**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

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**FORM 10-KSB**

**(MarkOne)**

**ý**                                 ANNUALREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**Forthe transition period from           to          **

**COMMISSIONFILE NUMBER 0-20191**

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**Intrusion Inc.**

(Exact name of registrantas specified in its charter)

| **DELAWARE**                                                     |   | **75-1911917**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **1101  EAST ARAPAHO ROAD, SUITE 200  RICHARDSON, TEXAS**        |   | **75081**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

 

Registrant’s telephone number, including area code: **(972) 234-6400**

Securities registered pursuant to Section 12(b)of the Act: **None**

Securities registered pursuant to Section 12(g)of the Act:**Common Stock, $0.01 par value**(Title of class)

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Check whether the issuer is not required to filereports pursuant to Section 13 or 15(d) of the Exchange Act. o

Check whether the issuer (1)  filed all reportsrequired to be filed by Section 13 or 15(d) of the Exchange Act during thepast 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes xNo o

Check if disclosure of delinquent filers in responseto Item 405 of Regulation S-B is not contained herein, and will not be contained,to the best of the registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-KSBor any amendment to this Form 10-KSB. x

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

State the issuer’s revenues for its most recent fiscalyear: $5,242,000.

State the aggregate market value of the voting andnon-voting equity held by non-affiliates of the Registrant computed byreference to the price at which the common equity was last sold, or the averagebid and asked price of such common equity, as of March 16, 2007: $3,036,659. Asof March 16, 2007, 9,222,139 shares of the Registrant’s Common Stock wereoutstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the Registrant’s definitive ProxyStatement filed in connection with the Registrant’s 2007 Annual Meeting ofStockholders are incorporated by reference into Part III of thisForm 10-KSB.

Transitional Small Business Disclosure Format (CheckOne):  Yes oNo x

 

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**INTRUSION INC.**

**INDEX**
|              | ** ** | ** **                                                                                      | ** ** | ** ** | ** ** |
|--------------|------------|-------------------------------------------------------------------------------------------------|------------|------------|------------|
| **PART I**   | ** ** | ** **                                                                                      | ** ** | ** ** | ** ** |
| Item 1.      |       | Description of Business                                                                         |       | 3          |       |
| Item 2.      |       | Description of Properties                                                                       |       | 19         |       |
| Item  3.     |       | Legal  Proceedings                                                                              |       | 19         |       |
| Item 4.      |       | Submission of Matters to a Vote of Security Holders                                             |       | 19         |       |
| **PART II**  | ** ** | ** **                                                                                      | ** ** | ** ** | ** ** |
| Item 5.      |       | Market for Common Equity and Related Stockholder  Matters                                       |       | 20         |       |
| Item 6.      |       | Management’s Discussion and Analysis or Plan of  Operations                                |       | 21         |       |
| Item 7.      |       | Financial  Statements                                                                           |       | 28         |       |
| Item 8.      |       | Changes In and Disagreements with Accountants on  Accounting and Financial Disclosure           |       | 28         |       |
| Item 8A.     |       | Controls and Procedures                                                                         |       | 28         |       |
| Item  8B.    |       | Other  Information                                                                              |       | 29         |       |
| **PART III** | ** ** | ** **                                                                                      | ** ** | ** ** | ** ** |
| Item 9.      |       | Directors and Executive Officers of Intrusion Inc.                                              |       | 29         |       |
| Item 10.     |       | Executive Compensation                                                                          |       | 29         |       |
| Item 11.     |       | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters |       | 30         |       |
| Item 12.     |       | Certain Relationships and Related Transactions                                                  |       | 30         |       |
| Item 13.     |       | Exhibits                                                                                        |       | 30         |       |
| Item 14.     |       | Principal Accountant Fees and Services                                                          |       | 33         |       |
| Signatures   |       |                                                                                            |       | 34         |       |

 

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**PART I**

**Item 1.          Descriptionof Business.**

In addition to the historical information containedherein, the discussion in this Form 10-KSB contains certainforward-looking statements, within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934, that involve risks and uncertainties, such as statements concerning:growth and anticipated operating results; developments in our markets andstrategic focus; new products and product enhancements; potential acquisitionsand the integration of acquired businesses, products and technologies;strategic relationships and future economic and business conditions. Thecautionary statements made in this Form 10-KSB should be read as beingapplicable to all related forward-looking statements whenever they appear inthis Form 10-KSB. Our actual results could differ materially from theresults discussed in the forward-looking statements. Factors that could causeor contribute to such differences include, but are not limited to, thosediscussed under the section captioned “Factors That May Affect FutureResults of Operations” in Item 1 of this Form 10-KSB as well as thosecautionary statements and other factors set forth elsewhere herein.

**General**

We develop, market and support a family of networkintrusion prevention, intrusion detection, regulated information compliance,data privacy protection and entity identification products.  Our product families include the ComplianceCommander for regulated information and data privacy protection, IntrusionSpySnare for real-time inline blocking of spyware and unwanted peer-to-peer(P2P) applications, Intrusion SecureNet for network intrusion prevention anddetection and TraceCop for identity identification.  Intrusion’s products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

We market and distribute our products through a directsales force to end-users, distributors and numerous system integrators, managedservice providers and value-added resellers. Our end-user customers includebanks, credit unions, other financial institutions, U.S. federal governmententities, foreign government entities and local government entities, hightechnology, e-commerce and telecommunication companies, hospital and otherhealthcare providers and academic institutions. Essentially, our end-users can be defined as ‘any end-user requiringnetwork security solutions for protecting their mission critical data’.

We were organized in Texas in September 1983 andreincorporated in Delaware in October 1995. For more than 15 years,we provided local area networking equipment and were known as Optical DataSystems or ODS Networks. On April 17, 2000, we announced plans to sell, orotherwise dispose of, our networking divisions, which included our EssentialCommunications division and our local area networking assets. On June 1,2000, we changed our name from ODS Networks, Inc. toIntrusion.com, Inc., and our ticker symbol from ODSI to INTZ to reflectour focus on intrusion prevention and detection solutions, along withinformation compliance and data privacy protection products. OnNovember 1, 2001, we changed our name from Intrusion.com, Inc. toIntrusion Inc.

Our principal executive offices are located at 1101East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephone numberis (972) 234-6400.  Our website URLis www.intrusion.com.  References to “we”,“us”, “our” or “Intrusion Inc.” refer to Intrusion Inc. and itssubsidiaries.  Compliance CommanderTM,SecureNetTM, TraceCopTM and SpySnareTM are trademarks of Intrusion Inc.

On March 25, 2004, we completed a $5.0 millionprivate placement of 5% Convertible Preferred Stock and warrants.  In the private placement, we sold 1,000,000shares of preferred stock at a price of $5.00 per share for gross proceeds of$5.0 million, less $275,000 of issuance costs. The preferred shares may be converted into 1,590,331 shares of commonstock at an initial conversion price of $3.144 per share.  Included in this transaction were warrants topurchase 556,619 shares of common stock at an exercise price of $3.144 pershare.  In connection with the closing ofthis private placement, we issued warrants to purchase 64,408 shares of ourcommon stock at an exercise price of $3.144 per share to our financial advisorfor assistance with the private placement.

On March 18, 2004, we filed an amendment to ourcertificate of incorporation to effect a one-for-four (1:4) reverse stock splitof our common stock.  The reverse stocksplit became effective on March 29, 2004. All outstanding share numbers and related common stock numbers, such asearnings per share and outstanding options, included in this report are setforth on a post-split basis.

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On March 28, 2005, we completed a private placement of1,065,200 shares of our Series 2 5% Convertible Preferred Stock and warrants topurchase 532,600 shares of our common stock for gross proceeds of$2,663,000.  The preferred shares may beconverted into 1,065,200 shares of common stock at an initial conversion priceof $2.50 per share, and the warrants may be exercised at a price of $2.77 pershare during the five-year period commencing on September 28, 2005.  In connection with the closing of thisprivate placement, we issued warrants to purchase 60,390 shares of our commonstock at an exercise price of $2.77 per share to employees of our financialadvisor for the private placement.

On December 2, 2005, we completed an additionalprivate placement of 564,607 shares of our Series 3 5% Convertible PreferredStock and warrants to purchase 282,306 shares of our common stock for grossproceeds of $1,230,843.  The preferredshares may be converted into 564,607 shares of common stock at an initialconversion price of $2.18 per share, and the warrants may be exercised at aprice of $0.40 per share during the five-year period commencing on June 2,2006.  In connection with the closing ofthis private placement, we issued warrants to purchase 27,531 shares of ourcommon stock at an exercise price of $2.58 per share to employees of ourfinancial advisor for the private placement.

OnMarch 29, 2006, we established a $1,000,000 line of credit with Silicon ValleyBank which may increase to $2,000,000 if we have EBITDA of at least $200,000for two consecutive quarters.  Under theterms of this agreement, we may borrow an amount equal up to 80% of eligibleaccounts receivable balances.  Inaddition, we may obtain inventory advances equal to 35% of finished goodsinventory, capped at the lesser of the inventory availability, $300,000 or 35%of our total borrowing base.  If ourcredit line increases to $2,000,000, inventory advances will be capped at thelesser of the inventory availability, $600,000 or 35% of our borrowingbase.  Amounts we borrow under the creditline accrue interest at an annual rate of prime plus 1% and are secured by alien on all of our assets.  The line ofcredit was renewed on March 29, 2007, accrued interest on all outstandingamounts is payable monthly in arrears and all outstanding principal and accruedbut unpaid interest on the amounts we borrow are due on March 28, 2008.

On December 28, 2006, we completed a private placementof 1,250,000 shares of our Common Stock for gross proceeds of $500,000.

On March 15, 2007, we completed an additional privateplacement of 925,926 shares of our Common Stock for gross proceeds of $500,000.

**Government Sales**

In December 2002, our SecureNet network securityproducts became the first product of their kind to receive Common CriteriaCertification under the National Information Assurance Partnership (NIAP)Common Criteria Evaluation and Validation Scheme, which is designed to furtherthe goals of the government and commercial sectors to improve security incommercial products.  This governmentinitiated partnership of the National Institute of Standards and Technology andthe National Security Agency establishes and verifies information technologystandards and certifies products that meet their standards, in an effort topromote the development and use of evaluated information technology productsand systems.  This organization alsodevelops national and international standards for information technology security,in an effort to increase the level of trust government and commercial consumershave in information systems and related networking products.

Sales to U.S. government customers accounted for 73.6%of our revenues for the year ended December 31, 2006, compared to 70.7% ofour revenue in 2005.  We expect tocontinue to derive a substantial portion of our revenues from sales togovernmental entities in the future as we continue to market our entityidentification products, our regulated compliance and data leakage preventionproducts, our network intrusion prevention products and our spyware preventionproducts to the government.  Sales to thegovernment presents risks in addition to those involved in sales to commercialcustomers which could adversely affect our revenues, including potentialdisruption due to irregularities in or interruptions to appropriation andspending patterns, delays in approving a federal budget and the government’sreservation of the right to cancel contracts and purchase orders for itsconvenience.

Generally, we make our sales under purchase orders andcontracts.  Our customers, includinggovernment customers, may cancel their orders or contracts with little or noprior notice and without penalty. Although we transact business with various government entities, webelieve that the cancellation of any particular order in itself could have amaterial effect on our financial results. In addition, we do not believe that any of our revenues with governmentcustomers are subject to renegotiation of profits.  However, because we derive and expect tocontinue to derive a substantial portion of our revenue from sales togovernment entities, a large number of cancelled or renegotiated governmentorders or contracts could have a material adverse effect on our financialresults.  Currently, we are not aware ofany proposed cancellation or renegotiation of any of our existing arrangementswith government entities, and, historically, government entities have notcancelled or renegotiated orders which had a material adverse effect on ourbusiness.

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**IndustryBackground**

With the permeation of the Internet as a businessenabler over the last decade, network security has changed from being atechnology deployed only by the government and the most sophisticated or mostparanoid of companies, to technology employed by all sizes of business and acritical component of all mission critical systems. Today, email, instantmessengers, World Wide Web access, web sites, web-based applications ande-commerce are integral components of communications and operations forbusiness and government, and the protection of the information communicatedthrough or stored in these applications is crucial. Although the Internet hasmany business advantages, its openness and accessibility makes it a potentialthreat to the networks and systems that are attached to it. Computer hackers,curious or disgruntled employees, competitors and innocent mistakes maycompromise or destroy information assets or disrupt the normal operations andbrand equity of the enterprise. In addition, new regulations and mandates bythe government to protect Personally Identifiable Information (PII) have madeit imperative that companies have real-time data security products andprocesses in place.

As a result, enterprises are adopting a variety ofsecurity solutions to meet the challenge posed by external and internalthreats. To be effective, organizations require enterprise-wide informationrisk management solutions that are broadly deployed and centrally managed.Organizations seek systems with the optimal combination of best-of-breedcapabilities and total cost of ownership. It is our belief that securing theenterprise network requires two key elements:

·                                          Control:the ability to affect network traffic including access to the network or partsthereof in order to enforce a security policy.

·                                          Visibility:the ability to see and understand the nature of the network and the traffic onthe network, which assists in decision making as well as crafting and constantimprovement of a security policy.

We focus on providing these two primary ingredients ofnetwork security within a single device for overall network security and forthe protection of specific classified, confidential or customer informationassets.

**Products**

The Intrusion SecureNet, Compliance Commander,SpySnare and TraceCop systems can operate standalone or with our ProviderManagement System.

Sensors are appliances or software components that areconnected to the network and monitor the traffic searching for matches tosignatures or database information as evidence of an external or internalnetwork attack or malicious use that could threaten information assets.Signatures are patterns, anomalies and traffic flows that match known attacksor indicate suspicious activities. When the Sensor matches traffic to asignature or customer defined database record it will detect, protect, block(if desired) and report to the Management System.

The Provider Management System controls the Sensorsand displays events produced by the Sensors. The Intrusion Provider is a three-tier enterprise management andmonitoring system. Provider is for enterprise deployments with no licenselimitations placed on architecture, freeing the enterprise to build themanagement system required. Provider follows the workflow of the securityanalyst with a highly productive environment for response, research, resolutionand decision support. The Provider suite includes applications for eventmonitoring, policy creation and tuning and centralized software deployment —making up the complete suite of tools required to manage and monitor aSecureNet, Compliance Commander or Spy Snare system from one sensor to morethan 100 sensors.

We have simplified deployment, management andmonitoring to reduce the total cost of ownership for an easy to set up andmanage enterprise system. To reduce barriers and provide complete enterpriseintegration, the Intrusion systems provide more customization and event flowoptions for high-end deployments.

Our systems are “plug-and-protect” and can beconnected to a network without interfering with the network operations by usingthe Intrusion Passive and Inline taps.

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*IntrusionCompliance Commander Products*

Compliance Commander provides protection against theloss and misuse of regulated, classified and commercially sensitive data.  Loss of information assets that containcustomer data has spawned a multitude of federal and state legislation to set astandard of care, use and protection for customer information.  Better known laws that regulate customerinformation include HIPAA, Gramm-Leach-Bliley Act (GLBA) and its UK equivalentPrivacy Act of 1998, and California SB 1386. Penalties for non-compliance include fines, lawsuits, imposed processesand enforced business limitations. Any enterprise that falls within the scopeof these laws is now working under a timeline to demonstrate compliance.  In addition, both government and commercialinstitutions are becoming increasingly concerned about the misuse and loss of classifiedor commercially sensitive data, and are seeking proactive solutions to dealwith these issues.

The Intrusion Compliance Commander products leveragethe same Management systems as SecureNet NIP&DS products. Our ComplianceCommander solutions are currently designed to address the security andconfidentiality issues in the following industries and customers:

·                                          Healthcarecompanies (including healthcare providers, insurance companies and medicalequipment manufacturers) who are working to comply with HIPAA, and

·                                          Financialinstitutions and e-commerce enterprises working to comply with the customerconfidentiality provisions of GLBA and CA SB 1386.

The Compliance Commander solutions provide accuracythrough our Dynamic Data Dictionary (D3) technology, which securely connectsdirectly to the customer’s database housing the confidential, classified, orregulated information. The Compliance Commander stays up to date with thedatabase to match network traffic to the information that is resident in thedatabase. This provides an automated accurate mechanism to identify leaks andmisuse of information assets.  By usingthe customer’s own data, the Compliance Commander virtually eliminates anypotential for false positives.  Users notonly benefit from the highly accurate data protection, but also quickly realizethe low-cost of ownership by the fully automated updating feature.

