convertible promissory note and senior secured promissory note in the three months ended September 30, 2010.




4.
Restricted Cash and Investments – Current and Long-Term




As of September 30, 2010 and June 30, 2010, we had restricted cash and investments, with maturities of less than one year, of $1,275,000 and $1,714,000, respectively and restricted investments, with maturities of more than one year, of $312,000 and $312,000, respectively.  Restricted cash and investments consisted of the following:


September 30,

2010


June 30,

2010Current assetsMoney market account

$
-


$
439,000Certificates of deposit


1,250,000



1,250,000Blocked account deposit


25,000



25,000$
1,275,000


$
1,714,000Long-term assetsCertificates of deposit


312,000



312,000$
312,000


$
312,000


The restricted investment of $439,000 held in a money market account collateralizes our performance under an irrevocable letter of credit issued on June 25, 2008, in the amount of $418,000.  The letter of credit provides performance security equal to 10% of the contract amount for security product which shipped in the first quarter of fiscal 2009. In September 2010, we entered into a supplementary agreement, effective as of February 2010, to extend the warranty period for the security product through August 2011 with China Civil Aviation Technology & Equipment Corporation (“AVITEC”).  To guarantee our performance under the supplementary warranty bond, and in view of the fact that we were not able to negotiate an extension to the existing letter of credit, AVITEC claimed compensation and drew against the letter of credit in July 2010 resulting in the transfer of $418,000 of funds held in the money market account to AVITEC.  Upon expiration of the warranty bond in August 2011, AVITEC will transfer $418,000 to us, less nominal bank fees. As of September 30, 2010, the funds transferred to AVITEC are included in our accounts receivable. The remaining funds held in the money market account, $21,000, were transferred to our operating account.




-10-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Pursuant to our agreement with DMRJ (see Note 12), we are required to maintain a balance of at least $500,000 in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement.  On December 16, 2008, we deposited $500,000 into a bank account pursuant to the blocked account agreement.  On March 12, 2009, we entered into a letter agreement with DMRJ, pursuant to which DMRJ consented to grant us access to $250,000 out of the funds held in the blocked account for a period commencing on March 12, 2009 through, but not including, April 15, 2009 at which date we were required to maintain a minimum balance of not less that $500,000 in the blocked account.  On June 24, 2009, DMRJ consented to grant us access to an additional $25,000, which was deposited into the account on July 8, 2009.  On July 16, 2009, DMRJ consented to the reduction in the minimum balance required to be maintained in the blocked account through September 3, 2009, after which time we were required to maintain a minimum balance of at least $500,000 in the blocked account.  On December 14, 2009, DMRJ consented to grant us access to the remaining $250,000 on deposit in the blocked account, of which $150,000 was applied against our obligation to DMRJ under the line of credit.  As of December 31, 2009, DMRJ waived the requirement to maintain a deposit balance of at least $500,000 in such account. As of September 30, 2010 and June 30, 2010, the balance in the blocked account was $0.




On September 4, 2009, we entered into an additional credit agreement with DMRJ. In connection with the credit agreement, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account will be applied towards the repayment of our obligations to DMRJ under the revolving note. Until the note and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.   As of September 30, 2010 and June 30, 2010, the balance in the blocked collections account was $25,000.




The restricted investments of $1,562,000 held in certificates of deposit collateralizes our performance under three irrevocable letters of credit issued in April 2010, aggregating to $1,488,000, plus the bank required collateralization deposit of $74,000: (1) provides performance security equal to 5% of the contract amount; (2) provides warranty performance security equal to 5% of the contract amount; and, (3) provides security equal to 15% of the contract amount against an advance deposit under the terms of our contract with the India Ministry of Defence. The letters of credit expire between December 21, 2010 – October 5, 2012.




5.
Stock Based Compensation




Our condensed consolidated statements of operations for the three months ended September 30, 2010 and 2009 include $65,000 and $43,000, respectively, of compensation costs and no income tax benefit related to our stock-based compensation arrangements for employee and non-employee director awards.  As of September 30, 2010, the total amount of unrecognized stock-based compensation expense was approximately $205,000, which will be recognized over a weighted average period of 3.0 years.




As of September 30, 2010, there were options outstanding to purchase 3,708,288 shares of our common stock at exercise prices ranging from $0.08 to $10.00.




6.
Related Party Transactions




In conjunction with our acquisition of Ion Metrics, Inc. in April 2008, we entered into a fixed asset lease agreement with Ferran Scientific, Inc., a firm owned by the father of the former Ion Metrics chairman. The lease, assumed as part of the Ion Metrics, Inc. acquisition, expires on December 31, 2013, under the terms of which we are leasing certain property and equipment, with annual lease payments of approximately $31,000 per year.




Robert Liscouski, a member of our Board of Directors, serves as the head of strategic and business development programs at Secure Strategy Group, a homeland security-focused banking and strategic advisory firm that has been retained by us to assist with our efforts to acquire additional capital.  During the three and three months ended September 30, 2010, this advisory firm was paid $29,000 and $63,000, respectively.  As of September 30, 2010, our obligation to the advisory firm was $29,000.




-11-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





7.
Note Payable – Related Party




On June 4, 2009, Michael Turmelle, a member of our Board of Directors, loaned $100,000 to us.  The loan bears interest at 10% and is unsecured.  In November 2009, we issued a convertible promissory note to Mr. Turmelle, a member of our Board of Directors, in consideration of a prior loan of $100,000 to us. The principal amount of the loan is convertible in whole or in part at the option of Mr. Turmelle into shares of our common stock at a conversion price of $0.08 per share.In July 2010, Mr. Turmelle, converted $100,000 of the principal amount owed by us under a promissory note into 1,250,000 shares of our common stock, at a conversion price of $0.08 per share.




As of September 30, 2010 and June 30, 2010, our obligation under the note for borrowed funds amounted to $0 and $100,000, respectively.  As of September 30, 2010, our obligation to Mr. Turmelle for accrued interest approximated $11,000.




8.
Inventories




We value our inventories at lower of cost or market.  Cost is determined by the first-in, first-out (FIFO) method, including material, labor and factory overhead.The components of inventories, net of reserves, consist of the following:




September 30,

2010


June 30,

2010Raw materials

$
429,000


$
350,000Work in progress


43,000



47,000Finished goods


698,000



563,000Total inventories

$
1,170,000


$
960,000


As of September 30, 2010 and June 30, 2010, our reserves for excess and slow-moving inventories were $43,000.




9.
Property and Equipment




Property and equipment consist of the following:




September 30,

2010


June 30,

2010Machinery and equipment

$
378,000


$
383,000Computers and software


358,000



358,000Furniture and fixtures


77,000



8,000Leasehold improvements


8,000



77,000Equipment under capital lease


61,000



61,000882,000



887,000Less:  accumulated depreciation and amortization


757,000



735,000$
125,000


$
152,000


For the three months ended September 30, 2010 and 2009, depreciation expense was approximately $26,000 and $34,000, respectively.




-12-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





10.
Accrued Expenses




Accrued expenses consist of the following:




September 30,

2010


June 30,

2010Accrued compensation and benefits

$
767,000


$
753,000Accrued taxes


617,000



603,000Accrued legal and accounting


110,000



179,000Accrued interest


858,000



705,000Accrued warranty costs


155,000



144,000Other accrued liabilities


168,000



284,000$
2,675,000


$
2,668,000


11.
Earnings Per Share




Basic earnings per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period.  Diluted earnings per share are based upon the weighted average number of common shares outstanding during the period plus additional weighted average common equivalent shares outstanding during the period.  Common equivalent shares result from the assumed exercise of outstanding stock options and warrants, the proceeds of which are then assumed to have been used to repurchase outstanding common stock using the treasury stock method and assumed conversion of certain convertible promissory notes and convertible preferred stock.  In addition, the numerator is adjusted for any changes in income or loss that would result from the assumed conversion of potential shares. As of September 30, 2010 and 2009, potentially dilutive shares would have been excluded from the earnings per share calculation, because their effect would be antidilutive.  Shares deemed to be antidilutive include stock options, warrants, convertible debt and convertible preferred stock.




Common stock equivalents excluded from the earnings per share calculation for the three months ended September 30, 2010 and 2009 were as follows:




Three Months EndedSeptember 30,

2010


September 30,

2009Common stock equivalents excludedStock options


1,708,534



115,458Warrants


897,675



208,438Convertible debt


49,955,882



57,740,536Convertible preferred stock


16,466,630



16,466,63069,028,721



74,531,062




12.
Long-Term Debt and Credit Arrangements




Med-Tec Payment Obligation




In July 2003, we entered into an asset purchase agreement with Med-Tec Iowa, Inc., our former exclusive distributor of prostate seeds, to purchase Med-Tec’s customer lists and further to release each other from further obligations under an earlier distribution agreement.  The purchase price of $1,250,000, which was payable in varying amounts over 28 months, with the final payment payable on December 1, 2005, was recorded at the present value of the future payment stream, using a rate of 10.24%, which equaled $1,007,000.  This amount was recorded as an intangible asset and was amortized over our estimated useful life of 29 months.  The outstanding and past due principal balance as of September 30, 2010 and June 30, 2010 was approximately $55,000, respectively.




-13-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Senior Secured Convertible Promissory Note, Senior Secured Promissory Note  and Revolving Credit Facility




On December 10, 2008, we entered into a note and warrant purchase agreement with DMRJ Group LLC, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  The note, which is collateralized by all of our assets, originally bore  interest at 11.0% per annum.  The effective interest rate on the note is approximately 23.4%.  We prepaid interest in the amount of $616,000 upon the issuance of the note.  In lieu of paying any commitment fees, closing fees or other fees in connection with the purchase agreement, we transferred our entire interest in 1,500,000 shares of the common stock of CorNova, Inc., a privately-held development stage medical device company, to DMRJ.  The note, which has been amended and restated, as described below, was originally convertible in whole or in part at the option of DMRJ into shares of our common stock at a conversion price of $0.26 per share.




We valued the note upon issuance at its residual value of $4,341,000 based on the fair values of the financial instruments issued in connection with this convertible debt financing, including the warrant, the fair value of the note conversion option liability and the fair value of the CorNova common stock transferred to DMRJ.  The amounts recorded in the financial statements represents the amounts attributed to the senior secured convertible debt of $5,600,000, net of the fair value of $153,000 allocated to the warrant, $638,000 allocated to the note conversion liability fair value and $468,000 representing the estimated fair value of the CorNova common stock transferred to DMRJ in the financing transaction.  The note discount was calculated based upon the residual method.  The discount on the note is being amortized to interest expense over the term of the note.  The fair value of the warrant and note conversion liability were determined using a binomial option pricing model.  See Notes 13 and 14 for the assumptions used in calculating the fair values.




