**Exhibit 10.4**
**DATAKEY, INC.**
**NONQUALIFIED STOCK OPTION AGREEMENT**
     THIS AGREEMENT, made effective as of this 23rd day of February 2004, byand between DATAKEY, INC., a Minnesota corporation (the “Company”), and DAVIDA. FESTE (“Optionee”).
W I T N E S S E T H:
     WHEREAS, Optionee on the date hereof is a key employee of the Company; and
     WHEREAS, to induce the Optionee to further the Optionee’s efforts in itsbehalf, the Company desires to grant to the Optionee a nonqualified stockoption to purchase shares of its Common Stock, which option shall be grantedoutside of the Company’s 1997 Stock Option Plan; and
     WHEREAS, the Administrator has authorized the grant of a nonqualifiedstock option to Optionee and has determined that, as of the effective date ofthis Agreement, the fair market value of the Company’s Common Stock is $0.79per share;
     NOW, THEREFORE, in consideration of the premises and of the mutualcovenants herein contained, the parties hereto agree as follows:
     1. **Grant of Option**. The Company hereby grants to Optionee on the date setforth above (the “Date of Grant”), the right and option (the “Option”) topurchase all or portions of an aggregate of One Hundred Thousand (100,000)shares of Common Stock at a per share price of $0.79 on the terms andconditions set forth herein, subject to adjustment pursuant to Paragraph 4below. This Option is a nonqualified stock option and will not be treated asan incentive stock option, as defined under Section 422, or any successorprovision, of the Internal Revenue Code of 1986, as amended (the “Code”), andthe regulations thereunder.
     2. **Duration and Exercisability**.
            a. The term during which this Option may be exercised shall terminate onFebruary 22, 2014, except as otherwise provided in Paragraphs 2(b) through 2(e)below. This Option shall become exercisable according to the followingschedule:     **Vesting Date** **Number of Shares**February 23, 2005  33,333 February 23, 2006  33,333 February 23, 2007  33,334 
 

 

**Exhibit 10.4**
Once the Option becomes exercisable to the extent of one hundred percent (100%)of the aggregate number of shares specified in Paragraph 1, Optionee maycontinue to exercise this Option under the terms and conditions of thisAgreement until the termination of the Option as provided herein. If Optioneedoes not purchase upon an exercise of this Option the full number of shareswhich Optionee is then entitled to purchase, Optionee may purchase upon anysubsequent exercise prior to this Option’s termination such previouslyunpurchased shares in addition to those Optionee is otherwise entitled topurchase.
            b. **Change of Control**. Upon a “transaction” or “change of controltransaction” (as those terms are defined in Paragraph 4(b) below), this Optionshall become immediately exercisable.
            c. **Termination of Employment (other than Disability or Death)**. IfOptionee ceases to be an employee of the Company or any Subsidiary for anyreason other than because of disability or death, this Option shall completelyterminate on the earlier of (i) the close of business on the three-monthanniversary date of the termination of employment, and (ii) the expiration dateof this Option stated in Paragraph 2(a) above. In such period following suchtermination of employment, this Option shall be exercisable only to the extentthe Option was exercisable on the vesting date immediately preceding the dateon which Optionee’s employment with the Company or Subsidiary terminated, buthad not previously been exercised. To the extent this Option was notexercisable upon termination of employment, or if Optionee does not exercisethe Option within the time specified in this Paragraph 2(c), all rights ofOptionee under this Option shall be forfeited.
            d. **Disability**. If Optionee ceases to be an employee of the Company or anySubsidiary because of disability (as such term is defined in Code Section22(e)(3), or any successor provision), this Option shall completely terminateon the earlier of (i) the close of business on the twelve-month anniversarydate of the termination of employment, and (ii) the expiration date under thisOption stated in Paragraph 2(a) above. In such period following termination ofemployment, this Option shall be exercisable only to the extent the Option wasexercisable on the vesting date immediately preceding the termination ofemployment. If Optionee does not exercise the Option within the time specifiedin this Paragraph 2(d), all rights of Optionee under this Option shall beforfeited.
            e. **Death**. In the event of Optionee’s death, this Option shall terminateon the earlier of (i) the close of business on the twelve-month anniversarydate of the date of Optionee’s death, and (ii) the expiration date of thisOption stated in Paragraph 2(a) above. In such period following Optionee’sdeath, this Option may be exercised by the person or persons to whom Optionee’srights under this Option shall have passed by Optionee’s will or by the laws ofdescent and distribution only to the extent the Option was exercisable on thevesting date immediately preceding the date of Optionee’s death. If suchperson or persons fail to exercise this Option within the time specified inthis Paragraph 2(e), all rights under this Option shall be forfeited.
 