*IntrusionSpySnare Product*

“Spyware” is softwarethat gathers user information without their knowledge through their Internetconnection.  Most spyware programs areindependent executable files that take on the authorization abilities of thevictim.  They include auto-install andauto-update capabilities and can report on any attempts to remove or modifythem.  Spyware can install Dynamic LinkLibrary and other executable files. Spyware can also read, write and delete files and even reformat yourhard drive and do this while sending a steady stream of information back to theadvertising and marketing companies or hackers.

Usuallybundled as a hidden component with software downloaded for free from or sharedvia the Internet, spyware monitors user activity on the Internet and transmitsthat information such as email addresses, Internet use, passwords and creditcard numbers to someone else.  Becausespyware uses the host computer’s memory and system resources while othercomputer programs are running, it can often lead to system crashes orinstability.

Our SpySnare product utilizes our high-performance,low-latency network analysis engine to implement deep-packet inspections inorder to determine if spyware signatures are attempting to get into thecustomer’s network.  In addition tospyware signatures, SpySnare also includes P2P file sharing signatures whichmay be an unwanted source for spyware insertions.  Once the user connects to a P2P site, aspyware program can unknowingly get returned to the user’s PC along with theintended file or application.  By usingspecific signatures for known spyware, SpySnare provides real-time awareness ofnetwork traffic which removes much of the guesswork involved in establishingthe necessary network defenses and preventing spyware infections.  Once SpySnare detects a spyware signaturematch, it flags and drops the spyware traffic and alerts the administrator.

Another benefit of our SpySnare product is its abilityto block outbound spyware notification attempts.  For example, when a traveling laptop getsinfected with spyware and returns to connect to the company network, thespyware program will notify the spyware host website of its presence.  SpySnare will detect the outbound “phone-home”attempt and will likewise block the spyware traffic at the perimeter.

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*IntrusionSecureNet NIP&DS Products*

We believe a primary advantage of the SecureNet NIP&DSis that with a single license purchase, the consumer may choose to deploy thesystem for intrusion prevention (IPS) or intrusion detection (IDS), providing asuperior level of flexibility and simple migration from passive detection toactive prevention without additional licensing cost.

Our Network Intrusion Detection System (NIDS) productprovides detection of specific exploit and misuse patterns in the traffic that thefirewall allows.  NIDS detects knownexploits and misuse patterns, suspicious activities and anomalous traffic orbehavior within both inbound and outbound traffic. This added visibilityprovides a checking mechanism for the efficacy of the firewall’s rule base.

Our Network Intrusion Prevention System (NIPS) productprovides network monitoring and analysis functionality like NIDS, with theadded ability to block malicious network traffic. NIPS actively regulatesinbound and outbound traffic based on specific users’ access while controllingwhat they can do with that access on a granular, per-conversation basis.

Our SecureNet NIP&DS products provide usercustomizable, protocol decode detection technology for up to Gigabit networks.While Intrusion SecureNet Sensors are in the top-tier of the market fordetection and throughput technology, we believe one of the primary benefitsprovided by our NIP&DS products is to reduce the total cost of ownership toour customers.

Our SecureNetSensors have their own web browser interface for simplified configuration.SecureNet Sensors also deliver complete, stand-alone NIP&DS for the smalland medium business with local management and monitoring. This allows customersto use their standard web browser to access a full power, full-featuredNIP&DS, without additional hardware or software.

Our SecureNet NIP&DS Sensors are available asSoftware Sensors and Hardware Sensors with performance and pricing appropriatefor networks ranging from 10Mb/s to Gigabit with a Common Criteria EAL2certified Gigabit appliance.

*Intrusion TraceCopProducts*

Our TraceCop product assists in identifying andlocating network attackers who use, abuse and probe an enterprise network.  TraceCop utilizes a database having worldwideIP addresses.  The TraceCop database isregularly updated.

**Third-Party Products**

We believe that it is beneficial to work with thirdparties with complementary technologies to provide integrated solutions to ourcustomers. As there is rapid technological advancement and significantconsolidation in the network security industry, there can be no assurance thatwe will have access to all of the third-party products that may be desirable orfor the term desirable to offer fully integrated solutions to our customers.

We currently have two third-party productrelationships.  We do not consider eitherof these third-party relationships to be material and we do not expect thesales from these relationships to be material, as the product offerings areonly complementary to our existing product offerings.

**Customer Services**

In addition to offering our network security products,we also offer a wide range of services, including design and configuration,project planning, training, installation and maintenance.

**Product Development**

The network security industry is characterized byrapidly changing technology, standards, economy and customer demands. Webelieve that our future success depends in large part upon the timelyenhancement of existing products as well as the development of technologicallyadvanced new products that meet industry standards, perform successfully andsimplify the users’ tasks so that they can do more with fewer resources.  We are currently marketing SecureNet,Compliance Commander, SpySnare and TraceCop products to meet emerging marketrequirements and are continuously engaged in testing to ensure that ourproducts interoperate with other manufacturers’ products, which comply withindustry standards.

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During 2006 and 2005, our research and developmentexpenditures were $2.1 million and $2.6 million, respectively. All of ourexpenditures for research and development have been expensed as incurred.  At December 31, 2006, we had 16employees engaged in research and product development.

**Manufacturing and Supplies**

In the past, we relied on the outsourcing ofmanufacturing components, assembly and certain other operations to reduce fixedcosts and to provide flexibility in meeting market demand of our hardwareproducts.  As we continue our transitionfrom a hardware business to primarily a software business, we expect to reduceour reliance on third party manufacturers and suppliers.

Our internal manufacturing operations consistprimarily of replication of software on CDs, packaging, testing and qualitycontrol of finished units.

The hardware we sell is standard off-the-shelfproducts, which we OEM or resell from our suppliers.

**Intellectual Property and Licenses**

Our success and our ability to compete are dependent,in part, upon our proprietary technology. While we have applied for certainpatents, we currently rely on a combination of contractual rights, tradesecrets and copyright laws to establish and protect our proprietary rights inour products. We have also entered into non-disclosure agreements with oursuppliers, resellers and certain customers to limit access to and disclosure ofproprietary information. There can be no assurance that the steps taken by usto protect our intellectual property will be adequate to preventmisappropriation of our technology or that our competitors will notindependently develop technologies that are substantially equivalent orsuperior to our technology.

We have entered into software and product licenseagreements with various suppliers. These license agreements provide us withadditional software and hardware components that add value to our securityproducts. These license agreements do not provide proprietary rights that areunique or exclusive to us and are generally available to other parties on thesame or similar terms and conditions, subject to payment of applicable licensefees and royalties.  We do not considerany of the product license, software or supplier agreements to be material toour business, but rather complementary to our business and product offerings.

**Sales, Marketing and Customers**

***Field Sales Force.***   Ourdirect sales organization focuses on major account sales, channel partnersincluding distributors, Value Added Resellers (VARs) and integrators; promotesour products to current and potential customers; and monitors evolving customerrequirements. The field sales and technical support force provides training andtechnical support to our resellers and end users and assists our customers indesigning secure data networking solutions.

We currently conduct sales and marketing efforts fromour principal office in Richardson (Dallas), Texas.  In addition, we have sales personnel, salesengineers or sales representatives located in California, Georgia, Europe andAsia.

***Distributors.***   Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued. Recognition of sales to distributors andrelated gross profits are deferred until the distributors resell themerchandise. However, since we have legally sold the inventory to thedistributor and we no longer have care, custody or control over the inventory,we recognize the trade accounts receivable and reduce inventory related to thesale at the time of shipment to the distributor.

***Resellers.***   Resellerssuch as domestic and international system integrators and VARs sell ourproducts as stand-alone solutions to end users and integrate our products withproducts sold by other vendors into network security systems that are sold toend users. Our field sales force and technical support organization providesupport to these resellers. Our agreements with resellers are non-exclusive,and our resellers generally sell other products that may compete with our products.Resellers may place higher priority on products of other suppliers who arelarger than and have more name recognition than us, and there can be noassurance that resellers will continue to sell and support our products.

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***Foreign Sales.***   Webelieve that rapidly evolving international markets are important sources offuture net sales. Our export sales are currently being made through an indirectsales force comprised of international resellers in Europe, Asia and Canada.  Export sales accounted for approximately 9.4%and 10.7% of total revenue in 2006 and 2005, respectively.  See “Management’s Discussion and Analysis orPlan of Operations” included in this report for a geographic breakdown of ourrevenue in 2006 and 2005. Sales to foreign customers and resellers generallyhave been made in United States dollars.

***Marketing.***   We haveimplemented several methods to market our products, including public relationsand placed articles, regular participation in and presenting during trade showsand seminars, advertisement in trade journals, telemarketing, distribution ofsales literature and product specifications and ongoing communication with ourresellers and installed base of end-user customers.

***Customers.***   Ourend-user customers include banks, credit unions, other financial institutions,U.S. federal government entities, foreign government entities and localgovernment entities, high technology, e-commerce and telecommunicationcompanies, hospital and other healthcare providers and academicinstitutions.  Essentially, our customersinclude any entity requiring network security solutions for protecting theirmission critical data.  Sales to certaincustomers and groups of customers can be impacted by seasonal capitalexpenditure approval cycles, and sales to customers within certain geographicregions can be subject to seasonal fluctuations in demand.

Although we sell our products to many customersthrough various distribution channels, no one commercial customer or reselleraccounted for 10% or more of our total revenue in any of the past three fiscalyears.  However, in 2006, 73.6% of ourrevenue was derived from a variety of U.S. government entities through directsales and indirectly through system integrators and resellers.  In 2006, 65.6% of our total revenues areattributable to three customers, one of which exceeds 10% of our total revenuesindividually.  Comparatively, sales tothe U.S. Government through direct and indirect channels totaled 70.7% of totalrevenues for 2005 and three of those entities represented more than 10% of ourtotal revenues for the year.  A reductionin our sales to U.S. government entities could have a material adverse effecton our business and operating results if not replaced.

***Backlog.***   We believethat only a small portion of our order backlog is non-cancelable and that thedollar amount associated with the non-cancelable portion is immaterial. Wepurchase or contract inventory based upon our forecast of customer demand andmaintain inventories in advance of receiving firm orders from customers. Ordersare generally fulfilled within two days to two weeks following receipt of anorder. Due to the generally short cycle between order and shipment, we do notbelieve that our backlog as of any particular date is indicative of future netsales.

***Customer Support, Service and Warranty.***   Weservice, repair and provide technical support for our products. Our field salesand technical support force works closely with resellers and end-user customerson-site and by telephone to assist with pre- and post-sales support servicessuch as network security design, system installation and technical consulting.By working closely with our customers, our employees increase theirunderstanding of end-user requirements and provide input to the productdevelopment process.

We warrant all of our products against defects inmaterials and workmanship for periods ranging from 90 days to12 months. Before and after expiration of the product warranty period, weoffer both on-site and factory-based support, parts replacement and repairservices. Extended warranty services are separately invoiced on a time andmaterials basis or under an annual maintenance contract.

**Competition**

The market for network and data protection securitysolutions is intensely competitive and subject to frequent productintroductions with new technologies, improved price and performancecharacteristics. Industry suppliers compete in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support. We believe that our approach focusing on network perimeterswith market leading high-performance network technology that reduces the totalcost of ownership as compared to our competition provides us with an advantagewith large organizations with complex security requirements.

There are numerous companies competing in varioussegments of the data security markets. Our principal competitors in the networkintrusion prevention and detection market include Internet SecuritySystems, Inc.(IBM), Cisco Systems, Inc., Symantec, Inc.,Netscreen  (Juniper Networks, Inc.)McAfee Inc., Tipping Point Technologies, a division of 3Com Corporation, andNFR Security (Checkpoint).  Ourcompetitors in the regulated information compliance market include Vontu, PortAuthority (Websense), Vericept, Reconnex, Tablus and a small number of start-upcompanies that 

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enteredthe space within the last two years. Regarding the spyware prevention market,we currently directly and indirectly compete with a number of host-basedspyware detection systems, such as Ad-Aware, Spybot S&D and Spy Sweeper andsome inline proxy solutions such as Blue Coat Systems, Inc.

Furthermore, some of our competitors havesubstantially greater financial, technical, sales and marketing resources,better name recognition and a larger customer base than we do. In addition,many of our competitors may provide a more comprehensive networking andsecurity solution than we currently offer. Even if we do introduce advancedproducts that meet evolving customer requirements in a timely manner, there canbe no assurance that our new products will gain market acceptance.

Certain companies in the network security industryhave expanded their product lines or technologies in recent years as a resultof acquisitions. Further, more companies have developed products which conformto existing and emerging industry standards and have sought to compete on the basisof price. We anticipate increased competition from large networking equipmentvendors, which are expanding their capabilities in the network security market.In addition, we anticipate increased competition from private “start-up”companies that have developed or are developing advanced security products.Increased competition in the security industry could result in significantprice competition, reduced profit margins or loss of market share, any of whichcould have a material adverse effect on our business, operating results andfinancial condition. There can be no assurance that we will be able to competesuccessfully in the future with current or new competitors.

**Employees**

As of December 31, 2006, we employed a total of32 persons, including 11 in sales, marketing and technical support, 1 inmanufacturing and operations, 16 in research and product development and 4 inadministration and finance.

None of our employees are represented by a labororganization, and we are not a party to any collective bargaining agreement. Wehave not experienced any work stoppages and consider our relations with ouremployees to be good.

Competition in the recruiting of personnel in thenetworking and data security industry is intense. We believe that our futuresuccess will depend in part on our continued ability to hire, motivate andretain qualified management, sales and marketing, and technical personnel. Todate, we have not experienced significant difficulties in attracting orretaining qualified employees.

**Factors That May Affect FutureResults of Operations**

In addition to the other information in thisForm 10-KSB, the following factors should be considered in evaluatingIntrusion Inc. and our business.

***Our cash, cash equivalents, and investments decreased from $3.3 millionat December 31, 2005 to $0.9 million at December 31, 2006.  As a result of our expected continuing netcash outflows, we may not have sufficient cash to operate our business and maynot be able to maintain certain liquidity requirements.***

As of December 31, 2006, we had cash, cashequivalents and investments of approximately $0.9 million, down fromapproximately $3.3 million as of December 31, 2005.  We expect our net operating losses and operatingcash outflows to continue through at least the first quarter of 2007 andpossibly throughout the remainder of fiscal year 2007.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources. Of the $0.9 million in cash, cash equivalents and investments atDecember 31, 2006, $0.5 million was derived from a private investment by ourChief Executive and Chief Financial Officers which closed on December 28,2006.  As of February 28, 2007 we hadcash and cash equivalents of $300,000 and less than $100,000 in availablefunding under our existing credit lines. We expect to fund our operations through additional investments ofprivate equity, which, if we are able to obtain, will have the effect ofdiluting our existing common stockholders, perhaps significantly.  Specifically, on March 15, 2007, we completedan additional private placement of 925,926 shares of our Common Stock for grossproceeds of $500,000 and we have a March 15, 2007 written commitment from ourChief Executive Officer to invest up to an additional $750,000 in the Companyuntil March 2008, should such funding by required by the Company, on terms andconditions yet to be determined.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe next few months, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

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***Our revenues declined from $6.0 million in 2005 to $5.2 million in 2006in connection with a shift in focus from SecureNet products to ComplianceCommander and TraceCop products.  If ournewer products do not achieve market acceptance, our revenues will continue tosuffer.***

We have transitioned our sales strategy focus fromSecureNet to Compliance Commander and TraceCop. During this transition, sales of our newer products have not offset thelosses in sales associated with our older products.  As a result, our net revenues declined from$6.0 million in 2005 to $5.2 million in 2006. We can provide no assurances that sales of our newer products will everoffset the losses in sales of older products or generate sufficient revenues tosustain our business.

Our new network security products, regulated informationcompliance systems and entity identification products have only been in themarket place for a limited period of time and may have longer sales cycles thanour previous products.  Accordingly, wemay not achieve the meaningful revenue growth needed to sustainoperations.  If we are unable torecognize revenues due to longer sales cycles or other problems, our results ofoperations will be adversely affected, perhaps materially.

We have not yet received broad market acceptance for ournewer products.  We cannot assure youthat our present or future products will achieve market acceptance on asustained basis.  In order to achieve marketacceptance and achieve future revenue growth, we must introduce complementarysecurity products, incorporate new technologies into our existing product linesand design, develop and successfully commercialize higher performance productsin a timely manner.  We cannot assure youthat we will be able to offer new or complementary products that gain marketacceptance quickly enough to avoid decreased revenues during current or futureproduct introductions or transitions.