For the three months ended September 30, 2010 and 2009, we recorded $0 and $625,000 to interest expense in our statement of operations, respectively, to amortize the debt discount related to the $5,600,000 senior secured convertible promissory note.  As required under the terms of the note, we made a principal payment of $1,000,000 on December 24, 2008.  The note required us to make a principal payment in an amount equal to any funds released from the escrow created in connection with the May 2007 sales of the assets of Accurel Systems International to Evans Analytical, upon the release of such funds. DMRJ waived that requirement in connection with the settlement of the subsequent litigation with Evans.




Upon adoption of ASC 815-40-15 Accounting Standards Codification (“ASC”) 815-40-15 “Derivatives and Hedging”, at July 1, 2009, we recorded a fair value note conversion option liability of $1,183,000 resulting in an $802,000 adjustment to the opening balance of accumulated deficit and reclassified the original fair value of the warrant from additional paid in capital to the warrant derivative liability as summarized in the following table:




As reported on

June 30,

2009


As adjusted on

July 1,

2009


Cumulative Effect

of Change in

Accounting PrincipleDebt discount

$
-


$
352,000


$
352,000Warrant derivative liability


-



61,000



61,000Additional paid in capital


61,290,000



61,130,000



(160,000
)Senior secured convertible promissory note


4,049,000



4,119,000



70,000Note conversion option liability


-



1,183,000



1,183,000Accumulated deficit


(72,678,000
)


(73,480,000
)


(802,000
)




For the three ended September 30, 2010 and 2009, we recorded non-cash benefits of $1,076,000 and $376,000, respectively, in our statement of operations to record the change in fair value of the note conversion option liability. Fair value is estimated using a binomial option pricing model, which includes variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors. Changes in any of these variables could result in material adjustments to the expense recognized for changes in the valuation of the note conversion liability (see Note 13).




-14-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







The note contains restrictions and financial covenants including:  (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring  any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the surviving entity; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business and excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of shares of our common stock issuable upon exercise of  the warrant; that we maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00.




On March 12, 2009, we entered into a letter agreement with DMRJ pursuant to which we were granted access to $250,000 of previously restricted cash out of funds held in a blocked account.  The effect of the letter agreement made $250,000 available to us until the close of business on April 14, 2009. In consideration of the letter agreement, on March 12, 2009, we issued an amended and restated senior secured convertible promissory note and amended and restated warrant to DMRJ to purchase shares of common stock, which replaced the note and warrant issued on December 10, 2008.  The terms of the amended and restated note and the amended and restated warrant are identical to the terms of the original note and warrant, except that the amended instruments reduced the initial conversion price of the original note from $0.26 to $0.18 and reduced the initial exercise price of the original warrant from $0.26 to $0.18.




On July 1, 2009, we entered into an amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000. We valued the note at its residual value of $726,000 based on the relative fair value of the Series F Convertible Preferred Stock issued in conjunction with the note (see Note 16).




The note, which has been amended, as described below, originally bore interest at the rate of 2.5% per month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable on the earlier of (i) December 10, 2009 and (ii) the receipt by us of net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities in one or more transactions. In addition, at our option, DMRJ may require us to prepay such amounts upon (i) certain consolidations, mergers and business combinations involving us; (ii) the sale or transfer of more than 50% of our assets, other than inventory sold in the ordinary course of business, in one or more related or unrelated transactions; or (iii) the issuance by us, in one or more related or unrelated transactions, of any equity securities or securities convertible into equity securities (other than options granted to employees and consultants pursuant to employee benefit plans approved by our Board of Directors), which results in net cash proceeds to us of more than $500,000; provided, however, that DMRJ may not require us to prepay more than the net cash proceeds of any transaction described in the preceding clause (iii) of this sentence. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ.




The amendment to the loan agreement provides that, in the event we have not obtained net proceeds from the issuance of debt or equity securities upon terms and conditions acceptable to DMRJ in its sole discretion of (i) $1,000,000 by July 24, 2009 and (ii) to the extent that we satisfied such requirements, an additional $2,000,000 by August 21, 2009, we will immediately engage in a sale process satisfactory to DMRJ in its sole discretion by implementing a contingency plan which may be established by DMRJ, including, without limitation, the engagement at our expense of a third party investment banker acceptable to DMRJ in its sole discretion.  We did not satisfy these requirements and, in August 2009, we engaged Pickwick Capital Partners to market our company for sale. As of September 30, 2010, we have not received any satisfactory proposals to acquire the company and are not actively marketing the company for sale.




-15-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







In connection with the additional note issued on July 1, 2009, we also issued 871,763 shares of our Series F Convertible Preferred Stock to DMRJ, and agreed that, if we were unable to obtain net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities by August 31, 2009, we would issue 774,900 additional shares of Series F Preferred Stock to DMRJ. DMRJ later extended this deadline until October 1, 2009. We did not satisfy this requirement and issued the additional shares to DMRJ. The Series F Preferred Stock is convertible into that number of share of common stock which equals the original issue price of the Series F Preferred Stock ($0.08 per share) divided by the “Series F Conversion Price: (initially, $0.08 per share) multiplied by ten.  As of the issuance date of the Series F Preferred Stock, all of the 1,646,663 shares of Series F Preferred Stock held by DMRJ were convertible into 16,466,630 shares of common stock, or 25% of our common stock, calculated on a fully diluted basis. In the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the Series F Conversion Price then in effect, the Series F Conversion Price will be automatically adjusted to equal the price per share at which such shares are issued.  This reset provision completely protects an investor’s investment from subsequent price erosion until the occurrence of a liquidity event.  The anti-dilution protection will not apply, however, to issuances of stock and options to our employees, directors, consultants and advisors pursuant to any equity compensation plan approved by our stockholders.




In addition, for so long as the July 2009 note or the amended and restated senior secured convertible promissory note issued to DMRJ in March 2009 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issue to DMRJ that number of additional shares of Series F Preferred Stock which is necessary to result in the number of shares of common stock into which all Series F Preferred Stock held by DMRJ may be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto. After the repayment in full of the promissory notes, described above, the number of shares of common stock into which the Series F Preferred Stock is convertible will remain subject to reset provisions in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the Series F Conversion Price then in effect.




The Series F Preferred Stock is entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our common stock. In the event of any liquidation, dissolution or winding up of our company, the holders of the Series F Preferred Stock will be entitled to be paid an amount equal to $.08 per share of Series F Preferred Stock, plus any declared but unpaid dividends, prior to the payment of any amounts to the holders of our Series E Convertible Preferred Stock or common stock by reason of their ownership of such stock.




The holders of the Series F Preferred Stock have no voting rights except as required by applicable law. However, without the consent of the holders of a majority of the Series F Preferred Stock, we may not (i) amend, alter or repeal any provision of our Amended and Restated Articles of Organization or By-laws in a manner that adversely affects the powers, preferences or rights of the Series F Preferred Stock; (ii) authorize or issue any equity securities (or any equity or debt securities convertible into equity securities) ranking prior and superior to the Series F Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up; or (iii) consummate any capital reorganization or reclassification of any of our equity securities (or debt securities convertible into equity securities) into equity securities ranking prior and superior to the Series F Preferred Stock with respect to dividends, distributions, redemption rights or rights upon liquidation, dissolution or winding up.




On August 5, 2009, we entered into a second amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued DMRJ a bridge note in the principal amount of $700,000.  The note bore interest at the rate of 25% per annum. The outstanding principal balance and all interest due under this bridge note was paid on September 4, 2009.




-16-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





On September 4, 2009, we entered into an additional credit agreement with DMRJ, pursuant to which DMRJ provided us with a revolving line of credit in the maximum principal amount of $3,000,000. In connection with the credit agreement, we issued a promissory note to DMRJ evidencing our obligations under the credit facility. Each of our subsidiaries guaranteed our obligations under the credit facility. Our obligations and our subsidiaries’ obligations are secured by grants of first priority security interests in all of our respective assets. In addition, we agreed to cause all of our receivables and collections to be deposited in a bank deposit account pledged to DMRJ pursuant to a blocked account agreement. All funds deposited in the blocked collections account will be applied towards the repayment of our obligations to DMRJ under the note. Until the note and all of our obligations thereunder have been paid and satisfied in full, we will have no right to access or make withdrawals from the blocked account without DMRJ’s consent.




The note, which has been amended, as described below, originally bore interest at the rate of 25% per annum. Interest under the note is due on the first day of each calendar month. The principal balance of the note, together with all outstanding interest and all other amounts owed under the note, was originally due and payable on December 10, 2009. We may prepay all or any portion of the principal amount of the note, without penalty or premium, after prior notice to DMRJ. Subject to applicable cure periods, amounts due under the note are subject to acceleration upon certain events of default, including: (i) any failure to pay when due any amount owed under the note; (ii) any failure to observe or perform any other condition, covenant or agreement contained in the note or certain conditions, covenants or agreements contained in the credit agreement; (iii) certain suspensions of the listing or trading of our common stock; (iv) a determination that any misrepresentation made by us to DMRJ in the credit agreement or in any of the agreements delivered to DMRJ in connection with the credit agreement were false or incorrect in any material respect when made; (v) certain defaults under agreements related to any of our other indebtedness; (vi) the institution of certain bankruptcy and insolvency proceedings by or against us; (vii) the entry of certain monetary judgments against us that are not dismissed or discharged within a period of 20 days; (viii) certain cessations of our business in the ordinary course; (ix) the seizure of any material portion of our assets by any governmental authority; and (x) our indictment for any criminal activity.




In lieu of paying DMRJ any commitment fees, closing fees or other fees in connection with the credit agreement, we agreed to pay DMRJ an additional amount equal to 50% of or aggregate net profits, as defined, generated between the closing date through the termination of the credit facility. Such payments will be due and payable as earned upon (i) each request for an advance under the note, and (ii) the termination of the credit facility.  For the period September 4, 2009 through September 30, 2010, we experienced a net loss and no such payments were due or payable to DMRJ as of September 30, 2010.




Upon the closing of the credit facility, we requested and were granted an initial advance of approximately $1,633,000, of which we used approximately $715,000 to repay all of our outstanding indebtedness to DMRJ pursuant to the bridge note issued to DMRJ on August 5, 2009, and approximately $548,000 to retire certain obligations owed to other parties. We used the balance of the initial advance for working capital and ordinary course general corporate purposes.