 

**Exhibit 10.4**
     3. **Manner of Exercise**.
            a. **General**. The Option may be exercised only by Optionee (or other properparty in the event of death or incapacity) subject to such administrative rulesas the Administrator may deem advisable, by delivering within the option periodwritten notice of exercise to the Company at its principal office. The noticeshall state the number of shares as to which the Option is being exercised andshall be accompanied by payment in full of the option price for all sharesdesignated in the notice. The exercise of the Option shall be deemed effectiveupon receipt of such notice by the Company and upon payment that complies withthe terms of this Agreement. The Option may be exercised with respect to anynumber or all of the shares as to which it can then be exercised and, ifpartially exercised, may be exercised as to the unexercised shares any numberof times during the option period as provided herein.
            b. **Form of Payment**. Payment of the option price by Optionee shall be inthe form of cash, personal check, certified check or previously acquired sharesof Common Stock of the Company, or any combination thereof. Any stock sotendered as part of such payment shall be valued at its Fair Market Value. Forpurposes of this Agreement, “previously acquired shares of Common Stock” shallinclude shares of Common Stock that have been owned by Optionee for at leastsix months at the time of exercise. “Fair Market Value” shall mean (i) thereported closing price if such stock is reported by the Nasdaq Stock Market oris listed upon an established stock exchange or exchanges; (ii) the reportedclosing price or average of the closing “bid” and “asked” prices, whichever, ifsuch stock is quoted on the OTC Bulletin Board, National Quotation Bureau, Inc.or any comparable reporting service; or (iii) if such stock is not publiclytraded, the per share value as determined by the Board, or the Committee, inits sole discretion by applying principles of valuation with respect to allsuch options.
            c. **Stock Transfer Records**. As soon as practicable after the effectiveexercise of all or any part of the Option, Optionee shall be recorded on thestock transfer books of the Company as the owner of the shares purchased, andthe Company shall deliver to Optionee one or more duly issued stockcertificates evidencing such ownership. All requisite original issue ortransfer documentary stamp taxes shall be paid by the Company.
     4. **Recapitalization, Sale, Merger, Exchange or Liquidation.**
            a. **Recapitalization**. In the event of an increase or decrease in thenumber of shares of Common Stock resulting from a subdivision or consolidationof shares or the payment of a stock dividend or any other increase or decreasein the number of shares of Common Stock effected without receipt ofconsideration by the Company, the number of shares of Option Stock and theprice per share thereof shall be adjusted by the Board to reflect such change.Additional shares which may be credited pursuant to such adjustment shall besubject to the same restrictions as are applicable to the shares with respectto which the adjustment relates.
            b. **Other**. This Option shall become immediately exercisable, whether ornot it had become exercisable prior to the transaction or change of control, inthe event of :
 

 