***We had a net loss of $3.0 million and an accumulated deficit of $55.1million for the year ended December 31, 2006.  As a result, we must generate substantiallygreater revenues from sales in order to achieve profitability.***

We incurred significant operating losses for the fiscalyear ended December 31, 2006 and have incurred operating losses in previousyears.  For the year endedDecember 31, 2006, we incurred a net loss of $3.0 million and had anaccumulated deficit of approximately $55.1 million. ** **We need to generate and sustainsubstantially greater revenues from the sales of our products if we are toachieve profitability.  If we are unableto achieve these greater revenues, our losses will continue for the near termand possibly longer, and we may never achieve or sustain profitability orgenerate positive cash flow from operations.

***A large percentage of our revenues arereceived from U.S. government entities, and the loss of one of these customerscould reduce our revenues and materially harm our business and prospects.***

A large percentage of ourrevenues result from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the years ended December 31, 2004,2005****and 2006, sales to U.S.government entities collectively accounted for 53.6%, 70.7% and 73.6% of ourtotal net revenues, respectively. The loss of any of these key relationshipsmay send a negative message to other U.S. government entities or non-governmental customers concerning ourproduct offering.  We cannot assure youthat U.S. governmententitieswill be customers of ours in future periods or that we will be able todiversify our customer portfolio to adequately mitigate the risk of loss of anyof these customers.

***Government customers involve unique risks,which could adversely impact our revenues.***

We expect to continue to derive a substantial portion of ourrevenues from U.S. government customers in the future.  Sales to the government present risks inaddition to those involved in sales to commercial customers, includingpotential disruption due to appropriation and spending patterns, delays inapproving a federal budget and the government’s right to cancel contracts andpurchase orders for its convenience. General political and economic conditions, which we cannot accuratelypredict, directly and indirectly may affect the quantity and allocation of expendituresby federal departments.  In addition,obtaining government contracts may involve long purchase and payment cycles,competitive bidding, qualification requirements, delays or changes in funding,budgetary constraints, political agendas, extensive specification developmentand price negotiations and milestone requirements.  Each government entity also maintains its ownrules and regulations with which we must comply and which can varysignificantly among departments.  As aresult, cutbacks or re-allocations in the federal budget or losses ofgovernment sales due to other factors could have a material adverse effect onour revenues and operating results.

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***We are highly dependent on sales made through indirect channels, theloss of which would materially adversely affect our operations.***

For the years ended December 31, 2004, 2005 and 2006,we derived 36.9%, 36.2% and 17.3% of our revenues from sales through indirectsales channels, such as distributors, value-added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  We must expand our salesthrough these indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

***International sales comprise a materialportion of our overall revenues.  Ourability to sell our products internationally is subject to certain risks, whichcould harm our business.***

Revenues from foreign customers for the fiscal years endedDecember 31, 2004, 2005 and 2006 accounted for approximately 19.2%, 10.7% and9.4%, respectively, of our revenues.  Weexpect sales to foreign customers to continue to represent a significantportion of our revenues in the future. Our international operations are subject to many inherent risks that mayadversely affect our business, financial condition and operating results,including:

·                  political, social and economic instability;

·                  trade restrictions;

·                  increases in duty rates and other potentially adversetax consequences;

·                  exposure to different legal standards, particularlywith respect to the protection of intellectual property;

·                  burdens of complying with a variety of foreign laws;

·                  unexpected changes in regulatory requirements;

·                  import and export license requirements andrestrictions of the United States and each other country where we operate;

·                  fluctuations in currency exchange rates; and

·                  changes in local purchasing practices, includingseasonal fluctuations in demand.

Any interruptions or declines in our international saleswould result in a significant adverse impact on our results of operations andbusiness.

***The payment ofaccrued dividends on our preferred stock may strain our cash resources.***

On March 25, 2004, we completed a $5,000,000 privateplacement pursuant to which we issued 1,000,000 shares of our 5% ConvertiblePreferred Stock (the “Series 1 Preferred Stock”) and warrants to acquire556,619 shares of our common stock.  Theconversion price for the Series 1 Preferred Stock and the exercise price of thewarrants is $3.144 per share.  We alsoissued our placement agent a warrant for 64,408 shares of our common stock atan exercise price of $3.144 per share.  Asof February 28, 2007, there were 259,696 shares of the Series 1 Preferred Stockoutstanding, representing approximately 413,003 shares of common stock uponconversion, and warrants to purchase 621,027 shares of common stockoutstanding.

On March 28, 2005, we completed a $2,663,000 privateplacement pursuant to which we issued 1,065,200 shares of our Series 2 5%Convertible Preferred Stock (the “Series 2 Preferred Stock”) and warrants toacquire 532,600 shares of our common stock. We also issued two affiliates of our placement agent warrants topurchase an aggregate of 60,390 shares of common stock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of February 28,2007, there were 460,000 shares of the Series 2 Preferred Stock outstanding,representing 460,000 shares of common stock upon conversion, and warrants topurchase 592,990 shares of common stock outstanding.

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On December 2, 2005, we completed a $1,230,843 privateplacement pursuant to which we issued 564,607 shares of our Series 3 5% preferredstock  (the “Series 3 Preferred Stock”)and warrants to acquire 282,306 shares of our common stock.  We also issued two affiliates of ourplacement agent warrants to purchase an aggregate of 27,531 shares of commonstock.  The conversion price of theSeries 3 Preferred Stock is $2.18 per share and the exercise price of thewarrants is $2.58 per share.  As ofFebruary 28, 2007, there were 468,735 shares of Series 3 Preferred Stockoutstanding, representing 468,735 shares of common stock upon conversion, andwarrants to purchase 309,837 shares of common stock outstanding.

During the fiscal year ended December 31, 2006, wepaid $66,000 in dividends to the holders of our 5% Preferred Stock, $74,000 individends to the holders of our Series 2 5% Preferred Stock and $53,000 individends to the holders of our Series 3 5% Preferred Stock.  At December 31, 2006, we have dividendsaccrued of $16,364 related to our 5% Preferred Stock, $4,884 related to ourSeries 2 5% Preferred Stock and $4,339 related to our Series 3 5%Preferred Stock.

Delaware law provides that we may only pay dividendsout of our capital surplus or, if no surplus is available, out of our netprofits for the fiscal year the dividend is declared and/or the precedingfiscal year.  We have not had net profitsfor the last two fiscal years ended as of December 31, 2006.  However, we did have sufficient capitalsurplus, defined as the amount by which our net assets exceed our statedcapital, based on par value of our outstanding shares as provided by Delawarelaw.  We cannot assure you that our netassets will continue to exceed our stated capital or that we will have netprofits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  The accrual of thesedividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business.

If we are unable to paydividends on our preferred stock, we could be required to redeem theoutstanding shares of Series 2 Preferred Stock and Series 3 Preferred Stock forshares of our common stock issued at a price equal to 75% of the average of thevolume weighted average price of our common stock for the ten days ending onthe day immediately preceding an election to redeem, subject, in the case ofthe Series 3 Preferred Stock, to a floor of $0.87.  As a result, the issuance or potentialissuance of these additional shares of common stock could cause our stock priceto decline.  Furthermore, our inabilityto pay dividends could adversely affect our ability to raise equity financingin the future if required.

***You will experience substantialdilution upon the conversion or redemption of the shares of preferred stock andthe exercise of warrants that we issued in our recent private placements or inthe event we raise additional funds through the issuance of new shares of ourcommon stock or securities convertible or exercisable into shares of commonstock.***

On March 16, 2007, we had 9,222,139 shares of commonstock outstanding.  Upon conversion ofall outstanding shares of our preferred stock and exercise of the warrants, wewill have 12,087,731 shares of common stock outstanding, approximately a 31.1%increase in the number of shares of our common stock outstanding.

Further, the occurrenceof certain events entitles holders of our Series 2 Preferred Stock and Series 3Preferred Stock to require us to redeem their shares for a certain number ofshares of our common stock.  Assuming (i)we have paid all liquidated damages and other amounts to the holders, (ii)incurred accrued but unpaid dividends on February 28, 2007 of $17,600, (iii) avolume weighted average price of $0.48, which was the ten-day volume weightedaverage closing price of our common stock on February 28, 2007, and (iv) our8,296,213shares ofcommon stock outstanding on February 28, 2007, upon exercise of theirredemption right by the holders of the Series 3 Preferred Stock and the Series2 Preferred Stock, we would be obligated to issue approximately 13,107,243shares of our common stock.  This wouldrepresent an increase of approximately 158.0% in the number of shares of ourcommon stock as of February 28, 2007.

In addition, managementmay issue additional shares of common stock or securities exercisable orconvertible into shares of common stock in order to finance the Company’scontinuing operations.  Any futureissuances of such securities would have additional dilutive effects on theexisting holders of our Common Stock.

***The conversion of preferred stock or exercise of warrants we issued inthe private placements may cause the price of our common stock to decline.***

The holders of the shares of our 5% Preferred Stock and warrants we issued in connection with the sale of our 5% PreferredStock may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to aneffective registration statement we filed with the Commission on August 6,2004.  As of February 28, 2007, 740,304shares of our 5%Preferred Stock had converted into 1,177,327shares of common stock.

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The holders of the shares of Series 2 5% Preferred Stock and warrants we issued in connection with the sale of our Series 2Preferred Stock may freely convert their shares of preferred stock and exercisetheir warrants and sell the underlying shares of common stock pursuant to an effectiveregistration statement we filed with the Commission on May 5, 2005.  As of February 28, 2007, 605,200 shares ofSeries 2 PreferredStock had converted into 605,200 shares of common stock.

The holders of the shares of Series 3 5% Preferred Stock and warrants we issued in connection with the sale of our Series 3Preferred Stock, may freely convert their shares of Series 3 Preferred Stock and exercise their warrants and sell the underlying shares of commonstock pursuant to an effective registration statement we filed with theCommission on January 5, 2006.  Asof February 28, 2007, 95,872 shares of Series 3 Preferred Stock hadconverted into 95,872 shares of common stock.

For the four weeks ended on February 23, 2007, the averagedaily trading volume of our common stock on The OTCBB was 21,300shares.  Consequently, if holders of preferred stockor warrants elect to convert their remaining shares or exercise their warrantsand sell a material amount of their underlying shares of common stock on theopen market, the increase in selling activity could cause a decline in themarket price of our common stock. Furthermore, these sales, or the potential for these sales, couldencourage short sales, causing additional downward pressure on the market priceof our common stock.

***Certainrights of the holders of our preferred stock and the terms of our securedcredit line may hinder our ability to raise additional financing.***

Under the terms of our preferred stock instruments, wecannot issue shares of capital stock with rights senior to those of ourexisting 5% Preferred Stock, Series 2 5% Preferred Stock or Series 3 5%Preferred Stock without the approval of at least a majority of the holders ofour 5% Preferred Stock, all of the holders of our Series 2 5% Preferred Stock,and holders of at least 75% of our Series 3 5% Preferred Stock voting or actingas separate classes.  We also cannotincur certain indebtedness without the approval of at least a majority of theholders of our Preferred Stock. Furthermore, the terms of our secured credit line with Silicon ValleyBank include covenants which restrict our ability to incur additional debt andpay certain dividends.  The combinationof these provisions could hinder or delay our ability to raise additional debtor equity financing.

***Our failure to realize the expectedbenefits of our recent restructuring efforts could adversely affect ouroperating results.***

Since we began restructuring in 2002, we have incurredapproximately $1.1 million in restructuring charges, severance, and relatedexpenses. We have also implemented other strategic initiatives, such asreductions in our work force and facilities and aligning our organizationaround our business objectives.  Anyfurther work force reductions could result in temporary reduced productivity ofour remaining employees.  Additionally,our customers and prospects may delay or forgo purchasing our products due to aperceived uncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

***We resemble a developmental stage company and our business strategy maynot be successful.***

From our founding in 1983 until 2000, we derivedsubstantially all of our revenue from the design, manufacture and sale of localarea networking equipment.  In order topermit us to focus our resources solely on developing and marketing our networksecurity products, we sold our local area networking assets and related networkingdivisions.  We now depend exclusively onrevenues generated from the sale of our network security products, which havereceived limited market acceptance.  Wehave recently introduced our regulated information compliance systems, entityidentification products and spyware products, and the market for these productshas only begun to emerge.  We can provideno assurances that our newly introduced products will ever achieve widespreadmarket acceptance or that an adequate market for these products will everemerge.  Consequently, we resemble adevelopmental stage company and will face the following inherent risks anduncertainties:

·                  the need for our network security products, regulatedinformation compliance systems, entity identification products and spywareproducts to achieve market acceptance and produce a sustainable revenue stream;

·                  our ability to manage costs and expenses;

·                  our dependence on key personnel;

·                  our ability to obtain financing on acceptable terms;and

·                  ourability to offer greater value than our competitors.

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Our business strategy may not successfully address theserisks.  If we fail to recognizesignificant revenues from the sales of our network security products, regulatedinformation compliance systems, entity identification products and spywareproducts, our business, financial condition and operating results would bematerially adversely affected.

***Our management and larger stockholdersexercise significant control over our company and have the ability  approve or take actions that may be adverseto your interests.***

As of March 16, 2007, our executive officers,directors and preferred stockholders beneficially own approximately 41.7% ofour voting power.  As a result, thesestockholders will be able to exercise significant control over all mattersrequiring stockholder approval, including the election of directors andapproval of significant corporate transactions, which could delay or preventsomeone from acquiring or merging with us. These stockholders may use their influence to approve or take actionsthat may be adverse to your interests. Further, the Company contemplates the possible issuance of shares of ourCommon Stock or of securities exercisable or convertible into shares of ourCommon Stock in connection with a future investment by our Chief ExecutiveOfficer, pursuant to his written commitment to fund in an amount up to$750,000, should the Company require such funds.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management groupbeneficially holds.

***We face intense competition from bothstart-up and established companies that may have significant advantages over usand our products.***

The market for network security solutions is intenselycompetitive. There are numerous companies competing with us in various segmentsof the data security markets, and their products may have advantages over ourproducts in areas such as conformity to existing and emerging industrystandards, interoperability with networking and other security products,management and security capabilities, performance, price, ease of use,scalability, reliability, flexibility, product features and technical support.

Our principal competitors in the network intrusionprevention and detection market include Internet Security Systems, Inc.(IBM), Cisco Systems, Inc., Symantec, Inc., Juniper Networks, Inc., McAfeeInc., Tipping Point Technologies, a division of 3Com Corporation, and NFRSecurity, Inc.  Our competitors inthe regulated information compliance market include Vontu, Port Authority (Websense),Vericept, Reconnex, Tablus and a small number of start-up companies thatentered the space within the last two years. Regarding the spyware preventionmarket, we currently directly and indirectly compete with a number ofhost-based spyware detection systems, such as Ad-Aware, Spybot S&D and SpySweeper and some inline proxy solutions such as Blue Coat Systems, Inc.  Our current and potential competitors mayhave one or more of the following significant advantages over us:

•                    greater financial, technical andmarketing resources;

•                    better name recognition;

•                    more comprehensive security solutions;

•                    better or more extensive cooperativerelationships; and

•                    larger customer base.

We cannot assure you that we will be able to competesuccessfully with our existing or new competitors.  Some of our competitors may have, in relationto us, one or more of the following: longer operating histories,longer-standing relationships with OEM and end-user customers and greater customerservice, public relations and other resources. As a result, these competitorsmay be able to more quickly develop or adapt to new or emerging technologiesand changes in customer requirements, or devote greater resources to thedevelopment, promotion and sale of their products. Additionally, it is likelythat new competitors or alliances among existing competitors could emerge andrapidly acquire significant market share.

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***If we fail to respond to rapidtechnological changes in the network security industry, we may lose customersor our products may become obsolete.***

The network security industry is characterized by frequentproduct introductions, rapidly changing technology and continued evolution ofnew industry standards.  We must alsointroduce upgrades to our products rapidly in response to customer needs suchas new computer viruses or other novel external attacks on computernetworks.  In addition, the nature of thenetwork security industry requires our products to be compatible andinteroperable with numerous security products, networking products, workstationand personal computer architectures and computer and network operating systemsoffered by various vendors, including our competitors.  As a result, our success depends upon ourability to develop and introduce in a timely manner new products andenhancements to our existing products that meet changing customer requirementsand evolving industry standards. The development of technologically advancednetwork security products is a complex and uncertain process requiring highlevels of innovation, rapid response and accurate anticipation of technologicaland market trends.  We cannot assure youthat we will be able to identify, develop, manufacture, market or support newor enhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

***Our products are highly technical and if theycontain undetected errors, our business could be adversely affected and wemight have to defend lawsuits or pay damages in connection with any alleged oractual failure of our products and services.***

Our products are highly technical and complex, arecritical to the operation of many networks and, in the case of our securityproducts, provide and monitor network security and may protect valuableinformation. Our products have contained and may contain one or more undetectederrors, defects or security vulnerabilities. Some errors in our products mayonly be discovered after a product has been installed and used by endcustomers. Any errors or security vulnerabilities discovered in our productsafter commercial release could result in loss of revenues or delay in revenuerecognition, loss of customers and increased service and warranty cost, any ofwhich could adversely affect our business and results of operations. Inaddition, we could face claims for product liability, tort or breach ofwarranty. Defending a lawsuit, regardless of its merit, is costly and maydivert management’s attention. In addition, if our business liability insurancecoverage is inadequate or future coverage is unavailable on acceptable terms orat all, our financial condition could be harmed.