On December 20, 2009, we received written notice from DMRJ, stating that we were in default of our obligations under each of the promissory notes described above. On December 10, 2009, we failed to pay an aggregate of $7,505,678 in principal, together with approximately $149,292 of interest, due on such date to DMRJ upon the maturity of those notes.




As a result of these defaults, effective December 11, 2009, (i) the interest rate that we are obligated to pay to DMRJ under the promissory note issued in March 2009 automatically increased from 11% per annum to 2.5% per month (or the maximum applicable legal interest rate, if less); (ii) the interest rate that we are obligated to pay to DMRJ under the promissory note issued in July 2009 automatically increased from 2.5% per month to 3.0% per month (or the maximum applicable legal interest rate, if less); and (iii) the interest rate that we are obligated to pay to DMRJ under the promissory note issued in September 2009 increased from 25% per annum to 30% per annum (or the maximum applicable legal interest rate, if less). All such default interest is payable upon demand by DMRJ.




-17-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





On December 31, 2009, we received written notice from DMRJ, withdrawing its December 20, 2009 default notice.  Also on December 31, 2009, DMRJ elected to convert $120,000 of the principal amount owed by us under one of the promissory notes into 1,500,000 shares of our common stock, at an adjusted conversion price of $.08 per share. DMRJ has subsequently converted additional portions of our indebtedness on similar terms. Under the promissory notes and related agreements, however, DMRJ may not convert any portion of the notes if the number of shares of common stock to be issued pursuant to such conversion, when aggregated with all other shares of common stock owned by DMRJ at such time, would result in DMRJ beneficially owning in excess of 4.99% of the then issued and outstanding shares of common stock. DMRJ may waive such limitation by providing us with 61 days prior written notice.




On January 12, 2010, we entered into an omnibus waiver and first amendment to credit agreement and third amendment to note and warrant purchase agreement with DMRJ pursuant to which: (i) our line of credit under the September 2009 credit agreement was increased from $3,000,000 to $5,000,000; (ii) the maturity of all of our indebtedness to DMRJ, including indebtedness under (a) the March 2009 amended and restated promissory note, (b) the July 2009 promissory note and (c) the September 2009 revolving promissory note, was extended from December 10, 2009 to June 10, 2010; (iii) DMRJ waived all existing defaults under all of these notes and all related credit agreements through the new maturity date of June 10, 2010; (iv) the interest rate payable on our obligations under each of these promissory notes was reduced to 15% per annum; (v) all arrangements pursuant to which we were to share with DMRJ any profits resulting from certain transactions was removed from the credit documents; (vi) we agreed to certain limitations on equity financings without DMRJ’s prior consent; and (vii) we agreed that we will not prepay more than $3,600,000 of the $5,600,000 of indebtedness owed to DMRJ under the March 2009 amended and restated promissory note without DMRJ’s prior consent.




On April 23, 2010, we entered into an omnibus second amendment to credit agreement and fourth amendment to note and warrant purchase agreement with DMRJ pursuant to which: (i) our line of credit under the September 2009 credit agreement was increased from $5,000,000 to $10,000,000; and (ii) the maturity of all of our indebtedness to DMRJ, including indebtedness under each of the promissory notes described in the preceding paragraph was extended from June 10, 2010 to September 30, 2010.




On September 30, 2010, we entered into an omnibus third amendment to the credit agreement and fifth amendment to note and warrant purchase agreement  pursuant to which the maturity of all of the our indebtedness to DMRJ, including indebtedness in the preceding paragraphs, was extended from September 30, 2010 to March 31, 2011.




As of September 30, 2010 our obligation to DMRJ under the senior secured convertible promissory note, as amended, the senior secured promissory note and under the credit facility approximated $3,920,000, $1,000,000 and $8,702,000, respectively. Further, as of September 30, 2010, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $836,000.




As of February 28, 2011, our obligations to DMRJ under the amended and restated senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $3,680,000, $1,000,000 and $12,325,000, respectively.  Further, as of February 28, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $1,139,000.




The failure to refinance or otherwise negotiate extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.


-18-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding and the notes may be immediately callable.




13.
Note Conversion Option Liability




ASC 815-40-15, “Derivatives and Hedging,” requires issuers to record, as liabilities, financial instruments that provide for reset provisions as an adjustment mechanism to the relevant exercise or conversion price, since they are not deemed to be indexed to our common stock. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. In our December 10, 2008 financing transaction with DMRJ Group LLC, we issued a senior secured promissory note in the principal amount of $5,600,000. The promissory note contains reset provisions, in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the note conversion price, the conversion price will be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. The conversion option liability should initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three months ended September 30, 2010 and 2009, we recorded non-cash benefits of $1,076,000 and $376,000, respectively, in our statement of operations. Fair value is estimated using a binomial option pricing model, which includes variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors.  The note conversion option liability was valued using a binomial option pricing model, with the following assumptions on the following dates:




Note Conversion Option Liability - Fair Value CalculationJuly 1,

2009


September 30,

2009


June 30,

2010


September 30,

2010Convertible debt amount

$
4,600,000


$
4,600,000


$
3,920,000


$
3,920,000Potential number of convertible shares


57,500,000



57,500,000



49,000,000



49,000,000Conversion price

$
0.08


$
0.08


$
0.08


$
0.08Stock price on date of measurement

$
0.08


$
0.08


$
0.30


$
0.26Expected volatility


93.7
%


95.5
%


157.1
%


165.1
%Expected dividend yield


0.0
%


0.0
%


0.0
%


0.0
%Risk free interest rate


0.3
%


0.1
%


0.2
%


0.2
%Expected term (years)


0.44



0.19



0.25



0.50Fair value

$
1,183,000


$
807,000


$
10,686,000


$
9,610,000




We considered several factors in determining the value of our common stock for use in the binomial option model calculation.  Due to our financial condition, our common is not traded on a national exchange, but is traded on the Over-the-Counter Bulletin Board. Quotations from the Over-the-Counter Bulletin Board reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. We have issued a warrant, a convertible debt instrument and a convertible preferred stock instrument which are convertible into a significant number of common shares to DMRJ, our primary investor.   In addition we have considered the historical daily trading volume of our stock and the potential impact that a significant issuance of share of our common stock would have on our stock price.  Due to these factors, we applied a 20% discount to the price of our stock on the date of the calculation of the note conversion option liability.




-19-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS








The fair value of the note conversion option liability will be measured at the end of each reporting period and the hange in fair value will be reported in our statement of operations.  Upon adoption of ASC 815-40-15 at July 1, 2009, we recorded a fair value note conversion option liability of $1,183,000 resulting in an $802,000 adjustment to the opening balance of accumulated deficit.




14.
Warrant Derivative Liability





ASC 815-40-15, “Derivatives and Hedging,” requires freestanding contracts that are settled in our own stock, including common stock warrants to be designated as an equity instrument, asset or liability. Under the provisions of ASC 815-40-15, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. In our December 10, 2008 financing transaction with DMRJ Group LLC, we issued a warrant to purchase 1,000,000 shares of our common stock. The warrant contains reset provisions, in the event that we issue additional shares of common stock (or securities convertible into or exercisable for additional shares of common stock) at a price below the exercise price, the warrant will be automatically adjusted to equal the price per share at which such shares are issued or deemed to be issued. The warrant derivative liability should initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three and three months ended September 30, 2010, we recorded non-cash benefits of $31,000 and $7,000, respectively in our statement of operations. Fair value is estimated using a binomial option pricing model, which includes variables such as the expected volatility of our share price, interest rates, and dividend yields. These variables are projected based on our historical data, experience, and other factors. The warrant derivative liability was valued using a binomial option pricing model, with the following assumptions on the following dates:




Warrant Derivative Liability - Fair Value CalculationJuly 1,

2009


September 30,

2009


June 30,

2010


September 30,

2010Shares eligible to be purchased


1,000,000



1,000,000



1,000,000



1,000,000Exercise price

$
0.08


$
0.08


$
0.08


$
0.08Stock price on date of measurement

$
0.08


$
0.08


$
0.30


$
0.26Expected volatility


104.0
%


89.7
%


157.1
%


161.0
%Expected dividend yield


0.0
%


0.0
%


0.0
%


0.0
%Risk free interest rate


2.7
%


2.4
%


1.2
%


0.7
%Expected life


4.50



4.19



3.44



3.19Fair value

$
61,000


$
54,000


$
278,000


$
247,000


We considered several factors in determining the value of our common stock for use in the binomial option model calculation.  Due to our financial condition, our common is not traded on a national exchange, but is traded on the Over-the-Counter Bulletin Board. Quotations from the Over-the-Counter Bulletin Board reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions. We have issued a warrant, a convertible debt instrument and a convertible preferred stock instrument which are convertible into a significant number of common shares to DMRJ, our primary investor.   In addition we have considered the historical daily trading volume of our stock and the potential impact that a significant issuance of share of our common stock would have on our stock price.  Due to these factors, we applied a 20% discount to the price of our stock on the date of the calculation of the warrant derivative liability.




-20-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







We originally recorded the fair value of this warrant of approximately $160,000 as an increase to additional paid in capital.  Upon adoption of ASC 815-40-15 at July 1, 2009, we reclassified $160,000 from additional paid in capital to the warrant derivative liability. The fair value of the warrant derivative liability will be measured at the end of each reporting period and the change in fair value will be reported in our statement of operations.




15.
Series E Convertible Preferred Stock




In March 27, 2009, we announced the settlement of our litigation and the mutual release by us and Evans Analytical Group, LLC of all claims related to the sale of Accurel.  In settling this litigation, we issued 1,000,000 shares of Series E Convertible Preferred Stock, having an aggregate liquidation preference of $5,000,000.  The preferred stock, however, is subject to cancellation, without consideration and without liability to us, under certain conditions related to our continued cooperation in the pursuit (as controlled and funded by Evans and its counsel) of certain claims against a former officer of ours and Accurel related to the sale of Accurel to Evans, including the outcome of such litigation.  The stock must be redeemed by us at the aggregate liquidation preference on the tenth anniversary of the issuance, unless earlier redeemed, cancelled or converted.  The stock is convertible into common stock under various scenarios, by either party after the ninth anniversary of the settlement agreement, and under certain other circumstances.  The preferred stock will be entitled to participate on an “as converted” basis in all dividends or distributions declared or paid on our common stock and holders of the preferred stock will have no voting rights except as required by applicable law.  Accounting Standards Codification (“ASC”) 480 “Distinguishing Between Liabilities from Equity” requires that financial instruments with redemption features, not solely within the control of the issuer, be classified as temporary equity, outside of permanent equity.