**Exhibit 10.4**
                (i) an acquisition of the Company by a corporation, partnership, trust orother entity not controlled by the Company through (a) the sale ofsubstantially all of the Company’s assets and the consequent discontinuance ofits business or (b) through a merger, consolidation, exchange, reorganization,reclassification, extraordinary dividend, divestiture or liquidation of theCompany, other than a merger or consolidation which would result in the votingsecurities of the Company outstanding immediately prior thereto continuing torepresent (either by remaining outstanding or by being converted into votingsecurities of the surviving entity) at least 80% of the combined voting powerof the voting securities of the Company or such surviving entity outstandingimmediately after such merger or consolidation (collectively referred to as a“transaction”), or
                (ii) a change of control such that (a) any individual, partnership, trustor other entity becomes the “beneficial owner” (as defined in Rule 13d-3 underthe Exchange Act), directly or indirectly, of 30% or more of the combinedvoting power of the Company’s outstanding securities ordinarily having theright to vote at elections of directors of the Company, or (b) individuals whoconstituted the Board of Directors of the Company on February 27, 1997 ceasefor any reason to constitute at least a majority thereof, provided that anyperson becoming a director subsequent to such date whose election, ornomination for election by the Company’s shareholders, was approved by a voteof at least a majority of the directors comprising the Board of Directors ofthe Company on such date (either by a specific vote or by approval of the proxystatement of the Company in which such person is named as a nominee fordirector, without objection to such nomination) shall be, for purposes of thisclause (b) considered as though such person were a member of the Board ofDirectors of the Company on such date (collectively referred to as a “change ofcontrol”).
In addition to the foregoing, in the event of such a transaction or change ofcontrol, the Board may provide for one or more of the following:
                     (A) the cancellation of this Option to the extent not exercised prior to adate specified by the Board (which date shall give Optionee a reasonable periodof time in which to exercise the Option prior to the effectiveness of suchtransaction);
                     (B) that Optionee shall receive, with respect to each share of OptionStock subject to this Option, as of the effective date of any such transaction,cash in an amount equal to the excess of the Fair Market Value of such OptionStock on the date immediately preceding the effective date of such transactionover the exercise price per share of the Option; provided that the Board may,in lieu of such cash payment, distribute to Optionee shares of stock of theCompany or shares of stock of any corporation succeeding the Company by reasonof such transaction, such shares having a value equal to the cash paymentherein; or
                     (C) continuance of this Option and provide to Optionee the right toexercise this Option as to an equivalent number of shares of stock of thecorporation succeeding the Company by reason of such transaction.
 

 

**Exhibit 10.4**
The Board may restrict the rights of orthe applicability of this Paragraph 4to the extent necessary to comply with Section 16(b) of the Securities Exchange Act of 1934, theInternal Revenue Code or any other applicable law or regulation. The grant ofthis Option shall not limit in any way the right or power of the Company tomake adjustments, reclassifications, reorganizations or changes of its capitalor business structure or to merge, exchange or consolidate or to dissolve,liquidate, sell or transfer all or any part of its business or assets.
     5. **Miscellaneous**.
            a. **Employment; Rights as Shareholder**. This Agreement shall not confer onOptionee any right with respect to the continuance of employment by the Companyor any of its Subsidiaries, nor will it interfere in any way with the right ofthe Company to terminate such employment. Optionee shall have no rights as ashareholder with respect to shares subject to this Option until such shareshave been issued to Optionee upon exercise of this Option. No adjustment shallbe made for dividends (ordinary or extraordinary, whether in cash, securitiesor other property), distributions or other rights for which the record date isprior to the date such shares are issued, except as provided in Paragraph 4above.
            b. **Securities Law Compliance**. The exercise of all or any parts of thisOption shall only be effective at such time as counsel to the Company shallhave determined that the issuance and delivery of Common Stock pursuant to suchexercise will not violate any state or federal securities or other laws.Optionee may be required by the Company, as a condition of the effectiveness ofany exercise of this Option, to agree in writing that all Common Stock to beacquired pursuant to such exercise shall be held, until such time that suchCommon Stock is registered and freely tradable under applicable state andfederal securities laws, for Optionee’s own account without a view to anyfurther distribution thereof and that such shares will be not transferred ordisposed of except in compliance with applicable state and federal securitieslaws.
            c. **Withholding Taxes**. In order to permit the Company to comply with allapplicable federal or state income tax laws or regulations, the Company maytake such action as it deems appropriate to insure that, if necessary, allapplicable federal or state payroll, income or other taxes are withheld fromany amounts payable by the Company to Optionee. If the Company is unable towithhold such federal and state taxes, for whatever reason, Optionee herebyagrees to pay to the Company an amount equal to the amount the Company wouldotherwise be required to withhold under federal or state law. Optionee may,subject to the approval and discretion of the Administrator or suchadministrative rules it may deem advisable, elect to have all or a portion ofsuch tax withholding obligations satisfied by delivering shares of theCompany’s Common Stock having a fair market value equal to such obligations.
            d. **Nontransferability**. During the lifetime of Optionee, the accruedOption shall be exercisable only by Optionee or by the Optionee’s guardian orother legal representative, and shall not be assignable or transferable byOptionee, in whole or in part, other than by will or by the laws of descent anddistribution.
 