***A breach of network security could harm public perception of oursecurity products, which could cause us to lose revenues.***

If an actual or perceived breach of network securityoccurs in the network of a customer of our security products, regardless ofwhether the breach is attributable to our products, the market perception ofthe effectiveness of our products could be harmed. This could cause us to losecurrent and potential end customers or cause us to lose current and potentialvalue-added resellers and distributors. Because the techniques used by computerhackers to access or sabotage networks change frequently and generally are notrecognized until launched against a target, we may be unable to anticipatethese techniques

***Ifour products do not interoperate with our customers’ networks, installationswill be delayed or cancelled and could harm our business.***

Our products are designed to interface with ourcustomers’ existing networks, each of which have different specifications andutilize multiple protocol standards and products from other vendors. Many ofour customers’ networks contain multiple generations of products that have beenadded over time as these networks have grown and evolved. Our products will berequired to interoperate with many or all of the products within these networksas well as future products in order to meet our customers’ requirements. If wefind errors in the existing software or defects in the hardware used in ourcustomers’ networks, we may have to modify our software or hardware to fix orovercome these errors so that our products will interoperate and scale with theexisting software and hardware, which could be costly and negatively impact ouroperating results. In addition, if our products do not interoperate with thoseof our customers’ networks, demand for our products could be adverselyaffected, orders for our products could be cancelled or our products could bereturned. This could hurt our operating results, damage our reputation andseriously harm our business and prospects.

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***While we believe that we currently have adequate internal control overfinancial reporting, we are exposed to risks from recent legislation requiringcompanies to evaluate those internal controls.***

Section 404 of the Sarbanes-Oxley Act of 2002 requiresour management to report on the effectiveness of our internal control overfinancial reporting. We have an ongoing program to perform the system andprocess evaluation and testing necessary to comply with these requirements. Wehave and will continue to incur significant expenses and devote managementresources to Section 404 compliance on an ongoing basis. In the event that ourchief executive officer, chief financial officer or independent registeredpublic accounting firm determine in the future that our internal controls overfinancial reporting are not effective as defined under Section 404, investorperceptions may be adversely affected and could cause a decline in the marketprice of our stock.

***Our products can have long sales andimplementation cycles, which may result in us incurring substantial expensesbefore realizing any associated revenues.***

The sale and implementation of our products to largecompanies and government entities typically involves a lengthy educationprocess and a significant technical evaluation and commitment of capital andother resources.  This process is alsosubject to the risk of delays associated with customers’ internal budgeting andother procedures for approving capital expenditures, deploying new technologieswithin their networks and testing and accepting new technologies that affectkey operations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expendsignificant time and resources before we receive any revenues from a customeror potential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

***Consolidation in the network securityindustry may limit market acceptance of our products.***

Several of our competitors have acquired security companieswith complementary technologies in the past. We expect consolidation in the network security industry to continue inthe future.  These acquisitions maypermit our competitors to accelerate the development and commercialization ofbroader product lines and more comprehensive solutions than we currentlyoffer.  Acquisitions of vendors or othercompanies with which we have a strategic relationship by our competitors maylimit our access to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market shares, customerbases, sales forces, product offerings and technology and marketing expertise,which may make it more difficult for us to compete.

***We must adequately protect our intellectualproperty in order to prevent loss of valuable proprietary information.***

We rely on a combination of patent, copyright, trademarkand trade secret laws, confidentiality procedures and non-disclosure agreementsto protect our proprietary technology. However, unauthorized parties may attempt to copy or reverse-engineeraspects of our products or to obtain and use information that we regard asproprietary.  Policing unauthorized useof our products is difficult, and we cannot be certain that the steps we havetaken will prevent misappropriation of our intellectual property.  This is particularly true in foreigncountries where the laws may not protect proprietary rights to the same extentas the laws of the United States and may not provide us with an effectiveremedy against unauthorized use.  If ourprotection of our intellectual property proves to be inadequate orunenforceable, others may be able to use our proprietary developments without compensationto us, resulting in potential cost advantages to our competitors.

***We may incur substantialexpenses defending ourselves against claims of infringement.***

There are numerous patents held by many companies relatingto the design and manufacture of network security systems.  Third parties may claim that our productsinfringe on their intellectual property rights. Any claim, with or without merit, could consume our management’s time,result in costly litigation, cause delays in sales or implementations of ourproducts or require us to enter into royalty or licensing agreements. Royaltyand licensing agreements, if required and available, may be on termsunacceptable to us or detrimental to our business.  Moreover, a successful claim of productinfringement against us or our failure or inability to license the infringed orsimilar technology on commercially reasonable terms could seriously harm ourbusiness.

***Fluctuations in our quarterly revenues maycause the price of our common stock to decline.***

Our operating resultshave varied significantly from quarter to quarter in the past, and we expectour operating results to vary from quarter to quarter in the future due to avariety of factors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond tounexpected decreases in revenues. Therefore, if revenues are below our expectations, this shortfall islikely to adversely and 

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disproportionately affect our operating results.  Accordingly, we may not attain positiveoperating margins in future quarters. Any of these factors could cause our operating results to be below theexpectations of securities analysts and investors, which likely wouldnegatively affect the price of our common stock.

***The price of our common stock has been volatile in the past and maycontinue to be volatile in the future due to factors outside of our control.***

The market price of our common stock has been highlyvolatile in the past and may continue to be volatile in the future.  For example, in fiscal year 2006, the marketprice of our common stock on The OTCBB and The Nasdaq Capital Market fluctuatedbetween $0.22 and $2.87 per share.  Themarket price of our common stock may fluctuate significantly in response to anumber of factors, many of which are outside our control, including:

•                    variations in our quarterly operatingresults;

•                    changes in estimates of our financialperformance by securities analysts;

•                    changes in market valuations of ourcompetitors;

•                    announcements by us or our competitors ofnew products, significant contracts, acquisitions, strategic relationships,joint ventures or capital commitments;

•                    product or design flaws, product recallsor similar occurrences;

•                    additions or departures of key personnel;

•                    sales of common stock in the future; and

•                    fluctuations in stock market prices andvolume, which can be particularly common among network security and other hightechnology companies.

***Our past reductions in our work force maymake it more difficult for us to attract and retain the personnel necessary tosuccessfully operate our business.***

We rely upon the continued service of a relatively smallnumber of key technical, sales and senior management personnel.  Our future success depends on retaining ourkey employees and our continuing ability to attract, train and retain otherhighly qualified technical, sales and managerial personnel.  We do not have employment agreements with ourkey technical, sales and senior management personnel.  As a result, our employees could resign withlittle or no prior notice.  We may not beable to attract, assimilate or retain other highly qualified technical, salesand managerial personnel in the future. The loss of any of our key technical, sales and senior managementpersonnel or our inability to attract, train and retain additional qualifiedpersonnel could seriously harm our business.

***Our acquisition of complementaryproducts or businesses may adversely affect our financial condition.***

We have made acquisitionsin the past and, in the future we may acquire or invest in additionalcompanies, business units, product lines or technologies to accelerate thedevelopment of products and sales channels complementary to our existingproducts and sales channels.  Negotiationof potential acquisitions and integration of acquired products, technologies orbusinesses could divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properlyintegrate acquired products, technologies or businesses with our existingproducts and operations, train, retain and motivate personnel from the acquiredbusiness or combine potentially different corporate cultures, we may notreceive the intended benefits of our acquisitions, which could adversely affectour business, operating results and financial condition.

***Compliance with export regulations mayhinder our sales to foreign customers.***

Certain of our data security products incorporateencryption and other technology that may require clearance and export licensesfrom the U.S. Department of Commerce under United States exportregulations.  Any inability to obtainthese clearances or licenses or any foreign regulatory approvals, if required,on a timely basis could delay sales and have a material adverse effect on ouroperating results.

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***Provisions of our charter documents and Delaware law may haveanti-takeover effects.***

Certain provisions of our certificate of incorporationand bylaws, such as our ability to offer “blank check” preferred stock and theinability of our stockholders to act by written consent, could make it moredifficult for a third party to acquire us, even if doing so would be beneficialto our stockholders.  We are also subjectto the provisions of Section 203 of the Delaware General Corporation Law,which restricts certain business combinations with interested stockholders andcould inhibit a non-negotiated merger or other business combination.

***Military actions may disrupt our business by reducing spending on ourproducts, increasing our costs and affecting our international operations.***

United States militaryactions or other events occurring in response to or in connection with them,including future terrorist attacks, actual conflicts involving the UnitedStates or its allies or military or trade disruptions could impact ouroperations by:

·                  reducing or delaying government, militaryor corporate spending on network security products;

·                  increasing the cost and difficulty inobtaining materials or shipping products; and

·                  affecting our ability to conduct businessinternationally.

Should these events occur, our business, operatingresults and financial condition could be materially and adversely affected.

**Item 2.**                          Descriptionof Property.

Our headquarters are located in a two-story buildingin Richardson, Texas.  We occupy approximately30,000 square feet of floor space in this facility. This facility includes ourcorporate administration, operations, marketing, research and development,sales and technical support personnel. The lease for this facility extends through February 2010.

Approximatelythirty percent of our security software research and development staff islocated in a 6,464 square foot leased property in San Diego, California.  This lease is currently on a month to monthbasis.  Research and developmentpersonnel occupy this facility.

We believe that the existing facilities atDecember 31, 2006 will be adequate to meet our requirements through2007.  We believe that all facilities areadequately covered by appropriate property insurance.  See Note 4 of Notes to ConsolidatedFinancial Statements for additional information regarding our obligations underleases.

**Item 3.**                          LegalProceedings.

We are subject to legal proceedings and claims thatarise in the ordinary course of business. We do not believe that any claims exist where the outcome of suchmatters would have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact on future results.

**Item 4.**                          Submissionof Matters to a Vote of Security Holders.

There were no matters submitted to a vote of oursecurity holders during the fourth quarter of 2006.

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**PART II**

**Item 5.**                          Marketfor Common Equity and Related Stockholder Matters.

Our common stock tradeson The OTCBB, where it is currently listed under the symbol “INTZ.”  As of February 28, 2007, there wereapproximately 119 registered holders of record of the common stock. Thefollowing table sets forth, for the periods indicated, the high and low pershare intra-day sales prices for the common stock, as reported by The OTCBB.
| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|           |       |     |       |     |       |   |   |   |   |
| First Quarter  |       | $        | 2.87       |     | $          | 1.28 |   | $ | 6.20 |   | $ | 2.10 |   |
| Second Quarter |       | 1.52     |       | .40      |       | 4.15 |   | 1.92 |   |
| Third Quarter  |       | .72      |       | .28      |       | 3.59 |   | 2.61 |   |
| Fourth Quarter |       | .53      |       | .22      |       | 3.29 |   | 1.87 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

We have not declared or paid cash dividends on our commonstock in our two most recent fiscal years. We intend to retain any earnings for use in our business and do notanticipate paying any cash dividends on our common stock in the foreseeablefuture.  Future dividends on commonstock, if any, will be determined by our Board of Directors.  However, shares of our 5% convertiblepreferred stock accrue cash dividends equal to $0.25 per share per annum,payable in arrears on March 31 and September 30 of each year, andshares of our Series 2 5% and Series 3 5% convertible preferred stock accruecash dividends equal to $0.125 per share per annum payable in arrears on thefirst business day of March, June, September and December of each year.  We paid $192 thousand in dividends related toall of our 5% convertible preferred stock during 2006 and at December 31,2006, we have dividends accrued related to all of our 5% convertible preferredstock of $26 thousand.

Delaware law provides that we may only pay dividends out ofour capital surplus or, if no surplus is available, out of our net profits forthe fiscal year the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years, and as of December 31, 2006. However, we did have sufficient capital surplus, defined as the amountby which our net assets exceed our stated capital, based on par value of ouroutstanding shares as provided by Delaware law. Although we are currently able to pay accrued dividends on ouroutstanding shares of preferred stock, we cannot assure you that our net assetswill continue to exceed our stated capital or that we will have net profits inorder to pay these dividends in the future. These dividends continue to accrue on our outstanding shares ofpreferred stock, regardless of whether we are legally able to pay them.  The accrual of these dividends may adverselyaffect our operating results.  Inaddition, the payment of these dividends could strain our available cashresources, which could adversely affect our ability to operate or grow ourbusiness.  Furthermore, our inability topay dividends could adversely affect our ability to raise equity financing inthe future, if required.

All stock option plans under which our common stock isreserved for issuance have previously been approved by our shareholders. Thefollowing table provides summary information as of December 31, 2006 forall of our stock option plans (in thousands, except per share data). SeeNote 8 to our consolidated financial statements for additional discussion.
| ** **                                                  | ** ** | **Number of Shares  of Common Stock  to be Issued upon  Exercise of  Outstanding  Options** | ** ** | **Weighted Average  Exercise Price of  Outstanding Options,  Excludes  Warrants Rights** | ** ** | **No. of Shares of  Common Stock  Remaining Available  for Future Issuance** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |                                                                                                                                |       |                                                                                                              |       |                                                                                                            |       |
| Equity  compensation plans approved by security holders     |       | 1,086                                                                                                                               | (1)        | $                                                                                                                 | 3.23       |                                                                                                            | 96         | (2) |
| Equity  compensation plans not approved by security holders |       | —                                                                                                                              |       | —                                                                                                            |       | —                                                                                                          |       |
| Total                                                       |       | 1,086                                                                                                                               |       | $                                                                                                                 | 3.23       |                                                                                                            | 96         |   |

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(1)             Includedin the outstanding options are 654,500 from the 2005 Plan, 398,631 from the1995 Plan and 32,500 from the 1995 Non-Employee Director Plan.

(2)             Doesnot include Employee Stock Purchase Plan. At December 31, 2006, 79,298shares were available for future issuance under this plan.

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**Item 6.**                          Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

**“Safe Harbor”Statement under the Private Litigation Reform Act of 1995**

This Annual Report, including the sections entitled “RiskFactors,” “Management’s Discussion and Analysis of Financial Condition andResults of Operations,” and “Description of Business,” contains forward-lookingstatements.  These statements relate tofuture events or to our future financial performance, and involve known andunknown risks, uncertainties and other factors that may cause our actualresults, levels of activity, performance, or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by these forward-looking statements. In somecases, you can identify forward-looking statements by the use of words such as “may,”“could,” “expect,” “intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,”“predict,” “potential,” “continue,” or the negative of these terms or othercomparable terminology.  You should notplace undue reliance on forward-looking statements since they involve known andunknown risks, uncertainties and other factors which are, in some cases, beyondour control and which could materially affect actual results, levels ofactivity, performance or achievements. Factors that may cause actual results to differ materially from currentexpectations, which we describe in more detail elsewhere in this prospectus underthe heading “Risk Factors,” include, but are not limited to:

·                  Failure to respond to rapidtechnological changes in the network security industry;

·                  Failure of our networkintrusion detection, regulated information compliance, and entity identificationproducts to achieve market acceptance;

·                  Our status as adevelopmental stage company;

·                  Our need to generatesubstantially greater revenues from sales in order to achieve profitability;

·                  intense competition fromboth start-up and established companies that may have significant advantagesover us and our products;

·                  disruption to our businessdue to military actions;

·                  long sales andimplementation cycles of our products;

·                  insufficient cash to operateour business;

·                  failure to realize theexpected benefits of our recent restructuring efforts;

·                  the effect of consolidationin the network security industry;

·                  Risks involved withGovernment and international customers;

·                  Our inability to expand oursales;

·                  Failure to adequatelyprotect our intellectual property; or

·                  The rights of the holders ofour preferred stock and the terms of our secured credit line.

If one or more of these or other risks oruncertainties materialize, or if our underlying assumptions prove to beincorrect, actual results may vary significantly from what we projected. Anyforward-looking statement you read in this prospectus reflects our currentviews with respect to future events and is subject to these and other risks,uncertainties and assumptions relating to our operations, results ofoperations, growth strategy and liquidity. We assume no obligation to publiclyupdate or revise these forward-looking statements for any reason, or to updatethe reasons actual results could differ materially from those anticipated inthese forward-looking statements, even if new information becomes available inthe future. The Private Securities Litigation Reform Act of 1995 and Section27A of the Securities Act, each of which provide protection in connection withcertain forward-looking statements, do not directly protect any statements wemake in connection with this Annual Report.