On April 2, 2009, John Traub, a former officer of the company and Accurel, filed a complaint in the California Superior Court, Santa Clara County, for breach of contract and indemnification against us and our insurer, Carolina Casualty Company.  The complaint seeks defense costs and indemnification with respect to lawsuits filed against Traub by Evans Analytical Group.   On June 21, 2010, we resolved the litigation with Evans and Traub, resulting in the cancellation of 1,000,000 shares of Series E Convertible Preferred Stock.




16.
Series F Convertible Preferred Stock




In connection with the July 1, 2009 amendment to the December 10, 2008 note and warrant purchase agreement with DMRJ, pursuant to which we issued a senior secured promissory note to DMRJ in the principal amount of $1,000,000, we issued 871,763 shares of our Series F Convertible Preferred Stock.   The 871,763 shares of Series F Preferred Stock issued to DMRJ are convertible at the option of DMRJ into 15% of our common stock, calculated on a fully diluted basis.




Because we did not obtain net proceeds of at least $3,000,000 from the issuance of debt and/or equity securities by August 31, 2009 (later extended by DMRJ to October 1, 2009), we were required to issue to DMRJ 774,900 additional shares of Series F Preferred Stock. Upon the issuance of those shares, all of the Series F Preferred Stock then held by DMRJ was convertible into 25% of our common stock, calculated on a fully diluted basis. In addition, for so long as the promissory note issued in July 2009 or the amended and restated promissory note issued in March 2009 remain outstanding, we may not issue additional shares of common stock, or other securities convertible into or exercisable for common stock, if such securities would increase the number of shares of our common stock, calculated on a fully diluted basis, unless we simultaneously issues to DMRJ that number of additional shares of Series F Preferred Stock which is necessary to result in the number of shares of common stock into which all Series F Preferred Stock held by DMRJ may be converted representing the same percentage ownership of our common stock on a fully diluted basis after such issuance as immediately prior thereto (see Note 12).




-21-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS







As of the date of issuance, we have recorded the relative fair value of the Series F Preferred Stockof approximately $274,000 against the July 1, 2009 senior secured promissory note, which is accreted to the note over the life of the note.  The fair value of the Series F Preferred Stock is equal to the fair value of the company, defined as the product of our common shares outstanding times the closing price of our common stock on the date of issuance, multiplied by 25%. For the three months ended September 30, 2010 and 2009, $0 and $154,000, respectively, was accreted to the note and is recorded as interest expense in our statement of operations.   Accounting Standards Codification (“ASC”) 470-20 “Debt,” addresses the accounting for convertible instruments with beneficial conversion features.  In accordance with ASC 470-20, a conversion feature is beneficial, or “in the money,” when the conversion rate of the convertible security is below the market price of the underlying common stock.  A beneficial conversion feature, calculated as of the commitment date, is the difference between the convertible instruments conversion price and the fair value of the company’s common stock on that date multiplied by the number of common shares the Series F Preferred Stock converts into. On July 1, 2009 and August 31, 2009, the commitment dates for the Series F Preferred stock issuances, the fair value of our common stock was $0.10. The initial conversion price of the Series F Preferred Stock was $0.08 per share.  As of July 1, 2009 and August 31, 2009, the beneficial conversion feature on the Series F Preferred Stock was $329,000 and is accounted for as a deemed dividend.




17.
Stockholders’ Equity




Common Stock Options and Warrants




In connection with various financing agreements and services provided by consultants, we have issued warrants to purchase shares of our common stock.  The fair value of warrants issued is determined using an option pricing model.  In December 2008, in conjunction with the issuance of the senior secured convertible note to DMRJ, we issued a five-year warrant to purchase 1,000,000 shares of common stock at an initial exercise price of $0.26 per share.  The warrant is exercisable between December 10, 2008 and December 10, 2013.  We recorded the fair value of this warrant of approximately $160,000 against the senior secured convertible promissory note, which is accreted to the note and interest expense is recorded over the life of the note. In consideration of DMRJ’s execution of the letter agreement on March 12, 2009, we issued an amended and restated warrant to purchase shares of common stock, to reduce the initial exercise price of the warrant from $0.26 to $0.18. As a result of the issuance of the Series F Preferred Stock, the exercise price of the warrant was automatically reduced under its reset provisions to $0.08.  We adopted ASC 815-40-15 as of July 1, 2009 and reclassified $160,000 from additional paid in capital to the “Warrant Derivative Liability.” The warrant derivative liability should initially and subsequently be measured at fair value with changes in fair value recorded in earnings in each reporting period. For the three months ended September 30, 2010 and 2009, we recorded non-cash benefits of $31,000 and $7,000, respectively, in our statement of operations (see Note 14). As of September 30, 2010, there were warrants outstanding to purchase 2,004,791 shares of our common stock at exercise prices ranging from $0.08 to $12.45 expiring at various dates between October 14, 2010 and June 27, 2015.




During the three months ended September 30, 2010 and 2009, we issued 12,420 and 0 shares of our common stock as a result of the exercise of options by our employees.




Employee Stock Purchase Plan




During the three months ended September 30, 2010, and 2009 we did not issue any shares of common stock to our employees pursuant to the terms of the 2006 Employee Stock Purchase Plan.




Treasury Stock and Other Transactions




In June 2004, our Board of Directors authorized us to repurchase up to 300,000 shares of our common stock, from time to time in the open market, privately negotiated transactions, block transactions or at time and prices deemed appropriate by management.  As of September 30, 2010 and June 30, 2009, 10,545 shares were held in treasury at cost.  During each of the three months ended September 30, 2010 and 2009, we repurchased no shares of our common stock.  As of September 30, 2010, the maximum number of shares authorized to be repurchased were 289,455.




-22-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





18.
Income Taxes




We use the liability method to account for income taxes. Under this method, deferred taxes are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect in the years in which the differences are expected to reverse.  Deferred tax assets are recognized and measured based on the likelihood of realization of the related tax benefit in the future. The accounting standard clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The standard also provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. At the adoption date and as of September 30, 2010, we had no material unrecognized tax benefits and no adjustments to liabilities or operations were required.




For the three months ended September 30, 2010 and 2009, we provided for no taxes as we have significant net loss carryforwards.




19.
Commitments and Contingencies




We lease manufacturing, research and office space in Wilmington, MA, the lease of which expires on January 31, 2015.  Under the terms of the lease, we are responsible for our proportionate share of real estate taxes and operating expenses relating to this facility.  Effective with the sale of the assets of Accurel Systems on May 1, 2007, we executed a sublease agreement for one of our California facilities.  As a result of the Ion Metrics acquisition, we assumed a lease for research and office space in San Diego, CA, which lease was renewed and expires on January 31, 2012.  Total rent expense, including assessments for maintenance and real estate taxes for the three months ended September 30, 2010 and 2009, for both continuing and discontinued operations was $70,000 and $126,000, respectively.




In conjunction with the acquisition of Accurel, in March 2005, we assumed a lease for research and office space in Sunnyvale, CA, which lease initially expires in September 2010 and recorded a lease liability of $829,000.  This liability reflected management’s estimate of the excess of payments required under the Accurel facility lease, at the date of acquisition, versus the fair market value of lease payments that would have been required, had the lease been negotiated under current market conditions.  Subsequently, as a result of the sale of Accurel, we have recorded an additional liability of $487,000 representing that portion of the lease in excess of the sublease arrangement between Accurel Systems and Evans Analytical Group, LLC.




In April 2009, Silicon Valley CA-I, LLC, the lessor of such property to Accurel, filed suit against Accurel and Evans in the Superior Court of the State of California, County of Santa Clara, alleging nonpayment of rent. On June 24, 2009, Accurel entered into a release and settlement agreement with the lessor, under the terms of which Accurel was required to pay $224,840, representing the amounts that are past due under the lease, plus monthly rents owing under the lease, less the payment that Evans is required to make under the terms of the settlement agreement.  Accurel was required to pay such amount on or before September 4, 2009.   On September 4, 2009, Accurel remitted the settlement payment.  In accordance with the release and settlement agreement, provided that Accurel and Evans have complied with the terms of the lease and payment in accordance with the agreement, the lessor has agreed to dismiss the suit on or before September 14, 2009 and Accurel will have no further obligations or liabilities to the lessor.  On October 28, 2009, the request for dismissal was entered with the Superior Court of the State of California, County of Santa Clara.  As a result of the dismissal of litigation, we recorded a lease termination benefit of $384,000 related to Accurel’s lease obligations in the year ended June 30, 2010. The balance of the lease liability on September 30, 2010 and 2009 was $0 and $451,000, respectively.




In April 2007, in conjunction with our plans to conduct research, development and minor manufacturing work in New Mexico, we executed an operating lease which was initially to expire on May 1, 2010.  The lease allowed for early termination, which we elected in February 2008.  As a result of the early termination, we are responsible for reimbursing the landlord for certain leasehold improvements over a 24-month period.  As of September 30, 2010, the balance due is approximately $27,000 and is included in current liabilities.




-23-
 IMPLANT SCIENCES CORPORATION
  NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





20.
Financial Information By Segment




Operating segments are defined as components of an enterprise about which separate financial information is available that is regularly evaluated by the chief operating decision maker or decision making group, in determining how to allocate resources and in accessing performance.  Our chief operating decision making group is composed of the chief executive officer and members of senior management.  Based on qualitative and quantitative criteria, we have determined that we operate within one reportable segment, which is the Security Products Segment.




21.
Discontinued Operations




Medical Business Unit




The accompanying condensed consolidated balance sheets and statements of operations present the results of the Medical Business Unit as discontinued operations.




Condensed results of operations relating to the Medical Business Unit for the three months ended September 30, 2009 are as follows:


Three Months Ended

September 30,

2009Revenues

$
-Gross profit


(20,000
)Operating loss


(20,000
)Loss from discontinued operations

$
(20,000
)




22.
Legal Proceedings




From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities.  Each of these matters is subject to various uncertainties.




We may, from time to time, be involved in other actual or potential proceedings that it considers to be in the normal course of our business.  We do not believe that any of these proceedings will have a material adverse effect on our business.