 

Exhibit 10.4
            e. **Lockup Period Limitation**. Optionee agrees that in the event theCompany advises Optionee that it plans an underwritten public offering of itsCommon Stock in compliance with the Securities Act of 1933, as amended, andthat the underwriter(s) seek to impose restrictions under which certainshareholders may not sell or contract to sell or grant any option to buy orotherwise dispose of part or all of their stock purchase rights of theunderlying Common Stock, Optionee hereby agrees that for a period not to exceed180 days from the date of prospectus, Optionee will not sell or contract tosell or grant an option to buy or otherwise dispose of this option or any ofthe underlying shares of Common Stock without the prior written consent of theunderwriter(s) or its representative(s).
            f. **Blue Sky Limitation**. Notwithstanding anything in this Agreement to thecontrary, in the event the Company makes any public offering of its securitiesand determines in its sole discretion that it is necessary to reduce the numberof issued but unexercised stock purchase rights so as to comply with any statesecurities or Blue Sky law limitations with respect thereto, the Board ofDirectors of the Company shall have the right (i) to accelerate theexercisability of this Option and the date on which this Option must beexercised, provided that the Company gives Optionee 15 days’ prior writtennotice of such acceleration, and (ii) to cancel any portion of this Option orany other option granted to Optionee which is not exercised prior to orcontemporaneously with such public offering. Notice shall be deemed given whendelivered personally or when deposited in the United States mail, first classpostage prepaid and addressed to Optionee at the address of Optionee on filewith the Company.
            g. **Accounting Compliance**. Optionee agrees that, in the event of a “changeof control transaction” (as defined in Paragraph 2(b) above) and Optionee is an“affiliate” of the Company or any Subsidiary (as defined in applicable legaland accounting principles) at the time of such change of control transaction,Optionee will comply with all requirements of Rule 145 of the Securities Act of1933, as amended, and the requirements of such other legal or accountingprinciples, and will execute any documents necessary to ensure such compliance.
            h. **Stock Legend**. If applicable, the Company may put an appropriate legendon the certificates for any shares of Common Stock purchased by Optionee (or,in the case of death, Optionee’s successors) to reflect the restrictions ofParagraphs 5(b), 5(f), 5(g) and 5(h) of this Agreement.
            i. **Scope of Agreement**. This Agreement shall bind and inure to the benefitof the Company and its successors and assigns and Optionee and any successor orsuccessors of Optionee permitted by Paragraph 5(d) above.
            j. **Arbitration**. Any dispute arising out of or relating to this Agreementor the alleged breach of it, or the making of this Agreement, including claimsof fraud in the inducement, shall be discussed between the disputing parties ina good faith effort to arrive at a mutual settlement of any such controversy.If, notwithstanding, such dispute cannot be resolved, such dispute shall besettled by binding arbitration. Judgment upon the award rendered by thearbitrator may be entered in any court having jurisdiction thereof. Thearbitrator shall be a retired state or federal judge or an attorney who haspracticed securities or business litigation for at least ten years.
 

 

**Exhibit 10.4**
If the parties cannot agree on an arbitrator within 20 days, any party mayrequest that the chief judge of the District Court for Hennepin County,Minnesota, select an arbitrator. Arbitration will be conducted pursuant to theprovisions of this Agreement, and the commercial arbitration rules of theAmerican Arbitration Association, unless such rules are inconsistent with theprovisions of this Agreement. Limited civil discovery shall be permitted forthe production of documents and taking of depositions. Unresolved discoverydisputes may be brought to the attention of the arbitrator who may dispose ofsuch dispute. The arbitrator shall have the authority to award any remedy orrelief that a court of this state could order or grant; provided, however, thatpunitive or exemplary damages shall not be awarded. The arbitrator may awardto the prevailing party, if any, as determined by the arbitrator, all of itscosts and fees, including the arbitrator’s fees, administrative fees, travelexpenses, out-of-pocket expenses and reasonable attorneys’ fees. Unlessotherwise agreed by the parties, the place of any arbitration proceedings shallbe Hennepin County, Minnesota.
     IN WITNESS WHEREOF, the parties hereto have caused this Agreement to beexecuted on the day and year first above written.      DATAKEY, INC.