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**Overview**

We develop, market and support a family of networkintrusion prevention, intrusion detection, regulated information compliance,data privacy protection and entity identification products.  Our product families include the ComplianceCommander for regulated information compliance and data privacy protection,Intrusion SpySnare for real-time inline blocking of spyware and unwantedpeer-to-peer (P2P) applications, Intrusion SecureNet for network intrusionprevention and detection and TraceCop for identity identification.  Intrusion’s products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

We market and distribute our products through a directsales force to end-users, distributors and numerous system integrators, managedservice providers and value-added resellers. Our end-user customers includebanks, credit unions, other financial institutions, U.S. federal governmententities, foreign government entities and local government entities, hightechnology, e-commerce and telecommunication companies, hospital and otherhealthcare providers and academic institutions. Essentially, our end-user can be defined as ‘any end-user requiringnetwork security solutions for protecting their mission critical data’.

We were organizedin Texas in September 1983 and reincorporated in Delaware inOctober 1995. For more than 15 years, we provided local areanetworking equipment and were known as Optical Data Systems or ODS Networks. OnApril 17, 2000, we announced plans to sell, or otherwise dispose of, ournetworking divisions, which included our Essential Communications division andour local area networking assets. On June 1, 2000, we changed our namefrom ODS Networks, Inc. to Intrusion.com, Inc., and our ticker symbolfrom ODSI to INTZ to reflect our focus on intrusion prevention and detectionsolutions, along with information compliance and data privacy protectionproducts. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

Our principal executive offices are located at 1101East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephone numberis (972) 234-6400.  Our website URLis www.intrusion.com.  References to “we”,“us”, “our” or “Intrusion Inc.” refer to Intrusion Inc. and itssubsidiaries.  Compliance CommanderTM,SecureNetTM, TraceCopTM and SpySnareTM are registered trademarks of Intrusion Inc.

Our revenues have decreased over the past few yearsdue primarily to the change in our product focus from networking hardware tonetwork security software products with a corresponding decrease in our salesvolume related to this change in our product mix.  To date, we have not encountered significantcompetition in the market that has caused us to decrease our sales prices whencompared to sales prices in previous years. To help counteract our declining revenues and bring our operations inline with our new strategic focus, we reduced our employee headcount in2006.  At December 31, 2005 we employed43 employees and at December 31, 2006 we employed 32 employees.  As a result of our migration to software-basedsolutions, our margins have increased over the past two years from 51.0% in2004, to 58.0% in 2005 and 2006.  We havealso restructured our personnel and operations around the development and saleof our core software products.  As aresult of these efforts, we believe we have reduced operating expenses to alevel that will remain consistent going forward.

In order for us to operate and grow our business, wemust achieve and sustain operating profits and become cash flow positive.  This will require us to counteract reducedsales of our SecureNet products by generating additional revenues from sales ofour regulated information compliance and entity identification softwareproducts.  In order to obtain thesesales, our products must gain acceptance in intensely competitive and emergingmarkets.  We believe our ability tointroduce our Compliance Commander and TraceCop products into the marketplacein a timely manner and our efforts to maintain our reduced spending levels willhelp us achieve these results.

**Critical Accounting Policies and Estimates**

Management’s discussion and analysis of financialcondition and results of operations are based upon our consolidated financialstatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these financialstatements requires us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and related disclosureof contingent assets and liabilities. On an on-going basis, we evaluate ourestimates, including those related to product returns, bad debts, inventories,income taxes, warranty obligations, maintenance contracts and contingencies. Webase our estimates on historical experience and on various other assumptionsthat are believed to be reasonable under the circumstances, the results ofwhich form the basis for making judgments about the carrying values of assetsand liabilities that are not readily apparent from other sources. Actualresults may differ from these estimates under different assumptions orconditions.

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We believe thefollowing critical accounting policies affect our more significant judgmentsand estimates used in the preparation of our consolidated financial statements.

*Revenue Recognition*

We generally recognize product revenue upon shipmentof product. We accrue for estimated warranty costs and sales returns at thetime of shipment based on our experience. Revenue from maintenance contracts isdeferred and recognized over the contractual period the services are performed,generally one year.  There is a risk thattechnical issues on new products could result in unexpected warranty costs andreturns.  However, as we migrate to moreof a software-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve from current sales will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our warranty reserve to compensate for theadditional expense expected to be incurred. We review these estimates periodically and determine the appropriatereserve percentage.  However, to date,warranty costs and sales returns have not been material.  Historically, our estimates for these itemshave not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

We recognize software revenue from the licensing ofour software products in accordance with Statement of Position (“SOP”)No. 97-2 “Software Revenue Recognition”, SOP 98-9 “Modification of 97-2,Software Revenue Recognition, with respect to certain transactions” and StaffAccounting Bulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue fromthe licensing of our products is not recognized until all four of the followingcriteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectibility is probable. Bundled hardware and perpetualsoftware product sales are recognized at time of delivery, as our licenses arenot sold on a subscription basis.  In thecase of multiple product and service sales, we perform a Vendor SpecificObjective Evidence analysis to appropriately determine the amount of revenue derivedfrom each deliverable.  If our licensestrategy changes and we begin to offer licenses on a subscription basis, wewould perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical salesinformation on our product offerings.  Wedefer and recognize maintenance and support revenue over the term of thecontract period, which is generally one year.

We have signed distribution agreements withdistributors in the United States, Europe and Asia. In general, theserelationships are non-exclusive. Distributors typically maintain an inventoryof our products. Under these agreements, we provide certain protection to thedistributors for their inventory of our products for price reductions as wellas products that are slow moving or have been discontinued by us. Historically,returns from our distributors and charges related to price reductions oninventory held by distributors have not been material.  Recognition of sales to distributors andrelated gross profits are deferred until the distributors resell themerchandise. However, since we have legally sold the inventory to thedistributor and we no longer have care, custody or control over the inventory,we recognize the trade accounts receivable and reduce inventory related to thesale at the time of shipment to the distributor. Revenue, offset by deferredcost of sales, is included in deferred revenue in the accompanying financialstatements.  Since the net balance indeferred revenue represents the sales price less the cost of the productmaintained by the distributors, the deferred costs of these products areincluded in our obsolescence and slow-moving analysis and are written downaccording to their estimated current value. This transaction effectively recognizes expense for the write-down, ifany, and increases the net liability in the deferred revenue account.

We generally recognize service revenue upon deliveryof the contracted service.  Servicerevenue, primarily including maintenance, training and installation, arerecognized upon delivery of the service and typically are unrelated to productsales.  These services are not essentialto the functionality of the delivered product. To date, training and installation revenue has not been material.

*Allowance for Doubtful Accounts and Returns*

We maintain allowances for doubtful accounts forestimated losses resulting from the inability of our customers to make requiredpayments. Our receivables are uncollaterized and we expect to continue thispolicy in the future.  If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

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*Inventory*

We write down our inventory for estimated obsolescenceor unmarketable inventory equal to the difference between the cost of inventoryand the estimated market value based upon assumptions about future demand andmarket conditions. If actual market conditions are less favorable than thoseprojected by management, additional inventory write-downs may be required.   Historically, our estimates for inventoryobsolescence have not differed materially from actual results.

**Results of Operations**

The following tables set forth, for the periodsindicated, certain financial data as a percentage of net revenue.

|                                                   | ** ** | **Year Ended December 31,**                           | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **     2006     ** | ** ** | **     2005     ** | ** ** |
|                                              |       |                                                                 |       |   |   |
| Net product  revenue                              |       | 78.3                                                                 | %          | 73.2 | % |
| Net customer  support and maintenance revenue     |       | 21.7                                                                 |       | 26.8 |   |
| Total revenue                                     |       | 100.0                                                                |       | 100.0 |   |
| Cost of product  revenue                          |       | 38.2                                                                 |       | 39.4 |   |
| Cost of customer  support and maintenance revenue |       | 3.8                                                                  |       | 2.6 |   |
| Total cost of  revenue                            |       | 42.0                                                                 |       | 42.0 |   |
| Gross profit                                      |       | 58.0                                                                 |       | 58.0 |   |
| Operating  expenses:                              |       |                                                                 |       |   |   |
| Sales and marketing                               |       | 51.8                                                                 |       | 52.5 |   |
| Research and development                          |       | 39.4                                                                 |       | 42.7 |   |
| General and administrative                        |       | 23.9                                                                 |       | 18.8 |   |
| Severance costs                                   |       | 0.2                                                                  |       | 1.0 |   |
| Operating loss                                    |       | (57.3                                                                | )          | (57.0 | ) |
| Interest income,  net                             |       | 0.8                                                                  |       | 1.4 |   |
| Other income,  net                                |       | (1.2                                                                 | )          | 0.0 |   |
| Loss from  operations before income taxes         |       | (57.7                                                                | )          | (55.6 | ) |
| Income tax  provision                             |       | —                                                               |       | — |   |
| Net loss                                          |       | (57.7                                                                | )          | (55.6 | ) |
| Preferred stock  dividends accrued                |       | (3.3                                                                 | )          | (2.9 | ) |
| Beneficial  conversion feature on preferred stock |       | —                                                               |       | (24.0 | ) |
| Net loss attributable  to common stockholders     |       | (61.0                                                                | )%         | (82.5 | )% |

 

|                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|---------------------|------------|----------|------------|----------|------------|
|                |       |     |       |     |       |
| Domestic revenue    |       | 90.6     | %          | 89.3     | %          |
| Export revenue  to: |       |     |       |     |       |
| Europe              |       | 7.1      |       | 7.8      |       |
| Canada              |       | 1.6      |       | 0.5      |       |
| Asia                |       | 0.6      |       | 2.3      |       |
| Latin America       |       | 0.1      |       | 0.1      |       |
| Net revenue         |       | 100.0    | %          | 100.0    | %          |

 

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**2006 compared with 2005**

***Net Revenue***

Total revenue decreased to $5.2 million in 2006from $6.0 million in 2005.  The lack ofrevenue growth is related to shifting our focus from our SecureNet IPS productline to our Compliance Commander and TraceCop product lines.  Our customer support and maintenance revenuedecreased 29.1% from $1.6 million in 2005 to $1.1 million in 2006.  This decline is mainly due to the expirationof maintenance contracts related to our SecureNet and zero maintenance relatedto TraceCop products.  In 2006, totalrevenues related to our SecureNet product line decreased 56% or $2.2 millionfrom $3.9 million in 2005 to $1.7 million in 2006, and our non-core productlines, including our PDS and SecureCom hardware products decreased 66.7% or$0.2 million from $0.3 million in 2005 to $0.1 million in 2006.  Our product revenues remained constant at$4.1 million in 2006.  We expect ourproduct revenues to increase in the future as the market acceptance of ourCompliance Commander and TraceCop product lines increase.

Export sales in 2006 decreased to $0.5 million,or 9.4% of net revenue, compared to $0.6 million, or 10.7% of net revenuein 2005 primarily due our focus on domestic revenue sales.  As part of our headcount reductions, we havefocused most of our sales personnel on the domestic market.  Sales of our products internationally may besubject to exchange risk, which may cause our products to effectively increasein price, if the exchange rate moves significantly and the dollar gains valueover the foreign currency.

Historically, due to the timing of our sales cycle, a significantportion of our monthly sales occurs in the second half of the month.  Accordingly, our receivables increase at theend of each month, which causes a higher accounts receivable balance at monthend. This monthly trend also causes an inflated comparative relationshipbetween revenue and accounts receivable. We believe that this monthly trendwill continue because monthly sales forecast and planning meetings are held inthe first week of every month, the middle of the month is focused on salescalls to customers and the later half of the month on closing sales.

***Gross Profit***

Gross profit decreased 12.8% to $3.0 million in2006 from $3.5 million in 2005. As a percentage of net revenue, grossprofit remained constant at 58.0% for 2006 and 2005.  Gross profit on products increased from 46.0%in 2005 to 51.3% in 2006 due to the shift in a more profitable product mix,namely our software-based products. Gross profit on customer support and maintenance decreased from 90.2% in2005 to 82.2% in 2006.  The decrease ingross profit on customer support and maintenance was relatively small and ourgross profit in this area should remain strong as our hardware-related repaircosts in conjunction with our strategic decision to move towards software-basedsolutions should remain low.  As wecontinue to migrate from our older hardware-based products to our newersoftware-based products, we expect our product margins to continue to increase.

Gross profit as a percentage of net revenue isimpacted by several factors, including shifts in product mix, changes inchannels of distribution, sales volume, fluctuations in manufacturing costs,pricing strategies, and fluctuations in sales of integrated third-partyproducts.

***Sales and Marketing***

Sales and marketing expenses decreased 12.9% to$2.7 million in 2006 from $3.1 million in 2005, as we reducedexpenses to respond to the decline in sales. As a percentage of net revenue,sales and marketing expenses decreased to 51.8% in 2006 from 52.5% in 2005. Weexpect sales and marketing expenses to decrease in 2007 compared to 2006 as wehold the expense levels near fourth quarter 2006 levels, which decreased as aresult of a decrease in employee headcount. We also expect sales and marketing expenses, as a percentage of netrevenue, to decrease in 2007 compared to 2006 as we expect an increase inrevenue in 2007.

***Research and Development***

Research and development expenses decreased to$2.1 million, or 39.4% of net revenue, in 2006 compared to$2.6 million, or 42.7% of net revenue, in 2005.  Our research and development costs areexpensed in the period in which they are incurred. We expect research anddevelopment expenses to remain relatively constant in 2007 compared to2006.  We expect research and development,as a percentage of net revenue, also to decrease in 2007 compared to 2006 asour revenue increases.

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***General and Administrative***

General and administrative expenses increased slightlyto $1.3 million, or 23.9% of net revenue in 2006 compared to $1.1 million or18.8 % of net revenue in 2005.  We expectgeneral and administration expenses to remain relatively constant in 2007compared to 2006.

***Severance Costs***

In connection with our strategic alignment of oursales force domestically and our continued shift to our new security productlines during 2004, we streamlined operations and activities that are notaligned with these core markets and strategies. During 2006 we recordedseverance charges of $10 thousand, compared to $55 thousand in 2005.  All severance obligations related to the 2006expense were paid prior to December 31, 2006. All severance obligations related to the 2005 expense were paid prior toDecember 31, 2005.  We were notreceiving any benefits from those severed individuals subsequent to the year ofthe applicable expense.

***Interest Income, Net***

Net interest income decreased 46.4% to $45 thousand in2006 from $84 thousand in 2005 primarily due to a decrease in average cash andinterest-bearing investment balances. We expect net interest income to remainconsistent in 2007 compared to 2006.  Netinterest income will vary in the future based on our cash flow and rate ofreturn on investments.

***Income Taxes***

Our effective income tax rate was 0% in 2006 and 2005as valuation allowances have been recorded for the entire amount of the netdeferred tax assets due to uncertainty of realization.  We have fully utilized our net operating losscarryback.

**Liquidityand Capital Resources**

Our principal sources of liquidity atDecember 31, 2006 were $0.9 million of cash and cash equivalents. As ofDecember 31, 2006, we do not hold investments with a stated maturitybeyond one year. Working capital at December 31, 2006 was $0.5 millioncompared to $2.7 million as of December 31, 2005.

Net cash used in operations in 2006 was$2.9 million, primarily due to an operating loss of $3.0 million for theyear, a decrease in deferred revenue of $0.2 million, a decrease in inventoriesof $0.2 million, offset by depreciation and amortization of $0.1 million and anincrease in accounts receivable of $0.4 million.  Future fluctuations in accounts receivable,inventory balances and accounts payable will be dependent upon several factors,including quarterly sales, timely collection of accounts receivable, and theaccuracy of our forecasts of product demand and component requirements.

Net cash provided by investing activities in 2006 was$0.5 million, which consisted of maturities of short term investments of$0.5 million of available for sale securities.

Net cash provided by financing activities in 2006 was$0.5 million, consisting of net financing proceeds from private placements of$0.5 million, net proceeds from line of credit of $.2 million and dividendspaid on preferred stock of $0.2 million.

At December 31, 2006, we did not have anymaterial commitments for capital expenditures. Operating lease commitments of$1.2 million are detailed below. During 2006, we funded our operationsthrough the use of available cash, cash equivalents and investments, which wasraised primarily through financing generated through the sale of our Series 35% convertible preferred stock.

As of December 31, 2006, we had cash, cash equivalents andinvestments in the amount of approximately $0.9 million, down fromapproximately $3.3 million as of December 31, 2005.  However, throughout 2006, we continued toreduce expenses and realize the benefit of cost-cutting actions taken inprevious years.  Our net loss during thethird and fourth quarter 2006 was approximately $200 thousand per quarter.