-24-


Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations




Cautionary Note Regarding Forward-Looking Statements




This Quarterly Report on Form 10-Q contains certain statements that are “forward-looking” within the meaning of the Private Securities Litigation Reform Act of 1995 (the “Litigation Reform Act”).  These forward looking statements and other information are based on our beliefs as well as assumptions made by us using information currently available.




The words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “will,” “should” and similar expressions, as they relate to us, are intended to identify forward-looking statements.  Such statements reflect our current views with respect to future events, are subject to certain risks, uncertainties and assumptions, and are not guaranties of future performance.  Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected, intended or using other similar expressions.




In accordance with the provisions of the Litigation Reform Act, we are making investors aware that such forward-looking statements, because they relate to future events, are by their very nature subject to many important factors that could cause actual results to differ materially from those contemplated by the forward-looking statements contained in this Report. Important factors that could cause actual results to differ from our predictions include those discussed under this “Management’s Discussion and Analysis” and under “Risk Factors.”  Although we have sought to identify the most significant risks to our business, we cannot predict whether, or to what extent, any of such risks may be realized, nor can there be any assurance that we have identified all possible issues which we might face.  In addition, assumptions relating to budgeting, marketing, product development and other management decisions are subjective in many respects and thus susceptible to interpretations and periodic revisions based on actual experience and business developments, the impact of which may cause us to alter our marketing, capital expenditure or other budgets, which may in turn affect our financial position and results of operations.  For all of these reasons, the reader is cautioned not to place undue reliance on forward-looking statements contained herein, which speak only as of the date hereof.  We assume no responsibility to update any forward-looking statements as a result of new information, future events, or otherwise except as required by law.  We urge readers to review carefully the risk factors described in this Quarterly Report, in our Annual Report on Form 10-K for the fiscal year ended June 30, 2010 and in the other documents that we file with the Securities and Exchange Commission.  You can read these documents atwww.sec.gov.




Overview




We develop, manufacture and sell sophisticated sensors and systems for the Security, Safety and Defense (“SS&D”) industries.  A variety of technologies are currently used worldwide in security and inspection applications.  In broad terms, the technologies focus on detection in two major categories: (i) the detection of “bulk” contraband, which includes materials that would be visible to the eye, such as weapons, explosives, narcotics and chemical agents; and (ii) the detection of “trace” amounts of contraband, which includes trace particles or vapors of explosives, narcotics and chemical agents.  Technologies used in the detection of “bulk” materials include computed tomography, transmission and backscatter x-ray, metal detection, trace detection and x-ray, gamma-ray, passive millimeter wave, and neutron analysis.  Trace detection techniques include mass spectrometry, gas chromatography, chemical luminescence, or ion mobility spectrometry.




We have developed proprietary technologies used in explosives trace detection (“ETD”) applications and market and sell handheld and benchtop ETD systems that use our proprietary ETD technologies.  Our products are marketed and sold to a growing number of locations domestically and internationally.  These systems are used by private companies and government agencies to screen baggage, cargo, vehicles, other objects and people for the detection of trace amounts of explosives.




History




Since our incorporation in August 1984, we have operated as a multi-faceted company engaging in the development of ion-based technologies and providing commercial services and products to the semiconductor, medical device and security industries.  As further discussed in the Business Strategy section below, however, we have divested our semiconductor and medical business activities in order to focus on our security business.




-25-


Semiconductor Business Unit




Our business began as a result of the development of our proprietary ion-beam technology and application of this technology in services to the semiconductor industry.  At the outset, our initial business was to provide ion implantation services to the semiconductor industry for surface modification of silicon wafers.  Our services were provided to semiconductor companies, universities and research facilities as an outsource provider of these ion implantation services.  These services were performed at our Massachusetts facility, where we maintained and operated several ion implanters.




In November 2008, as part of our strategic initiative to focus on our security business, we sold substantially of all the assets of our wholly owned semiconductor wafer processing subsidiary, C Acquisition Corp., which had operated under the name Core Systems, to Core Systems Incorporated, an entity newly formed by the subsidiary’s general manager and certain other investors, for $3,000,000 plus the assumption of certain liabilities.  For the year ended June 30, 2009, the operations of Core Systems have been recorded in our statements of operations as discontinued operations.




In May 2007, as part of our strategic initiative to focus on our security business, we sold substantially all of the assets of our wholly owned semiconductor wafer analytical services subsidiary, Accurel Systems International Corporation, to Evans Analytical Group LLC in exchange for cash of $12,705,000, of which $1,000,000 was placed in escrow.




In February 2008, Evans filed suit against us and against John Traub, a former officer of the Company and of Accurel, requesting rescission of the acquisition agreement, plus damages, based on claims of misrepresentation and fraud.  In March 2008, Evans filed a claims notice with the escrow agent prohibiting release of any portion of the escrowed funds pending resolution of the lawsuit.  On March 27, 2009, we announced the settlement of this litigation and the mutual release by the Company and Evans of all claims related to the sale of Accurel.  In settling this litigation, we agreed to pay Evans damages in the amount of approximately $5,700,000 by releasing to Evans approximately $700,000 that had been held in escrow since the time of the closing and issuing to Evans 1,000,000 shares of Series E Convertible Preferred Stock having an aggregate liquidation preference of $5,000,000.




Mr. Traub had demanded that we indemnify him in connection with the Evans litigation. We refused to do so, and our insurer, Carolina Casualty Company, refused to advance Mr. Traub’s litigation expenses. In April 2009, Mr. Traub filed suit for breach of contract and indemnification against us and our insurer, demanding payment of his defense costs and indemnification with respect to the Evans litigation. On June 21, 2010, we resolved the litigation with Evans and Traub, resulting in the cancellation of 1,000,000 shares of Series E Convertible Preferred Stock. Please see more detailed discussions of the Evans matter in Note 15 to our condensed consolidated financial statements.




Medical Business Unit




We also used our ion beam technology to develop ion implantation and thin film coatings applications for medical devices.  As a result of these technologic advancements, which were in part funded by government research grants and awards, we were able expand our business and provide services and products to the medical industry.  The primary medical related businesses in which we engaged were (i) providing services to medical device companies for surface modification of implantable devices, (ii) the development of brachytherapy products, and (iii) the manufacture and sales of our proprietary radioactive seeds for the treatment of prostate cancer.




We provided ion implantation services to modify orthopedic joint implant surfaces, resulting in reduced polyethylene wear and increased implant life, through the second quarter of fiscal 2007.  In the second quarter of fiscal 2007, the customer discontinued its product line using our ion implantation services.  Using similar technology, we developed applications for coatings of cardiovascular devices, such as coronary stents.  In May 1999, we received Food and Drug Administration 510(k) clearance to market our radioactive seed for the treatment of prostate cancer.  We began commercial sales of our radioactive seed in fiscal 2001.




In further support of our strategic initiative to focus on our security business, in June 2007, we sold certain of the assets related to our brachytherapy products and divested our prostate seed and medical software businesses.  In March 2008, we informed our medical coatings customers of our intention to discontinue coating operations by the end of the 2008 calendar year. For the three ended September 30, 2009, the operations of the Medical Business Unit have been recorded in our statements of operations as discontinued operations.




-26-


Security Business Unit




Since May 1999, we have been performing research to improve ETD technology, and development of ETD products that can be used for detection of trace amounts of explosives.  At present, we have developed both portable and benchtop systems, which have been marketed and sold both domestically and internationally.  In order to reduce manufacturing costs and be responsive to large quantity orders, we use a contract manufacturer.  As we continue to sell and deliver our security products, we work both independently and in conjunction with various government agencies to develop the next generation of trace explosives detectors and to identify new applications for our proprietary technology.




In April 2008, we acquired all of the capital stock of Ion Metrics, Inc., located in San Diego, California.  Ion Metrics develops mass sensor systems to detect and analyze chemical compounds such as explosives, chemical warfare agents, narcotics, and toxic industrial chemicals for the homeland defense, forensic, environmental, and safety/security markets.  Ion Metrics’ miniaturized devices and system designs provide high performance and reliability in combination with low manufacturing costs. Ion Metrics’ operating results have been included in our  statement of operations commencing on April 10, 2008.




Technology and Intellectual Property




Since May 1999, we have performed research and development in the area of ETD. We have developed several proprietary technologies in key areas of ETD which we believe improve the harvesting, collection and detection of trace particles and vapors of explosives substances.  In addition, we are continuing our development efforts to adapt this technology for the detection of narcotics and other chemical agents.  Our intellectual property portfolio contains 17 security-related patents and patents pending:  ten issued United States patents, six United States patents pending, and one licensed patent.  We believe that our portfolio of patents and patents pending provides extensive protection in sample harvesting, sample detection and collection.  A key to our past and future success is our ability to innovate and offer differentiation in these areas.




We compartmentalize ETD into four major areas: (i) harvest, (ii) transport, (iii) analysis, and (iv) reporting.  These technologies are discussed in detail in the following sections.




Harvest - Aerosol Particle Release




Tiny particles of explosives and narcotics are “sticky” and may adhere to surfaces.  Particles could be transferred if an object, such as fingers or clothing, comes in contact with a particle.  We have demonstrated that a person touching an explosives material can transfer explosives particles to numerous other objects leaving a trail of particles behind.




Our competitors commonly swipe a surface to be interrogated for explosives particles with cloth or paper.  We believe that this “contact” methodology provides an effective but inconsistent method of harvesting sample as compared to an automated, non-contact collection of the trace sample.  We have developed a method, which we believe to be more efficient, using an aerosol of fine dry ice particles.  This technique, which is surprisingly inexpensive to use, could increase collection sensitivity substantially and eliminate direct contact with a surface.  Our aerosol technology functions as a very gentle version of “sandblasting” and is safe for almost all surfaces.  Since dry ice sublimes into gas, no residue is left behind, and the aerosol may be used indoors.  We have two patents pending on this methodology.




Transport




Vortex Sampling




Once the trace particle has been released from a surface, it has to be transported to a collection point.  Vortex sampling was the first of our sampling innovations.  We have six patents issued and two patents pending in the area of vortex sampling methodology.




Our vortex is similar to a miniature tornado.  A hollow spinning cylinder of air flowing outward surrounds and protects an inner vacuum flowing inward.  This vortex sampling technology enables particles released within the vortex, or blown into it, to be transported with high efficiency to a collection filter.