On December 28, 2006, we completed a private placementof 1,250,000 shares of our Common Stock for gross proceeds of $500,000.

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On March 15, 2007, we completed an additional privateplacement of 925,926 shares of our Common Stock for gross proceeds of $500,000.

OnMarch 29, 2006, we established a $1,000,000 line of credit with Silicon ValleyBank.  Under the terms of this agreement,we may borrow an amount equal up to 80% of eligible accounts receivablebalances.  In addition, we may obtaininventory advances equal to 35% of finished good inventory, capped at thelesser of the inventory availability, $300,000 or 35% of our total borrowingbase.  If our credit line increases to$2,000,000, inventory advances will be capped at the lesser of the inventoryavailability, $600,000 or 35% of our borrowing base.  Amounts we borrow under the credit lineaccrue interest at an annual rate of prime plus 1% and are secured by a lien onall of our assets.  Accrued interest onall outstanding amounts is payable monthly in arrears and all outstandingprincipal and accrued but unpaid interest on the amounts we borrow are due onMarch 28, 2008.  Our ability to receiveadvances under this credit line will increase if we generate additionalreceivables and inventory from the sale of our products.  We have current balance due under this creditline of $200,000 at December 31, 2006. Also, assuming eligible receivables and inventory equal to the $844,000of net accounts receivable and the $180,000 of finished goods inventory we hadat December 31, 2006, we could borrow up to an additional $139,000 under ourcredit line at December 31, 2006. The line of credit was renewed on March 29,2007, accrued interest on all outstanding amounts is payable monthly in arrearsand all outstanding principal and accrued but unpaid interest on the amounts weborrow are due on March 28, 2008.

We expect our net operating losses and operating cashoutflows to continue through at least the first quarter of 2007 and possiblythroughout the remainder of fiscal year 2007. The sufficiency of our cash resources may depend to a certain extent on generaleconomic, financial, competitive or other factors beyond our control.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  Of the $0.9 million in cash, cash equivalents and investments atDecember 31, 2006, $0.5 million was derived from a private investment by ourChief Executive and Chief Financial Officers which closed on December 28,2006.   As of February 28, 2007 we hadcash and cash equivalents of $300,000 and less than $100,000 in availablefunding under our existing credit line. Based on projections for increased revenues in 2007, the closing of the$0.5 million private placement on March 15, 2007 and a commitment from theCompany’s CEO to advance the Company up to $0.75 million in funding should itbe necessary, we believe that our available credit line and available cashresources will provide sufficient cash resources to finance our operations andexpected capital expenditures for the next twelve months.  It is possible that we may need to fund ouroperations through additional investments of private equity, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe next few months, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

We intend to explore the possible acquisitions ofbusinesses, products and technologies that are complementary to our existingbusiness. We are continuing to identify and prioritize additional securitytechnologies, which we may wish to develop, either internally or through thelicensing or acquisition of products from third parties. While we engage fromtime to time in discussions with respect to potential acquisitions, there canbe no assurances that any such acquisitions will be made or that we will beable to successfully integrate any acquired business. In order to finance suchacquisitions, it may be necessary for us to raise additional funds throughpublic or private financings. Any equity or debt financings, if available atall, may be on terms which are not favorable to us and, in the case of equityfinancings, may result in dilution to our stockholders.

### **Contractual Obligations**

Thefollowing table sets forth certain information concerning the futurecontractual obligations under our operating leases at December 31,2006.  We have no other significantcontractual obligations at December 31, 2006.

**Futureminimum lease payments consisted of the following on December 31, 2006 (inthousands):**

| 2007   |   | $      | 378    |   |
|--------|--------|--------|--------|--------|
| 2008   |   | 393    |   |
| 2009   |   | 409    |   |
| 2010   |   | 68     |   |
|   |   |   |   |
|   |   | $      | 1,248  |   |

 

27

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### **Off-Balance Sheet Arrangements**

As ofDecember 31, 2006, we did not have any significant off-balance sheetarrangements, as defined in Item 303(c)(2) of Regulation S-B.

**Quantitativeand Qualitative Disclosures About Market Risk.**

ForeignExchange.  Our revenue originatingoutside the U.S. in 2006 and 2005 was 9.4% and 10.7% of total revenues,respectively.  Revenues generated fromthe European region in 2006 and 2005 were 7.1% and 7.8% of total revenues,respectively.  Revenues generated fromthe Asia region in 2006 and 2005 were 0.6% and 2.3% of total revenues,respectively.  International sales aregenerated primarily from our foreign sales subsidiaries in the local countriesand are typically denominated in U.S. dollars. These subsidiaries incur substantially all of their expenses in the localcurrency.

Ourinternational business is subject to risks typical of an internationalbusiness, including differing economic conditions, changes in politicalclimate, differing tax structures, import and export regulations, otherregulations and restrictions, and foreign exchange rate volatility.Accordingly, our results could be materially adversely impacted by changes inthese or other factors. The effect of foreign exchange rate fluctuations on ourbusiness in 2005 and 2004 was not material.

InterestRates.  We invest our cash in a varietyof investment grade financial instruments, including bank time deposits, fixedrate obligations of corporations, municipalities, and state and nationalgovernmental entities and agencies. These investments are denominated in U.S. dollars.  Cash balances in foreign currencies overseasare operating balances and are invested in short-term time deposits of thelocal operating bank.

Interestincome on our investments is carried in “Interest income, net”. We account for ourinvestment instruments in accordance with Statement of Financial AccountingStandards No. 115, “Accounting for Certain Investments in Debt and EquitySecurities”.  All of the cash equivalentsand short-term investments are treated as available-for-sale underSFAS 115.

Investmentsin fixed-rate interest-earning instruments carry a degree of interest raterisk.  Fixed-rate securities may havetheir fair market values adversely impacted due to a rise in interest rates.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates or we may suffer losses in principal if forced to sell securities, whichhave seen a decline in market value due to changes in interest rates.  Our investment securities are held forpurposes other than trading.  Theweighted-average interest rate on investment securities for the year endedDecember 31, 2006 was 5.1%.  We heldno short-term investments at December 31, 2006.

**Item 7.          Financial Statements.**

Theinformation required by this item is included in Part III Item 13.

**Item 8.          Changes In and Disagreements with Accountants on Accountingand Financial Disclosure.**

None.

### **Item 8A.       Controlsand Procedures**

We maintain “disclosurecontrols and procedures,” as defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as amended (the “Exchange Act”),that are designed to ensure that information required to be disclosed by us inreports we file or submit under the Exchange Act is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating our disclosure controls and procedures, managementrecognized that disclosure controls and procedures, no matter how wellconceived and operated, can provide only reasonable assurance of achieving thedesired control objectives, and we necessarily are required to apply ourjudgment in evaluating the cost-benefit relationship of possible disclosurecontrols and procedures.

Our management,including our principal executive officer and principal financial officer,evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures as of December 31, 2006 and concluded that thedisclosure controls and procedures were effective.

28

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There were nochanges in our internal control over financial reporting that occurred duringthe quarter ended December 31, 2006 that have materially affected, or arereasonable likely to materially affect, our internal control over financialreporting.

At the end of2007, Section 404 of the Sarbanes-Oxley Act will require our management toprovide an assessment of the effectiveness of our internal control overfinancial reporting, and at the end of 2008, our independent registered publicaccountants will be required to audit management’s assessment. We are in theprocess of performing the system and process documentation, evaluation andtesting required for management to make this assessment and for its independentregistered public accountants to provide their attestation report. We have notcompleted this process or its assessment, and this process will requiresignificant amounts of management time and resources. In the course ofevaluation and testing, management may identify deficiencies that will need tobe addressed and remediated.

**Item 8B.       Other Information**

Notapplicable.

**PART III**

Certaininformation required by Part III is omitted from this Form 10-KSBbecause we will file a definitive Proxy Statement for our 2006 annualmeeting of stockholders pursuant to Regulation 14A (the “Proxy Statement”)no later than 120 days after the end of the fiscal year covered by thisForm 10-KSB, and certain information to be included therein isincorporated herein by reference.

**Item 9.          Directors and Executive Officers of Intrusion Inc.**

The informationrequired regarding Directors and Executive Officers of Intrusion Inc. appearingunder the captions “Election of Directors”, “Compliance with Section 16Reporting Requirements” and “Executive Officers” contained in the ProxyStatement is incorporated herein by reference.

**Item 10.        Executive Compensation.**

Theinformation set forth under the caption “Executive Compensation” contained inthe Proxy Statement is incorporated herein by reference.

*Compensation Committee Interlocksand Insider Participation*

Themembers of the Compensation Committee of our Board of Directors for the entire2006 fiscal year were J. Fred Bucy, Jr. (Chairman), Donald M. Johnston, andJames F. Gero, each of whom is an independent director.

Nomember of our Board of Directors or any committees of the Board, including theCompensation Committee, has an interlocking relationship with the board (ormember of such board) or any committee (or member of such committee) of a boardof any other company.

*March 25,2004 Private Placement*

OnMarch 25, 2004, we completed a $5,000,000 private placement of 1,000,000shares of our 5% convertible preferred stock and warrants to purchase 556,619shares of our common stock at an initial exercise price of $3.144 per share tovarious purchasers.  Mr. Gero, a directorand one of the members of the Compensation Committee, invested $300,000 in theprivate placement in consideration for 60,000 shares of preferred stock andwarrants to purchase 33,397 shares of common stock.  Mr. Gero participated in the privateplacement on the same terms and conditions as other investors, except that heis not entitled to a preemptive right to purchase a pro rata portion of certainfuture sales of securities by us.  Inaddition, as a director, Mr. Gero agreed not to sell any shares of common stockowned by him until the registration statement described below is declaredeffective by the SEC.

Aspart of this private placement, we entered into a Registration RightsAgreement, pursuant to which we are required to file a registration statementto register the shares of common stock issuable upon the conversion of thepreferred stock and upon the exercise of the warrants issued to the investorsin the private placement.  We failed tofile the registration statement by April 24, 2004 and did not have theregistration statement declared effective by July 24, 2004.  As a result, we paid liquidated damages equalto 2% of the aggregate purchase price paid to us in the private placement for eachthirty-day period, pro rated for any shorter period, that the filing oreffectiveness of the registration statement is delayed.  Mr. Gero

29

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waived his rightfor any liquidated damages related to our late filing of the registrationstatement.  In accordance with thisobligation, we filed a registration statement on Form S-3 including theseshares of common stock on April 20, 2004. The registration statement includes the 128,817 shares of common stockunderlying the preferred stock and warrants purchased by Mr. Gero in theprivate placement as well as 125,000 shares previously acquired by Mr. Gero ina private transaction with a third party.

*March 28,2005 Private Placement*

OnMarch 28, 2005, we completed a $2,663,000 private placement of 1,065,200 sharesof our Series 2 5% convertible preferred stock and warrants to purchase 532,600shares of our common stock at an initial exercise price of $2.77 per share tovarious purchasers.  Mr. Gero invested$150,000 in this private placement in consideration for 60,000 shares ofpreferred stock and warrants to purchase 30,000 shares of common stock.  Mr. Gero participated in the privateplacement on the same terms and conditions as other investors except that he isnot entitled to a preemptive right to purchase a pro rata portion of certainfuture sales of securities by us or to receive liquidated damages under theprovisions of the Registrations Rights Agreement we executed in connection withthis private placement.

*December2, 2005 Private Placement*

OnDecember 2, 2005, we completed a $1,230,843 private placement of 564,607 sharesof our Series 3 5% convertible preferred stock and warrants to purchase 282,306shares of our common stock at an initial exercise price of $2.58 per share tovarious purchasers.  Mr. Gero invested$60,000 in this private placement in consideration for 27,523 shares ofpreferred stock and warrants to purchase 13,762 shares of common stock.  Mr. Gero participated in the privateplacement on the same terms and conditions as other investors except that he isnot entitled to a preemptive right to purchase a pro rata portion of certainfuture sales of securities by us or to receive liquidated damages under theprovisions of the Registrations Rights Agreement we executed in connection withthis private placement.  In addition, Mr.Gero will not be able to convert his shares of preferred stock into, orexercise his warrants for, shares of common stock unless and until approved byour stockholders to the extent required by Nasdaq.

**Item 11.        Security Ownership of Certain Beneficial Owners and Management.**

Theinformation set forth under the caption “Security Ownership of CertainBeneficial Owners and Management” contained in the Proxy Statement isincorporated herein by reference.

**Item 12.        Certain Relationships and Related Transactions.**

Theinformation set forth under “Certain Transactions with Management” contained inthe Proxy Statement is incorporated herein by reference.

**Item 13.        Exhibits.**

(a)           1.   **Consolidated Financial Statements.**

Thefollowing consolidated financial statements of Intrusion Inc. andsubsidiaries, are submitted as a separate section of this report (SeeF-pages), and are incorporated by reference in Item 7:

| Report of Independent  Registered Public Accounting Firm                                                  |   | F-1 |
|-----------------------------------------------------------------------------------------------------------|--------|-----|
| Consolidated  Balance Sheets at December 31, 2006 and 2005                                           |   | F-2 |
| Consolidated Statements of Operations for the years  ended December 31, 2006, and 2005               |   | F-3 |
| Consolidated Statements of Stockholders’ Equity for  the years ended December 31, 2006 and 2005 |   | F-4 |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2006 and 2005                |   | F-5 |
| Notes to Consolidated Financial Statements                                                                |   | F-6 |

 

30

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(b)**                                 Exhibits**

Thefollowing Exhibits are filed herewith pursuant to Item 601 ofRegulation S-B or incorporated herein by reference to previous filings asnoted:
| **Exhibit  Number**  | ** ** | **Description of Exhibit**                                                                                                                                        |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   2.1(3)   |       | Certificate of Ownership  and Merger Merging Intrusion.com, Inc. into Intrusion Inc.                                                                              |
|   3.1(5)   |       | Amended and Restated  Certificate of Incorporation of the Registrant                                                                                              |
|   3.2(7)   |       | Certificate of  Amendment to Certificate of Incorporation of Registrant                                                                                           |
|   3.3(8)   |       | Certificate of Designation  for the Registrant’s 5% Convertible Preferred Stock                                                                              |
|   3.4(10)  |       | Certificate of Designations of the Registrant’s Series 2  5% Convertible Preferred Stock                                                                     |
|   3.5(11)  |       | Certificate  of Designation for the Registrant’s Series 3 5% Convertible Preferred Stock                                                                     |
|   3.6(4)   |       | Bylaws of the  Registrant                                                                                                                                         |
|   4.1(9)   |       | Specimen Common Stock  Certificate                                                                                                                                |
|   4.2(8)   |       | Specimen 5% Convertible  Preferred Stock Certificate                                                                                                              |
|   4.3(10)  |       | Specimen  Series 2 5% Convertible Preferred Stock Certificate                                                                                                     |
|   4.4(11)  |       | Specimen  Series 3 5% Convertible Preferred Stock Certificate                                                                                                     |
|   4.5(8)   |       | Form of Warrant to  Purchase Shares of Common Stock issued to the investors in the Registrant’s  March 25, 2004 private placement                            |
|   4.6(8)   |       | Warrant to Purchase  Common Stock dated March 25, 2004, issued by the Registrant to Black  Point Partners                                                    |
|   4.7(8)   |       | Registration Rights  Agreement dated as of March 25, 2004, by and among the Registrant and  the entities listed on Schedule A thereto                   |
|   4.8(8)   |       | Form of Lock-Up  Agreement executed by the Registrant’s officers and directors in connection  with the Registrant’s March 25, 2004 private placement    |
|   4.9(10)  |       | Form of Common Stock Purchaser Warrant issued to the  investors in the Registrant’s March 28, 2005 private placement                                         |
|   4.10(10) |       | Form of Representative’s Warrant for the Purchase of  Shares of Common Stock issued to certain affiliates of Stonegate Securities,  Inc. on March 28, 2005   |
|   4.11(10) |       | Registration Rights Agreement dated as of March 28, 2005, by and among  the Registrant and each  of the purchasers listed on the signature pages thereto          |
|   4.12(10) |       | Form of Voting  Agreement executed by each of the officers and directors of Registrant in  connection with the March 28, 2005 private placement                   |
|   4.13(10) |       | Securities Purchase Agreement dated as of March 28, 2005, by and among  the Registrant and the investors listed on Exhibit A thereto                              |
|   4.14(10) |       | Placement Agency Agreement dated February 7, 2005, by and  between the Registrant and Stonegate Securities, Inc.                                                  |
|   4.15(11) |       | Form of Common Stock Purchaser Warrant issued to the  investors in the Registrant’s December 2, 2005 private placement                                       |
|   4.16(11) |       | Form of Representative’s Warrant for the Purchase of  Shares of Common Stock issued to certain affiliates of Stonegate Securities,  Inc. on December 2, 2005 |
|   4.17(11) |       | Registration Rights Agreement dated as of December 2, by and among the  Registrant and each  of the purchasers listed on the signature pages thereto              |
|   4.18(11) |       | Form of Voting  Agreement executed by each of the officers and directors of Registrant in  connection with the December 2, 2005 private placement                 |
|   4.19(11) |       | Securities Purchase Agreement dated as of December 2, 2005, by and  among the Registrant and the investors listed on Exhibit A thereto                            |
|   4.20(11) |       | Placement Agency Agreement dated December 2, 2005, by and  between the Registrant and Stonegate Securities, Inc.                                                  |
| 10.1(1)              |       | 1987 Incentive  Stock Option Plan of the Registrant, as amended                                                                                                   |
| 10.2(1)              |       | 1995 Stock  Option Plan of the Registrant, as amended                                                                                                             |
| 10.3(1)              |       | Form of Indemnification  Agreement                                                                                                                                |
| 10.4(2)              |       | 1995 Non-Employee  Directors Stock Option Plan of the Registrant (amended and restated as of  January 10, 2002)                                              |
| 10.5(9)              |       | Lease Agreement between  CalWest Industrial Holdings Texas, L.P. and Intrusion Inc.                                                                               |
| 10.6(8)              |       | Securities Purchase  Agreement dated as of March 25, 2004, by and among the Registrant and  the purchasers listed on Exhibit A thereto                       |