-27-





Long-Life Sample Trap




Once particles have been liberated from the surface being interrogated, the particles are transported to our innovative trapping filter, which is an ultra-fine stainless steel woven mesh.  The trapping filter has a long usable life, which could span several years, requiring inexpensive, routine maintenance.  We believe the trapping filter provides an innovative solution to the more costly consumables used by several of our competitors engaged in ETD using contact methodology for sampling and detection.




Analysis




Flash Desorption




Flash desorption is an optical method for converting the chemistry of a particle, such as the chemicals composing explosives or narcotics, into a vapor that can be subjected to analyses for the discrimination of chemical properties.  In conventional trace chemical detectors, a sample is slowly warmed in an oven producing diluted vapor with low chemical concentrations.  Optical flash vaporization heats a sample within microseconds, producing a high sample concentration for detection.




This method is not appropriate with conventional sample collection methods, such as paper wipes, because the paper is white, and the light from the bright flash reflects off, producing little heating.  However, by using our trapping filter, a very fast detection response can be achieved without loss in sensitivity.  We have two patents issued and one patent pending in the area of flash desorption methodology.  The first product under development to take advantage of our flash desorption technology is our air cargo screening system described under “Products” below.




Photonic Ionization




The conventional method of ionizing vapors for analysis is to use a radioactive beta source.  While ETD equipment using radioactive sources are simple, effective, and need no electricity in the ionization process, there are important issues involving safety, licensing, regular verification of source integrity, and disposal.  Some markets, such as Japan and Australia, are known to reject instruments with radioactive sources.  We believe that most markets would prefer not to have to address the issues surrounding ETD equipment with radioactive sources.




We have developed two types of photonic, non-radioactive ion sources for our instruments for applications requiring either the ionization of positive ions or negative ions.  These ion sources may be found individually or in combination within our products, depending on the application for which the ETD equipment is to be used.  We have two patents issued and one patent pending in the area of photonic ionization.




Reporting




Reporting is that portion of the cycle that displays and stores information generated during the analysis phase.  This is the information a system operator sees and that indicates if an alarm condition exists or if the test is negative.  Information can be displayed in both graphical and tabular formats.  The reporting also indicates when the instrument is ready for the next sample as well as displaying built-in system diagnostics.




Products




We have developed several explosives detection systems designed for use in aviation and transportation security, high threat facilities and infrastructure, military installations, customs and border protection, and mail and cargo screening.  The systems use our proprietary Quantum SnifferTM technologies, including photon-based, non-radioactive ion source in combination with ion mobility spectrometry, a classic detection tool sensitive to the unique speeds with which ions of various substances move through the air (“IMS”) to electronically detect minute quantities of explosives vapor and particles.




-28-







Current Products




Quantum SnifferTMQS-H150 Portable Explosives Detector




The Quantum Sniffer QS-H150 Portable Explosives Detector employs a patented vortex collector for the simultaneous detection of explosives particulates and vapors with or without physical contact and in real-time.  We believe that our advanced QS-H150 is more sensitive than other detection devices.  The QS-HS150 can detect vapors and nanogram quantities of explosives particulates for most explosives substances considered to be threats.  Such substances include, but are not limited to, military and commercial explosives, improvised and homemade explosives, and propellants and taggants.




The QS-H150 has automatic and continuous self-calibration.  It monitors its environment, senses changes that would affect its accuracy, and re-calibrates accordingly.  The system requires no user intervention and no calibration consumables.  The detection process begins with the collection of a sample with our patented vortex collector.  After collection, the sample is ionized photonically and analyzed using IMS technology.  The presence of a threat substance is indicated by a visible and audible alarm.  The threat substance is then identified and displayed on the integrated LCD screen.




When detecting a threat substance, the QS-H150 rapidly alarms.  This real-time detection limits equipment contamination and allows for fast clear-down.  Operation and maintenance are cost-effective.  Since there is no requirement for dopants, calibration consumables or verification consumables, the overall cost of consumables is minimized.  Routine maintenance consists only of care and cleaning using common supplies, and desiccant replacement as required.  No radioactive material is used in the QS-H150, so there are no associated certifications, licenses, inspections, or end-of-life disposal issues.




Quantum SnifferTMQS-BTS Benchtop Explosives Detector




The two part QS-BTS systems consist of our QS-H150 Portable Explosives Detector, along with a base unit which contains a monitor, printer and power supply.  The QS-BTS functions as a benchtop system with the added capability of functioning as a portable, hand-held trace explosives detector. Optionally, and at any time, the base unit may be connected for convenient access to spectrogram display and analysis tools, administrative tools, and diagnostics.




Products Under Development




Quantum SnifferTMQS-B200 Benchtop Explosives Detector




The QS-B200 Benchtop Explosives Detector uses dual IMS with non-radioactive ionization for the detection and identification of a wide range of military, commercial, and improvised explosives.  The QS-B200 has automatic and continuous self-calibration.  It monitors its environment, senses changes that would affect its accuracy, and re-calibrates accordingly.  For detection, the sample is collected with a standard trap, ionized, and analyzed via IMS.  The presence of a threat is indicated by a visible and audible alarm, and the substance is identified and displayed on the integrated touch screen display.  Users may save data locally, print via a built-in thermal printer, or send data through standard interfaces such as USB, LAN, etc.  Multi-level password-protected data security is standard.  We believe that the operation and maintenance of the QS-B200 are extremely cost-effective. Routine maintenance consists only of care and cleaning using common supplies, and desiccant replacement as required.  No radioactive material is used in the QS-B200, so there are no associated certifications, licenses, inspections, or end-of-life disposal issues.




Quantum SnifferTMQS-Hx Portable Explosives Detector




We are developing a next generation hand held detector that will use dual IMS non-radioactive ionization for the detection and identification of a wide range of military, commercial and improvised explosives, as well as narcotics. The QS-Hx will have automatic and continuous self-calibration, multi-level password-protected data security and will include a data management interface with data export to a network for recordkeeping, providing a link with the central command centers and logistics systems used by major carriers.




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Miniature Mass Spectrometer




We initially developed our own proprietary ion mobility spectrometer. We believe that as market demand grows for greater precision of substance identification and the list of substances to be detected increases, more advanced detectors will be required.




Our acquisition of Ion Metrics enabled us to obtain miniaturized quadrupole mass spectrometry (“QMS”) detector technology.  The QMS detector is roughly the size of an AA battery and has low manufacturing costs.  When used in conjunction with an IMS, the QMS detector senses the molecular weight of the chemical species resulting in an “orthogonal” detection method in which a more fundamental characteristic of a substance is measured.  We believe that, because it is unlikely that two substances would share the same mass and the same ion mobility in air, QMS detector technology improves the accuracy of detection and minimizes false alarms.  We are currently developing interfaces for integrating the QMS detector into our future products.




Hyphenated Detectors




Depending on the application and the number of “interfering” background chemicals, it may be necessary to incorporate additional “orthogonal” detection methods.  The combination of multiple sensors is commonly known as hyphenated systems.  By measuring different properties of the same species, interferents are separated from target species for a deterministic detection and identification and have minimum rates of false alarms. The combination of these sensors in series is commonly known as employing “hyphenated” detection methods.  A hyphenated system is one in which a sequence of different types of detectors all must agree that an alarm has occurred before a valid alarm is declared.




We are currently developing hyphenated systems employing conventional ion mobility, differential mobility and mass spectrometry for the DHS.




We believe detection systems incorporating hyphenated detection methods could accelerate the expansion of our product line to more effectively address the needs of the security, safety and defense sector, as well as accelerate our entry into the narcotics, chemical warfare, biological warfare and toxic industrial chemical detection marketplaces.  Combining new technologies with our other innovative products could enhance our competitive position while improving sales volumes and product margins in the future. We expect hyphenated systems to appear in our future product offerings.




Manufacturing Operations




We manufacture our security products primarily through a sole source contract manufacturer located locally in Worcester, Massachusetts.  We believe our strategy to outsource manufacturing reduces manufacturing costs, improves scheduling flexibility, and allows us to focus our internal resources and management on product development, marketing, sales and distribution.  We also maintain an internal production group at our corporate headquarters in Wilmington, Massachusetts responsible for pre-production logistics, oversight of contract manufacturing, quality control and inventory management.




Critical Accounting Policies




Our significant accounting policies are summarized in Note 2 to our consolidated financial statements included in Item 7 of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2010.  However, certain of our accounting policies require the application of significant judgment by our management, and such judgments are reflected in the amounts reported in our condensed consolidated financial statements.  In applying these policies, our management uses our judgment to determine the appropriate assumptions to be used in the determination of estimates.  Those estimates are based on our historical experience, terms of existing contracts, our observance of market trends, information provided by our strategic partners and information available from other outside sources, as appropriate.  Actual results may differ significantly from the estimates contained in our condensed consolidated financial statements.




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Results of Operations




Three Months Ended September 30, 2010 vs. September 30, 2009




Revenues




Security revenues for the three months ended September 30, 2010 were $1,004,000 as compared with $1,820,000 for the comparable prior year period, a decrease of $816,000 or 44.8%.  Revenue from security products for the three months ended September 30, 2010 were $1,004,000 as compared with $1,635,000 for the comparable prior year period, a decrease of $631,000 or 38.6%.  Revenue from government-funded contracts and other services for the three months ended September 30, 2010 were $0 as compared with $185,000 for the comparable prior year period, a decrease of $185,000.  The decrease in security revenue is primarily a result of a decrease in the number of units sold of our explosives detection products during the three months ended September 30, 2010 as compared to the comparable prior year period. Revenue from government contracts decreased due to the expiration of several contracts in the last quarter of our fiscal year ended June 30, 2010.  Until such time that we are successful in securing additional government contracts, we do not expect to report revenue from government contracts for the foreseeable future. We will continue to pursue these grants and contracts to support our research and development efforts in the areas of trace explosives detection.




Cost of Revenues




Cost of revenues for the three months ended September 30, 2010 were $636,000 as compared with $979,000 for the comparable prior year period, a decrease of $343,000 or 35.0%.  The decrease in cost of revenues is primarily a result of the decrease in unit sales of security product in the three months ended September 30, 2010.




Gross Margin




Gross margin for the three months ended September 30, 2010 was $368,000 or 36.7% of security revenues as compared with gross margin of $841,000 or 46.2% of security revenues for the comparable prior year period.  The decrease in gross margin is a result of competitive pricing pressures and increased per unit manufacturing overhead, as overhead costs were allocated to a reduced volume.