 

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| 10.7(4)   |   | Amended and  Restated 401(k) Savings Plan of the Registrant                                                                                                                                           |
|-----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8(4)   |   | 1997 Employee  Stock Purchase Plan of the Registrant, as amended January 17, 2001                                                                                                                |
| 10.9(6)   |   | Intrusion Inc.  401(k) Savings Plan Summary of Material Modifications                                                                                                                                 |
| 10.10(12) |   | 2005 Stock Incentive Plan of the Registrant                                                                                                                                                           |
| 10.11(12) |   | Form of Notice of Grant of Stock Option                                                                                                                                                               |
| 10.12(12) |   | Form of Stock Option Agreement                                                                                                                                                                        |
| 10.13(12) |   | Form of Stock Issuance Agreement                                                                                                                                                                      |
| 10.14(12) |   | Form of Notice of Grant of Non-Employee Director  Automatic Stock Option (Initial Grant)                                                                                                              |
| 10.15(12) |   | Form of Notice of Grant of Non-Employee Director  Automatic Stock Option (Annual Grant)                                                                                                               |
| 10.16(12) |   | Form of Automatic Stock Option Agreement                                                                                                                                                              |
| 10.17(13) |   | Waiver of Liquidated Damages dated as of July 23, 2004,  by and among the Registrant, G. Ward Paxton and James F. Gero                                                                                |
| 10.18(14) |   | Loan and Security Agreement dated as of March 29, 2006,  by and between the Registrant and Silicon Valley Bank                                                                                        |
| 10.19(14) |   | Intellectual Property Security Agreement dated as of  March 29, 2006, by and between the Registrant and Silicon Valley Bank                                                                           |
| 10.20(15) |   | Subscription and Investment Representation Agreement by  and between Intrusion Inc. and G. Ward Paxton, dated December 28, 2006.                                                                      |
| 10.20(15) |   | Subscription and Investment Representation Agreement by  and between Intrusion Inc. and Michael L. Paxton, dated December 28, 2006.                                                                   |
| 10.20(16) |   | Subscription and Investment Representation Agreement by  and between Intrusion Inc. and G. Ward Paxton, dated March 15, 2007.                                                                         |
| 10.20(16) |   | Subscription and Investment Representation Agreement by  and between Intrusion Inc. and Michael L.   Paxton, dated March 15, 2007.                                                               |
| 21(5)     |   | List of Subsidiaries of  Registrant                                                                                                                                                                   |
| 23.1(17)  |   | Consent of KBA Group  LLP, Independent Registered Public Accounting Firm                                                                                                                              |
| 31.1(17)  |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(a) of the Exchange Act                                                                                                              |
| 31.2(17)  |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(a) of the Exchange Act                                                                                                              |
| 32.1(17)  |   | Certification of Chief  Executive Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
| 32.2(17)  |   | Certification of Chief  Financial Officer Pursuant to Rule 13a-14(b) of the Exchange Act and 18  U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

----

(1)             Filedas an Exhibit in the Registrant’s Registration Statement on Form S-1, asamended (File No. 33-6899), which was declared effective on May 21,1992, by the Securities and Exchange Commission, which Exhibit is incorporatedherein by reference.

(2)             Filedas an Exhibit to the Registrant’s Definitive Proxy Statement onSchedule 14A in connection with the solicitation of proxies for its 2002Annual Meeting of Stockholders, which Exhibit is incorporated herein byreference.

(3)             Filedas an Exhibit to the Registrant’s Definitive Proxy Statement onSchedule 14A in connection with the solicitation of proxies for its 2002Annual Meeting of Stockholders, which Exhibit is incorporated herein byreference.

(4)             Filedas an Exhibit to the Registrants’ Annual Report on Form 10-K, for thefiscal year ended December 31, 2000.

(5)             Filedas an Exhibit to the Registrant’s Annual Report on Form 10-K for thefiscal year ended December 31, 2001, which Exhibit is incorporated hereinby reference.

(6)             Filedas an Exhibit to the Registrant’s Quarterly Report on Form 10-Q for thequarter ended March 31, 2002, which Exhibit is incorporated herein byreference.

(7)             Filedas an Exhibit to the Registrant’s Definitive Proxy Statement onSchedule 14A in connection with the solicitation of proxies for itsSpecial Meeting of Stockholders held March 18, 2004, which Exhibit isincorporated herein by reference.

(8)             Filedas an Exhibit to the Registrant’s Current Report on Form 8-K datedMarch 26, 2004 (as amended), which Exhibit is incorporated by reference.

32

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(9)             Filedas an Exhibit to the Registrant’s Annual Report on Form 10-K for the fiscalyear ended December 31, 2003 (as amended), which Exhibit is incorporatedherein by reference.

(10)       Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated March 29,2005, which Exhibit is incorporated herein by reference

(11)       Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated December 6,2005, which Exhibit is incorporated herein by reference.

(12)       Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated June 15,2005, which Exhibit is incorporated herein by reference.

(13)       Filedas an Exhibit to the Registrant’s Quarterly Report on Form 10-Q for the quarterended September 30, 2004, which Exhibit is incorporated herein by reference.

(14)       Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated March 29,2006, which Exhibit is incorporated herein by reference.

(15)       Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated January 4,2007, which Exhibit is incorporated herein by reference.

(16)       Filedas an Exhibit to the Registrant’s Current Report on Form 8-K dated March 16,2007, which Exhibit is incorporated herein by reference.

(17)       Filedherewith.

**Item 14.**                   PrincipalAccountant Fees and Services

The information set forth under “Fees Paid toIndependent Public Accountants” contained in the Proxy Statement isincorporated herein by reference.

33

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the Registrant has duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.
| Dated:  March 29, 2007 |     | INTRUSION INC. |
|-----------------------------|----------|---------------------|
|                        |     | (Registrant)        |
|                        |     |                |
|                        |     | By:                 | /s/ G. WARD  PAXTON |
|                        |     |                | G. Ward Paxton |
|                        | * * | * *            | *Chairman,  President, and Chief Executive Officer* |
|                        | * * | * *            | *(Principal  Executive Officer)* |

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, this report has been signed below by the following persons onbehalf of the Registrant and in the capacities and on the dates indicated.
|                         | **Signature** | ** **                                    | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-------------------------|---------------|-----------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
|                    |          |                                          |       |                 |
| /s/  G. WARD PAXTON     |          | Chairman, President,                          |       | March 29,  2007 |
| G.  Ward Paxton         |          | Chief Executive  Officer, and Director        |       |                 |
|                    |          |                                          |       |                 |
| /s/  T. JOE HEAD        |          | Vice Chairman, Vice  President                |       | March 29,  2007 |
| T.  Joe Head            |          | and Director                                  |       |                 |
|                    |          |                                          |       |                 |
| /s/  MICHAEL L. PAXTON  |          | Vice President, Chief  Financial              |       | March 29,  2007 |
| Michael  L. Paxton      |          | Officer, Treasurer and  Secretary             |       |                 |
|                    |          | (Principal Financial  and Accounting Officer) |       |                 |
|                    |          |                                          |       |                 |
| /s/  JAMES F. GERO      |          | Director                                      |       | March 29,  2007 |
| James  F. Gero          |          |                                          |       |                 |
|                    |          |                                          |       |                 |
| /s/  J. FRED BUCY, JR.  |          | Director                                      |       | March 29,  2007 |
| J.  Fred Bucy, Jr.      |          |                                          |       |                 |
|                    |          |                                          |       |                 |
| /s/  DONALD M. JOHNSTON |          | Director                                      |       | March 29,  2007 |
| Donald  M. Johnston     |          |                                          |       |                 |
|                    |          |                                          |       |                 |

 

34

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**ANNUALREPORT ON FORM 10-KSB**

**ITEM7**

**FINANCIALSTATEMENTS**

**YEARSENDED DECEMBER 31, 2006 and 2005**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

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**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

The Board ofDirectors and StockholdersIntrusion Inc.

Wehave audited the accompanying consolidated balance sheets ofIntrusion Inc. and subsidiaries (the “Company”) as of December 31,2006 and 2005, and the related consolidated statements of operations,stockholders’ equity, and cash flows for the years then ended. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audits to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  The Company is not required to have nor werewe engaged to perform audits of their internal control over financial reporting.  Our audits included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting.  Accordingly, we express nosuch opinion.  An audit also includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements, assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofIntrusion Inc. and subsidiaries as of December 31, 2006 and 2005, andthe consolidated results of their operations and their cash flows for the yearsthen ended in conformity with accounting principles generally accepted in theUnited States of America.

Asdiscussed in Note 2 to the consolidated financial statements, effective January1, 2006, the Company adopted Statement of Accounting Standards No. 123(R),Share-Based Payment.

/s/ KBA Group LLPDallas, TexasMarch 29, 2007

 

F-1

----

**INTRUSION INC.AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, except par valueamounts)**
| ** **                                                                                                                                        | ** ** | **December 31,** | ** **                    |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|-------------------------------|
| ** **                                                                                                                                        | ** ** | **2006**              | ** **                    | **2005** | ** ** |
| **Assets**                                                                                                                                        |       |                  |                          |   |   |
| Current Assets:                                                                                                                                   |       |                  |                          |   |   |
| Cash and cash  equivalents                                                                                                                        |       | $                     | 933                           |   | $ | 2,844 |   |
| Short-term  investments                                                                                                                           |       | —                |                          | 500 |   |
| Accounts receivable,  net of allowance for doubtful accounts and returns of $90 in 2006 and $102 in  2005                                         |       | 844                   |                          | 443 |   |
| Inventories, net                                                                                                                                  |       | 209                   |                          | 373 |   |
| Prepaid expenses                                                                                                                                  |       | 198                   |                          | 191 |   |
| Total current assets                                                                                                                              |       | 2,184                 |                          | 4,351 |   |
| Property and Equipment:                                                                                                                           |       |                  |                          |   |   |
| Equipment                                                                                                                                         |       | 409                   |                          | 650 |   |
| Furniture and  fixtures                                                                                                                           |       | 20                    |                          | 48 |   |
| Leasehold  improvements                                                                                                                           |       | 101                   |                          | 101 |   |
|                                                                                                                                              |       | 530                   |                          | 799 |   |
| Accumulated  depreciation and amortization                                                                                                        |       | (368                  | )                             | (543 | ) |
|                                                                                                                                              |       | 162                   |                          | 256 |   |
| Other assets                                                                                                                                      |       | 41                    |                          | 41 |   |
| **TOTAL ASSETS**                                                                                                                                  |       | $                     | 2,387                         |   | $ | 4,648 |   |
| ** **                                                                                                                                        |       |                  |                          |   |   |
| **Liabilities and Stockholders’  Equity**                                                                                                    |       |                  |                          |   |   |
| Current Liabilities:                                                                                                                              |       |                  |                          |   |   |
| Line of credit                                                                                                                                    |       | $                     | 200                           |   | $ | — |   |
| Accounts  payable, trade                                                                                                                          |       | 555                   |                          | 415 |   |
| Accrued vacation  expense                                                                                                                         |       | 212                   |                          | 263 |   |
| Accrued warranty  expense                                                                                                                         |       | 49                    |                          | 49 |   |
| Other accrued  expenses                                                                                                                           |       | 283                   |                          | 415 |   |
| Deferred revenue                                                                                                                                  |       | 367                   |                          | 527 |   |
| Total current  liabilities                                                                                                                        |       | 1,666                 |                          | 1,669 |   |
| **TOTAL LIABILITIES**                                                                                                                             |       | 1,666                 |                          | 1,669 |   |
|                                                                                                                                              |       |                  |                          |   |   |
| **Commitments and Contingencies**                                                                                                                 |       |                  |                          |   |   |
|                                                                                                                                              |       |                  |                          |   |   |
| Stockholders’ Equity:                                                                                                                        |       |                  |                          |   |   |
| Preferred stock,  $0.01 par value:                                                                                                                |       |                  |                          |   |   |
| Authorized  shares — 5,000                                                                                                                   |       |                  |                          |   |   |
| Series 1 shares  issued and outstanding — 260 in 2006 and 260 in 2005 Liquidation preference  of $1,331 in 2006                              |       | 918                   |                          | 918 |   |
| Series 2 shares  issued and outstanding — 460 in 2006 and 500 in 2005 Liquidation preference  of $1,155 in 2006                              |       | 724                   |                          | 787 |   |
| Series 3 shares  issued and outstanding — 469 in 2006 and 565 in 2005 Liquidation preference  of $1,026 in 2006                              |       | 667                   |                          | 805 |   |
| Common stock,  $0.01 par value:                                                                                                                   |       |                  |                          |   |   |
| Authorized  shares — 80,000  Issued shares — 8,306 in 2006 and 6,919 in 2005  Outstanding shares — 8,296 in 2006 and 6,909 in 2005 |       | 83                    |                          | 69 |   |
| Common stock  held in treasury, at cost—10 shares                                                                                            |       | (362                  | )                             | (362 | ) |
| Additional  paid-in-capital                                                                                                                       |       | 53,947                |                          | 52,994 |   |
| Accumulated  deficit                                                                                                                              |       | (55,077               | )                             | (52,053 | ) |
| Accumulated  other comprehensive loss                                                                                                             |       | (179                  | )                             | (179 | ) |
| Total stockholders’  equity                                                                                                                  |       | 721                   |                          | 2,979 |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                               |       | $                     |     2,387 |   | $ |     4,648 |   |

 

See accompanying notes.

F-2

----

 

**INTRUSION INC.AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per shareamounts)**
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
|                                                                        |       |                                       |       |   |   |
| Net product revenue                                                         |       | $                                          | 4,106      |   | $ | 4,375 |   |
| Net customer support  and maintenance revenue                               |       | 1,136                                      |       | 1,603 |   |
| Total revenue                                                               |       | 5,242                                      |       | 5,978 |   |
| Cost of product revenue                                                     |       | 2,002                                      |       | 2,357 |   |
| Cost of customer  support and maintenance revenue                           |       | 202                                        |       | 157 |   |
| Total cost of revenue                                                       |       | 2,204                                      |       | 2,514 |   |
| Gross profit                                                                |       | 3,038                                      |       | 3,464 |   |
| Operating expenses:                                                         |       |                                       |       |   |   |
| Sales and  marketing                                                        |       | 2,714                                      |       | 3,137 |   |
| Research and  development                                                   |       | 2,067                                      |       | 2,553 |   |
| General and  administrative                                                 |       | 1,251                                      |       | 1,126 |   |
| Severance costs                                                             |       | 10                                         |       | 55 |   |
| Operating loss                                                              |       | (3,004                                     | )          | (3,407 | ) |
| Interest income, net                                                        |       | 45                                         |       | 84 |   |
| Other income (expense),  net                                                |       | (65                                        | )          | 2 |   |
| Loss from operations  before income taxes                                   |       | (3,024                                     | )          | (3,321 | ) |
| Income tax provision                                                        |       | —                                     |       | — |   |
| Net loss                                                                    |       | (3,024                                     | )          | (3,321 | ) |
| Preferred stock  dividends accrued                                          |       | (175                                       | )          | (168 | ) |
| Beneficial conversion  feature on preferred stock                           |       | —                                     |       | (1,434 | ) |
| Net loss attributable  to common stockholders                               |       | $                                          | (3,199     | ) | $ | (4,923 | ) |
|                                                                        |       |                                       |       |   |   |
| Net loss per share  attributable to common stockholders (basic and diluted) |       | $                                          | (0.45      | ) | $ | (0.77 | ) |
| Weighted average common shares outstanding (basic and diluted)              |       | 7,043                                      |       | 6,424 |   |

 

See accompanyingnotes.