Research, Development and Regulatory Expenses




Research and development expense for the three months ended September 30, 2010 was $470,000 as compared with $595,000 for the comparable prior year period, a decrease of $125,000 or 21.0%.  We continue to expend funds to further the development of new products in the areas of explosives detection, as well as to prepare for certain government laboratory acceptance testing.  The decrease in research and development expenses in the three months ended September 30, 2010 is due primarily to decreased payroll and related fringe benefits costs resulting from a reduction in personnel.




Selling, General and Administrative Expenses




Selling, general and administrative expenses for the three months ended September 30, 2010 were $1,148,000 as compared with $1,227,000 for the comparable prior year period, a decrease of $79,000, or 6.4%.  The decrease in selling, general and administrative expenses is due primarily to decreased legal fees, decreased loan financing fees, decreased consulting fees and decreased rent and related occupancy costs, offset partially by increased payroll and related fringe benefits costs resulting from the addition of sales and marketing personnel.




Other Income and Expense, Net




For the three months ended September 30, 2010, we recorded other income, net of $603,000 as compared with other expense, net of $366,000, for the comparable prior year period, an increase of $969,000. The increase was primarily due to decreases in fair value of the note conversion option liability of $1,076,000 and warrant derivative liability of $31,000, in the three months ended September 30, 2010, both of which are related to our financing with DMRJ Group LLC as compared to decreases in the fair value of $376,000 and $7,000, respectively, in the comparable prior period. Interest expense decreased to $516,000 in the three months ended September 30, 2010 from $767,000 in the comparable prior period, due to due to decreased amortization of debt related to our financing with DMRJ. Offsetting these decreases in interest expense is increased interest expense due to higher borrowings under our credit facility with DMRJ and higher interest rates on these borrowing. Interest income decreased $6,000 to $12,000, in the three months ended September 30, 2010 from $18,000, for the comparable prior year period, due to decreased interest income associated with the note receivable issued to us as part of the Core asset sale.




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Loss from Continuing Operations




The loss from continuing operations for the three months ended September 30, 2010 was $647,000 as compared with a loss of $1,347,000 for the comparable prior year period, a decrease of $700,000, or 52.0%.  The decrease in the loss from continuing operations is primarily the result of the decreases in fair value of the note conversion option liability and warrant derivative liability, both of which are related to our financing with DMRJ Group LLC and, to a lesser extent, decreased interest expense and lower operating expenses, partially offset by decreased gross margin due to reduced security product revenues.




Loss from Discontinued Operations




The net income from discontinued operations for the three months ended September 30, 2010 was $0, as compared with a loss from discontinued operations of $20,000 for the comparable prior year period, an increase of $20,000 due to the operations of our medical reporting unit




Preferred Distribution, Deemed Dividends and Accretion




Preferred distribution, deemed dividends and accretion on the Series F Preferred Stock for three months ended  September 30, 2010 was $0, compared with $329,000 for the comparable prior year, a decrease of $329,000.  The Series F Preferred Stock, issued on July 1, 2009 and August 31, 2009, contained beneficial conversion features which amounted to $329,000 and is accounted for as a deemed dividend.




Liquidity and Capital Resources




As of September 30, 2010 and June 30, 2010, we had no cash and cash equivalents. On March 31, 2011, we must repay in full our obligations to DMRJ under the amended and restated senior secured promissory note issued to DMRJ in March 2009, under a second secured promissory note issued in July 2009 and under a revolving credit facility established in September 2009.  As of September 30, 2010, our obligations under the two promissory notes and under the revolving credit facility were $3,920,000, $1,000,000 and $8,702,000, respectively. Further, as of September 30, 2010, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $836,000. As of February 28, 2011 our obligation to DMRJ under the two senior notes and under the revolving credit facility were $3,680,000, $1,000,000 and $12,325,000, respectively, reflecting increased borrowing under the revolving credit facility to fund working capital required to fulfill our contract with the India Ministry of Defence. Further, as of February 28, 2011, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note, the senior secured promissory note and under the credit facility approximated $1,139,000.




During the three months ended September 30, 2010 we had net cash outflows of $627,000 from operating activities of continuing operations as compared to net cash outflows from operating activities of continuing operations of $2,529,000 for the comparable prior year period.  The $1,902,000 decrease in net cash used in operating activities of continuing operations during the three months ended September 30, 2010, as compared to the comparable prior year period, was primarily a result of (i) a decrease in accounts payable of $157,000, compared to a decrease in accounts payable of $1,100,000 in the prior period due to the payment of outstanding obligations; (ii) an increase of $924,000 in deferred revenue, compared to a $410,000 decrease in deferred revenue in the prior period due primarily to the receipt of the advance deposit of $893,000 under our contract with the India Ministry of Defence and the timing of or application of customer advance payments; (iii) a $368,000 decrease in prepaid expenses, compared to a $208,000 increase in prepaid expenses in the prior period, due to the receipt of inventory which had been prepaid; and (iv) a $55,000 decrease in accounts receivable, compared to a $326,000 increase in accounts receivable in the prior period, due to lower revenues, partially offset by a $210,000 increase in inventories, compared to a $157,000 decrease in the prior period, due to the receipt of inventory purchased to fulfill our contract  with the India Ministry of Defence. For the three months ended September 30, 2010, we had no cash from operating activities of discontinued operations, compared with net cash inflows of $16,000 from operating activities of discontinued operations for the comparable prior year period, a decrease of $16,000, due primarily to a decrease in the loss from discontinued operations in the three months ended September 30, 2010.




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During the three months ended September 30, 2010 we had net cash inflows of $68,000 from investing activities of continuing operations as compared to net cash inflows of $17,000 from investing activities of continuing operations for the comparable prior year period.  The $51,000 increase in net cash provided by investing activities of continuing operations during the three months ended September 30, 2010, as compared to the comparable prior year period, was primarily a result of $46,000 increase in cash transferred from restricted funds.




During the three months ended September 30, 2010 we had net cash inflows of $559,000 from financing activities of continuing operations as compared to net cash inflows of $2,828,000 from financing activities of continuing operations for the comparable prior year period.  The $2,269,000 decrease in net cash from financing activities of continuing operations during the three months ended September 30, 2010, as compared to the comparable prior year period, was primarily a result of $1,000,000 in cash provided by the issuance of a senior secured note to DMRJ in July 2009 and $1,833,000 in cash provided by the credit facility provided by DMRJ in September 2009, compared to $559,000 in cash provided by our credit facility in the three months ended September 30, 2010.  During the three months ended September 30, 2010, we received $2,000 in process from common stock due to the exercise of employee stock options.




In December 2008, we entered into a note and warrant purchase agreement with DMRJ Group LLC, an accredited institutional investor, pursuant to which we issued a senior secured convertible promissory note in the principal amount of $5,600,000 and a warrant to purchase 1,000,000 shares of our common stock.  Thereafter, we entered into a series of amendments, waivers and modifications of our facility with DMRJ.  As of the most recent amendments and modifications, entered into on September 30, 2010, we have a $10,000,000 line of credit with DMRJ and the maturity of all our indebtedness to DMRJ has been extended until March 31, 2011.




The note contains restrictions and financial covenants including:  (i) restrictions against declaring or paying dividends or making any distributions; against creating, assuming or incurring  any liens; against creating, assuming or incurring any indebtedness; against merging or consolidating with any other company, provided, however, that a merger or consolidation is permitted if we are the surviving entity; against the sale, assignment, transfer or lease of our assets, other than in the ordinary course of business and excluding inventory and certain asset sales expressly permitted by the note purchase agreement; against making investments in any company, extending credit or loans, or purchasing stock or other ownership interest of any company; and (ii) covenants that we have authorized or reserved for the purpose of issuance, 150% of the aggregate number of shares of our common stock issuable upon exercise of  the warrant; that we maintain a minimum cash balance of at least $500,000; that the aggregate dollar amount of all accounts payable be no more than 100 days past due; and that we maintain a current ratio, defined as current assets divided by current liabilities, of no less than 0.60 to 1.00




On December 20, 2009, we received written notice from DMRJ, stating that we were in default of our obligations under each of the promissory notes described above. As a result of these defaults, effective December 11, 2009, (i) the interest rate that we are obligated to pay to DMRJ under the promissory note issued in March 2009 automatically increased from 11% per annum to 2.5% per month (or the maximum applicable legal interest rate, if less); (ii) the interest rate that we are obligated to pay to DMRJ under the promissory note issued in July 2009 automatically increased from 2.5% per month to 3.0% per month (or the maximum applicable legal interest rate, if less); and (iii) the interest rate that we are obligated to pay to DMRJ under the promissory note issued in September 2009 increased from 25% per annum to 30% per annum (or the maximum applicable legal interest rate, if less). All such default interest is payable upon demand by DMRJ. On December 31, 2009, we received written notice from DMRJ, withdrawing its December 20, 2009 default notice.




The failure to refinance this indebtedness or otherwise negotiate extensions of our obligations to DMRJ would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.


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Our ability to comply with our debt covenants in the future depends on our ability to generate sufficient sales and to control expenses, and will require us to seek additional capital through private financing sources.  There can be no assurances that we will achieve our forecasted financial results or that we will be able to raise additional capital to operate our business.  Any such failure would have a material adverse impact on our liquidity and financial condition and could force us to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.  Further, upon the occurrence of an event of default under certain provisions of our agreements with DMRJ, we could be required to pay default rate interest equal to the lesser of 3.0% per month and the maximum applicable legal rate per annum on the outstanding principal balance outstanding and the notes may be immediately callable.




We are currently expending significant resources to develop the next generation of our current products and to develop new products.  , We will require additional funding in order to continue the advancement of the commercial development and manufacturing of the explosives detection system.  We will attempt to obtain such financing by: (i) government grants, (ii) private financing, or (iii) strategic partnerships.  However, there can be no assurance that we will be successful in our attempts to raise such additional financing.




We will require substantial funds for further research and development, regulatory approvals, and the marketing of our explosives detection products.  Our capital requirements depend on numerous factors, including but not limited to the progress of our research and development programs; the cost of filing, prosecuting, defending and enforcing any intellectual property rights; competing technological and market developments; changes in our development of commercialization activities and arrangements; the hiring of additional personnel; and acquiring capital equipment.




Based on the current sales, expense and cash flow projections, advances on our line of credit, proceeds from certain expected sales of assets, and the ability to raise additional capital, management believes it has plans in place to fund operations through March 31, 2011 and, if we are successful in refinancing our obligations to DMRJ, for the near future.  If we are successful in refinancing these obligations, there can still be no assurances that sales will materialize as forecasted, management will be successful in executing its business plan, and/or any capital we raise will be sufficient to fund operations indefinitely. Management will therefore continue to closely monitor and attempt to control our costs and will continue to actively seek the needed capital through government grants and awards, strategic alliances, private financing sources, and through our lending institutions.  Future expenditures for research and product development are discretionary and can be adjusted, as can certain selling, general and administrative expenses, based on the availability of cash.  The financial statements do not include any adjustments relating to the recoverability and classification of asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.




Off-Balance Sheet Arrangements




As of September 30, 2010 we had three irrevocable standby letters of credit outstanding in the approximate amount of $1,488,000.  These three letters of credit provide for:  (1) performance security equal to 5% of the contract amount; (2) warranty performance security equal to 5% of the contract amount; and, (3) security equal to 15% of the contract amount against an advance deposit under the terms of an order from the India Ministry of Defence.  The letters of credit expire between December 21, 2010 – October 5, 2012.




As of September 30, 2010, we did not have any other off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on our consolidated financial condition, results of operations, liquidity, capital expenditures or capital resources.




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New Accounting Pronouncements




In October 2009, the FASB issued Accounting Standards Update No. 2009-13, “Revenue Recognition (Topic 605) Multiple-Deliverable Revenue Arrangements (A Consensus of the FASB Emerging Issues Task Force)” (ASU 2009-13), which amends existing accounting standards for revenue recognition for multiple-element arrangements. This update removes the objective-and-reliable-evidence-of-fair-value criterion from the separation criteria used to determine whether an arrangement involving multiple deliverables contains more than one unit of accounting, replaces references to “fair value” with “selling price” to distinguish from the fair value measurements required under the “Fair Value Measurements and Disclosures” guidance, provides a hierarchy that entities must use to estimate the selling price, eliminates the use of the residual method for allocation, and expands the ongoing disclosure requirements. This update is effective for fiscal years beginning on or after June 15, 2010, and can be applied prospectively or retrospectively. We do not currently believe that the adoption of this update will have any effect on our consolidated financial position and results of operations.




Item 3.
Quantitative and Qualitative Disclosures About Market Risk.




Not required pursuant to Item 305(e) of Regulation S-K.




Item 4T.
Controls and Procedures





The certifications of our Chief Executive Officer and Chief Financial Officer attached as Exhibits 31.1 and 31.2 to this Quarterly Report on Form 10-Q include, in paragraph 4 of such certifications, information concerning our disclosure controls and procedures, and internal control over financial reporting.  Such certifications should be read in conjunction with the information contained in this Item 4 for a more complete understanding of the matters covered by such certifications.




Disclosure Controls and Procedures




Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of September 30, 2009.  The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, means controls and other procedures of a company that are designed to ensure that information required to be disclosed by the company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized, and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission.  Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions to be made regarding required disclosure.  It should be noted that any system of controls and procedures, however well designed and operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met and that management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.  Our management identified a material weakness in respect of our internal controls over financial reporting, specifically in our controls over the adoption of Accounting Standards Codification (“ASC”) 815-40-15 - “Derivatives and Hedging.” related to the non-cash accounting treatment of financial instruments which are not deemed to be indexed to the company’s common stock. Further, we are restating the aforementioned quarters to record, as of July 1, 2009 and August 31, 2009, the commitment dates of our Series F Convertible Preferred Stock, to record the deemed dividend resulting from the beneficial conversion feature contained in the Series F Convertible Preferred Stock, as required under Accounting Standards Codification (“ASC”) 470-20 “Debt.” As of September 30, 2010, we had not remediated this material weakness. As a result of this material weakness, our Chief Executive Officer and Chief Financial Officer, concluded that, we did not maintain effective internal control over financial reporting as of September 30, 2010 and further concluded that, as of such date, our disclosure controls and procedures were not effective at the reasonable assurance level.




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Remediation




We are committed to remediating the material weakness identified in our implementation of new accounting pronouncements. To remediate our material weakness we have recruited a senior accounting professional which will enhance the overall technical abilities of our accounting department.  This individual will assist with the preparation of our financial statements and with the documentation of our review of financial statements and schedules.  Further, we will evaluate additional training for existing personnel in the areas of GAAP and will take the necessary steps to improve our internal process of identifying, researching and evaluating the impact of new accounting pronouncements. This additional resource will enhance our GAAP capabilities related to review procedures, strengthen our segregation of duties as well as enhance our ability to account and report on complex material and/or non-routine transactions.




Changes in Internal Control Over Financial Reporting




Except as described above, there were no changes to our internal control over financial reporting during the quarter ended September 30, 2010 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.




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PART II.                      OTHER INFORMATION




Item 1.
Legal Proceedings




From time to time, we are subject to various claims, legal proceedings and investigations covering a wide range of matters that arise in the ordinary course of our business activities. Each of these matters is subject to various uncertainties.




Except as disclosed under Item 3 of our Annual Report on Form 10-K, as amended, for the fiscal year ended June 30, 2010, we are not a party to any other legal proceedings, other than ordinary routine litigation incidental to our business, which we believe will not have a material affect on our business, assets or results of operations.




Item 1A.
Risk Factors




Other than as set forth below, there have not been any material changes from the risk factors previously disclosed under Item 1A of our Annual Report on Form 10-K, for the fiscal year ended June 30, 2010.




We have identified a material weakness in our internal control over financial reporting that resulted in the restatement of our the condensed consolidated financial statements included in our Quarterly Reports on Form 10-Q for the fiscal quarters ended September 30, 2009, December 31, 2009 and March 31, 2010.  As of September 30, 2010, we had not remediated this material weakness. This material weakness could cause investors to lose confidence in the reliability of our financial statements, which could result in a decrease in the value of our common stock.




As directed by Section 404 of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commission adopted rules requiring public companies to include a report by management on the company’s internal controls over financial reporting in their annual reports on Form 10-K.  This report is required to contain an assessment by management of the effectiveness of the company’s internal controls over financial reporting.  On October 14, 2010, the Audit Committee of our Board of Directors, in consultation with our management, determined that the condensed consolidated financial statements included in our Quarterly Reports on Form 10-Q for the fiscal quarters ended September 30, 2009, December 31, 2009 and March 31, 2010, should no longer be relied on due to issues raised by our independent accountants, Marcum LLP, regarding errors in our adoption of Accounting Standards Codification 815 “Derivatives and Hedging” related to the non-cash accounting treatment of financial instruments which are not deemed to be indexed to our common stock. Further, we are restating the aforementioned quarters to record, as of July 1, 2009 and August 31, 2009, the commitment dates of our Series F Convertible Preferred Stock, the deemed dividend resulting from the beneficial conversion feature contained in the Series F Convertible Preferred Stock. Our management identified a deficiency in respect of our internal controls over financial reporting, specifically in our controls over the adoption of Accounting Standards Codification (“ASC”) 815-40-15 - “Derivatives and Hedging,” related to the non-cash accounting treatment of financial instruments which are not deemed to be indexed to the company’s common, that constitutes a material weakness.If we fail to implement the required new or improved controls, we may be unable to comply with the requirements of Section 404 in a timely manner.  This could result in an adverse reaction in the financial markets due to a loss of confidence in the reliability of our financial statements, which could cause the market price of our common stock to decline and make it more difficult for us to finance our operations.




We will be required to repay our borrowings from DMRJ Group LLC on March 31, 2011.




We will be required to repay all of our borrowings from DMRJ Group LLC on March 31, 2011.  Our obligations to DMRJ are secured by a security interest in substantially all of our assets.  As of September 30, 2010, the outstanding balance due to DMRJ under two senior secured promissory notes and a revolving credit facility were $3,920,000, $1,000,000 and $8,702,000, respectively.Further, as of September 30, 2010, our obligation to DMRJ for accrued interest under the amended senior secured convertible promissory note and the senior secured promissory note approximated $836,000.




If we are unable to repay these amounts as required, refinance our obligations to DMRJ, or negotiate extensions of these obligations, DMRJ may seize our assets and we may be forced to curtail or discontinue operations entirely and/or file for protection under bankruptcy laws.




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As of February 28, 2011, our obligation to DMRJ under the two senior notes and under the revolving credit facility were $3,680,000, $1,000,000 and $12,535,000, respectively, reflecting increased borrowing under the revolving credit facility to fund working capital.  Further, as of February 28, 2011, our obligation to DMRJ for accrued interest under the senior secured convertible promissory note and the senior secured promissory note approximated $1,139,000.




We will require additional capital to fund operations and continue the development, commercialization and marketing of our product.  Our failure to raise capital could have a material adverse effect on the business.




Management continually evaluates plans to reduce our operating expenses, increase sales and increase our cash flow from operations.  Despite our current sales, expense and cash flow projections, we will require additional capital in the third quarter of fiscal 2011 to fund operations and continue the development, commercialization and marketing of our products. Our failure to achieve our projections and/or obtain sufficient additional capital on acceptable terms would have a material adverse effect on our liquidity and operations and could require us to file for protection under bankruptcy laws.




Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds




In July 2010, Michael Turmelle, a member of our Board of Directors, converted $100,000 of the principal amount owed by us under a promissory note into 1,250,000 shares of our common stock, at a conversion price of $0.08 per share. The issuance of these shares to Mr. Turmelle is exempt from registration under the Securities Act pursuant to an exemption provided by Section 3(a)(9) of the Securities Act.




Item 3.
Defaults Upon Senior Securities




None.




Item 4.
Submission of Matters to a Vote of Security Holders




None.




Item 5.
Other Information




None.




Item 6.
Exhibits




Exhibit No.




10.1 (1)
Omnibus Third Amendment to Credit Agreement and Fifth Amendment to Note and Warrant Purchase Agreement, dated as of September 30, 2010 between Implant Sciences Corporation and DMRJ Group LLC




31.1 (2)
Certification of Principal Executive Officer pursuant to Section 3.02 of the Sarbanes-Oxley Act of 2002.




31.2 (2)
Certification of Principal Financial Officer pursuant to Section 3.02 of the Sarbanes-Oxley Act of 2002.




32.1 (2)
Certification of Chief 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 (2)
Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.




______________________




(1)
Filed as an Exhibit to Implant Sciences Corporation’s Form 8-K dated September 30, 2010 and filed October 6, 2010.




(2)
Filed herewith.









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SIGNATURES




Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on our behalf by the undersigned thereunto duly authorized.




Implant Sciences Corporation






By:  /s/ Glenn D. Bolduc


Glenn D. Bolduc


President, Chief Executive Officer




Dated:  March 21, 2011



















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