F-3

----

 

**INTRUSION INC.AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY**

**(In thousands)**
| ** **                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| **NUMBER OF PREFERRED  SHARES—ISSUED AND OUTSTANDING**                                         |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | 1,325                                      |       | 840 |   |
| Issuance of  preferred shares pursuant to private placement                                         |       | —                                     |       | 1,630 |   |
| Conversion of  preferred shares to common shares                                                    |       | (137                                       | )          | (1,145 | ) |
| Balance, end of  year                                                                               |       | 1,188                                      |       | 1,325 |   |
| **PREFERRED STOCK**                                                                                 |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | $                                          | 2,510      |   | $ | 2,968 |   |
| Issuance of  preferred shares pursuant to private placement, net of warrants and  transaction costs |       | —                                     |       | 2,480 |   |
| Conversion of  preferred shares to common shares                                                    |       | (201                                       | )          | (2,938 | ) |
| Balance, end of  year                                                                               |       | $                                          | 2,309      |   | $ | 2,510 |   |
| **NUMBER OF COMMON SHARES—ISSUED**                                                             |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | 6,919                                      |       | 5,431 |   |
| Issuance of  common shares under private placement                                                  |       | 1,250                                      |       | — |   |
| Conversion of  preferred shares to common shares                                                    |       | 137                                        |       | 1,488 |   |
| Balance, end of  year                                                                               |       | 8,306                                      |       | 6,919 |   |
| **COMMON STOCK**                                                                                    |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | $                                          | 69         |   | $ | 54 |   |
| Issuance of  common shares under private placement                                                  |       | 13                                         |       | — |   |
| Conversion of  preferred shares to common shares                                                    |       | 1                                          |       | 15 |   |
| Balance, end of  year                                                                               |       | $                                          | 83         |   | $ | 69 |   |
| **TREASURY SHARES**                                                                                 |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | $                                          | (362       | ) | $ | (362 | ) |
| Purchase of  treasury shares                                                                        |       | —                                     |       | — |   |
| Balance, end of  year                                                                               |       | $                                          | (362       | ) | $ | (362 | ) |
| **ADDITIONAL PAID-IN-CAPITAL**                                                                      |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | $                                          | 52,994     |   | $ | 49,095 |   |
| Stock based  compensation                                                                           |       | 441                                        |       | — |   |
| Issuance of  warrants with preferred stock private placement                                        |       | —                                     |       | 1,141 |   |
| Conversion of  preferred shares to common shares                                                    |       | 200                                        |       | 2,926 |   |
| Issuance of  common shares under private placement                                                  |       | 488                                        |       | — |   |
| Preferred stock  dividends accrued                                                                  |       | (176                                       | )          | (168 | ) |
| Balance, end of  year                                                                               |       | $                                          | 53,947     |   | $ | 52,994 |   |
| **ACCUMULATED DEFICIT**                                                                             |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | $                                          | (52,053    | ) | $ | (48,732 | ) |
| Net loss                                                                                            |       | (3,024                                     | )          | (3,321 | ) |
| Balance, end of  year                                                                               |       | $                                          | (55,077    | ) | $ | (52,053 | ) |
| **ACCUMULATED OTHER COMPREHENSIVE  LOSS**                                                           |       |                                       |       |   |   |
| Balance,  beginning of year                                                                         |       | $                                          | (179       | ) | $ | (173 | ) |
| Foreign currency  translation adjustment                                                            |       | —                                     |       | (6 | ) |
| Balance, end of  year                                                                               |       | $                                          | (179       | ) | $ | (179 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                 |       | $                                          | 721        |   | $ | 2,979 |   |
| **TOTAL COMPREHENSIVE LOSS**                                                                        |       | $                                          | (3,024     | ) | $ | (3,327 | ) |

 

See accompanyingnotes.

F-4

----

 

**INTRUSION INC.AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**
| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                   | ** ** | **2005** | ** ** |
| Operating Activities:                                                           |       |                                       |       |   |   |
| Net loss                                                                        |       | $                                          | (3,024     | ) | $ | (3,321 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:    |       |                                       |       |   |   |
| Depreciation and  amortization                                                  |       | 97                                         |       | 185 |   |
| Provision for  doubtful accounts                                                |       | (12                                        | )          | (405 | ) |
| Stock based  compensation                                                       |       | 441                                        |       | — |   |
| Changes in operating  assets and liabilities:                                   |       |                                       |       |   |   |
| Accounts  receivable                                                            |       | (389                                       | )          | 1,182 |   |
| Inventories                                                                     |       | 164                                        |       | 577 |   |
| Other assets                                                                    |       | (7                                         | )          | 225 |   |
| Accounts payable  and accrued expenses                                          |       | (27                                        | )          | (503 | ) |
| Deferred revenue                                                                |       | (160                                       | )          | (272 | ) |
| Net cash used in  operating activities                                          |       | (2,917                                     | )          | (2,332 | ) |
| Investing Activities:                                                           |       |                                       |       |   |   |
| Purchases of  short-term investments                                            |       | —                                     |       | (2,850 | ) |
| Maturities of short-term  investments                                           |       | 500                                        |       | 2,425 |   |
| Proceeds from  sale of property and equipment                                   |       | —                                     |       | 2 |   |
| Purchases of  property and equipment                                            |       | (3                                         | )          | (144 | ) |
| Net cash provided by  (used in) investing activities                            |       | 497                                        |       | (567 | ) |
| Financing Activities:                                                           |       |                                       |       |   |   |
| Proceeds from  line of credit                                                   |       | 200                                        |       | — |   |
| Proceeds from  exercise of employee stock options                               |       | 1                                          |       | — |   |
| Proceeds from  the issuance of common stock, net                                |       | 500                                        |       | 3,620 |   |
| Dividends paid  on preferred stock                                              |       | (192                                       | )          | (186 | ) |
| Net cash provided by  financing activities                                      |       | 509                                        |       | 3,434 |   |
| Effect of foreign  currency translation adjustment on cash and cash equivalents |       | —                                     |       | (6 | ) |
| Net increase (decrease)  in cash and cash equivalents                           |       | (1,911                                     | )          | 529 |   |
| Cash and cash  equivalents at beginning of year                                 |       | 2,844                                      |       | 2,315 |   |
| Cash and cash  equivalents at end of year                                       |       | $                                          | 933        |   | $ | 2,844 |   |
|                                                                            |       |                                       |       |   |   |
| SUPPLEMENTAL CASHFLOW  INFORMATION:                                             |       |                                       |       |   |   |
| Interest paid                                                                   |       | $                                          | 1          |   | $ | — |   |
| Income taxes paid                                                               |       | $                                          | —     |   | $ | — |   |
|                                                                            |       |                                       |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF NON CASH FINANCING ACTIVITIES:                      |       |                                       |       |   |   |
| Fair value of warrants  issued in connection with sale of preferred stock       |       | $                                          | —     |   | $ | 1,141 |   |
| Amortization of  preferred stock beneficial conversion feature                  |       | $                                          | —     |   | $ | 1,434 |   |
| Preferred stock dividends accrued                                               |       | $                                          | 176        |   | $ | 168 |   |

 

See accompanyingnotes.

F-5

----

**INTRUSION INC.AND SUBSIDIARIESNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**1. Description of Business**

We develop, market and support a family of networkintrusion prevention, intrusion detection, regulated information compliance,data privacy protection and entity identification products.  Our product families include the ComplianceCommander for regulated information and data privacy protection, IntrusionSpySnare for real-time inline blocking of spyware and unwanted peer-to-peer(P2P) applications, Intrusion SecureNet for network intrusion prevention anddetection and TraceCop for identity identification.  Intrusion’s products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

Wemarket and distribute our products through a direct sales force to end-users,distributors and numerous system integrators, managed service providers andvalue-added resellers.  Our end-usercustomers include banks, credit unions, other financial institutions, U.S.federal government entities, foreign government entities and local governmententities, high technology, e-commerce and telecommunication companies, hospitaland other healthcare providers and academic institutions. Essentially, ourend-user can be defined as ‘any end-user requiring network security solutionsfor protecting their mission critical data’.

Wewere organized in Texas in September 1983 and reincorporated in Delawarein October 1995. For more than 15 years, we provided local areanetworking equipment and were known as Optical Data Systems or ODS Networks. OnApril 17, 2000, we sold, or otherwise disposed of, our networkingdivisions, which included our Essential Communications division and our localarea networking assets. On June 1, 2000, we changed our name from ODSNetworks, Inc. to Intrusion.com, Inc., and our ticker symbol fromODSI to INTZ to reflect our focus on intrusion prevention and detectionsolutions, along with information compliance and data privacy protectionproducts. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

Ourprincipal executive offices are located at 1101 East Arapaho Road, Richardson,Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.

References to “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM, TraceCopTMand SpySnareTM are registered trademarks of Intrusion Inc.

As ofDecember 31, 2006, we had cash, cash equivalents and investments ofapproximately $0.9 million, down from approximately $3.3 million asof December 31, 2005.  On March 28,2005, we closed a $2.66 million private placement of Convertible PreferredStock and warrants.  On December 2, 2005,we closed a $1.23 million private placement of Convertible Preferred Stock andwarrants.  On March 29, 2006, we establisheda $1.0 million line of credit with Silicon Valley Bank, which was renewed onMarch 29, 2007.  On December 28, 2006, weclosed a $0.5 million private placement of common stock. Based on projectionsfor increased revenues in 2007,the closing of another $0.5 million privateplacement on March 15, 2007 and a commitment from the Company’s CEO to advancethe Company up to $0.75 million in funding should it be necessary through March2008, we believe that our available credit line and available cash resourceswill provide sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  The sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  In addition,the payment of dividends on our outstanding preferred stock may reduce ouravailable cash resources.  Moreover,despite actions to reduce our costs and improve our profitability, we expectour operating losses and net operating cash outflows to continue through atleast the first quarter of 2007 and possibly throughout the remainder of fiscalyear 2007.  We do not currently have anyarrangements for additional financing, and we may not be able to secureadditional debt or equity financing on terms that are acceptable to us, or atall, at the time when we need such funding. Additionally, we may not have sufficient availability under our creditline when we need additional funds. Under the terms of our credit line, we mayborrow an amount equal up to 80% of eligible accounts receivable balances.  In addition, we may obtain inventory advancesequal to 35% of finished good inventory, capped at the lesser of the inventoryavailability, $300,000 or 35% of our total borrowing base. If our business doesnot generate sufficient cash flows from operations and sufficient financingsare not available, we may not be able to operate or grow our business, pay ourexpenses when due or fund our other liquidity needs.

F-6

----

**2.Summary of Significant Accounting Policies**

***Principles of Consolidation***

Ourconsolidated financial statements include our accounts and those of our whollyowned subsidiaries. Intercompany balances and transactions have been eliminatedin consolidation.

***Cash and Cash Equivalents***

Cashand all highly liquid investments purchased with an original maturity of lessthan three months are considered to be cash and cash equivalents.

***Short-term Investments***

Short-terminvestments consist of U.S. government obligations and corporate securitieswith maturities between 90 days and one year as of the balance sheet date.Short-term investments are classified as available for sale.  These investments are valued at market value,which approximates amortized cost.  Thedifference between fair market value and amortized cost is notsignificant.  Realized gains and lossesfrom the sale of short-term investments are included in other income, net andare derived using the specific identification method for determining the costof securities.

***Risk Concentration***

Financialinstruments, which potentially subject us to concentrations of credit risk, areprimarily cash and cash equivalents, investments and accounts receivable.  Cash and cash equivalent deposits are at riskto the extent that they exceed Federal Deposit Insurance Corporation insuredamounts.  To minimize risk, we place ourinvestments in U.S. government obligations, corporate securities and moneymarket funds.  Substantially all of ourcash, cash equivalents and investments are maintained with two major U.S.financial institutions.

Wesell our products to customers in diversified industries worldwide, primarilyin North America, Europe and Asia. Fluctuations in currency exchange rates andadverse economic developments in foreign countries could adversely affect theCompany’s operating results.  We performongoing credit evaluations of our customers’ financial condition and generallyrequire no collateral.  We maintainreserves for potential credit losses, and such losses, in the aggregate, havenot exceeded management expectations.

Whilewe believe that many of the materials used in the production of our productsare generally readily available from a variety of sources, certain componentsare available from one or a limited number of suppliers.  The inability of any supplier or manufacturerto fulfill supply requirements of the Company could impact future results.

***Accounts Receivable and Allowance for Doubtful Accounts***

Tradeaccounts receivable are stated at the amount we expect to collect.  We maintain allowances for doubtful accountsfor estimated losses resulting from the inability of our customers to makerequired payments.  Management considersthe following factors when determining the collectibility of specific customeraccounts:  customer credit-worthiness,past transaction history with the customer, current economic industry trends,and changes in customer payment terms. If the financial condition of our customers were to deteriorate,adversely affecting their ability to make payments, additional allowances wouldbe required.  Based on management’sassessment, we provide for estimated uncollectible amounts through a charge toearnings and a credit to a valuation allowance. Balances that remain outstanding after we have used reasonable collectionefforts are written off through a charge to the valuation allowance and acredit to accounts receivable.

***Inventories and Change in Method for Valuing Inventory***

Inventoriesare stated at the lower of cost or market. We value our inventories using averagecost, which approximates actual cost on a first-in, first-out basis. Ourmanagement estimates the allowance required to state inventory at the lower ofcost or market. There is a risk that we will forecast demand for our productsand market conditions incorrectly and maintain excess inventories. Therefore,there can be no assurance that we will not maintain excess inventory and incurinventory lower of cost or market charges in the future.

F-7

----

***Property and Equipment***

Equipmentis stated at cost less accumulated depreciation and is depreciated on astraight-line basis over the estimated useful lives of the assets.  Such lives vary from 1 to 3 years.  Furniture and fixtures are stated at costless accumulated depreciation and is depreciated on a straight-line basis overthe estimated useful lives of the assets. Such lives vary from 1 to 5 years. Leasehold improvements are stated at cost less accumulated amortizationand are amortized on a straight-line basis over the shorter of estimated usefullives of the assets or the remaining terms of the leases.   Such lives vary from 2 to 5 years.  Expenditures for major renewals andbetterments that extend the useful lives of property and equipment arecapitalized.  Repair and maintenancecosts are expensed as incurred. Depreciation and amortization expense totaledapproximately $97,000 and $185,000 for the years ended December 31, 2006and 2005, respectively.

***Long-Lived Assets***

Wefollow the guidance in SFAS 144 “Accounting for the Impairment or Disposal ofLong-Lived Assets” and review long-lived assets, including property andequipment for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of an asset to futureundiscounted cash flows to be generated by the asset.  If the carrying value exceeds the futureundiscounted cash flows, the assets are written down to fair value usingdiscounted cash flows.  As ofDecember 31, 2006 and 2005, there was no impairment of long-lived assets.

***Foreign Currency Translation***

Ourinternational subsidiaries use the United States dollar as their functionalcurrency.  Although, our internationaloffices pay operating expenses in their local currency, they are fully fundedby us in United States dollars, and we exchange the United States dollarslocally to settle operating expenses incurred. As outlined in SFAS 52, assets and liabilities are translated at theexchange rate in effect at the balance sheet date, and income and expenseaccounts at average exchange rates during the year.  We recorded approximately $1,000 and $6,000in operating expenses in 2006 and 2005, respectively, which represents thetotal accumulated foreign currency translation adjustments related to foreignoffices.  These amounts also representthe annual change in the accumulated other comprehensive loss during 2006 and2005.

***Accounting for Stock Options***

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”(SFAS 123(R)), which replaces SFAS 123 and supersedes APB Opinion No. 25.  SFAS 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. The pro forma disclosurespreviously permitted under SFAS 123 no longer will be an alternative tofinancial statement recognition.

Prior to January 1, 2006,we accounted for employee stock-based compensation in accordance with APB 25and followed the disclosure requirements in accordance with SFAS 148.  No compensation cost was recorded for stockoptions, as historically all options granted under our stock option plans havean exercise price equal (at minimum) to the market value of the underlyingcommon stock on the date of grant.

Weadopted SFAS 123(R) on January 1, 2006 using the modified prospectiveapplication method described in the statement. Results for prior periods havenot been restated.  Stock-basedcompensation expense recognized during each period is based on the value of theportion of stock-based payment awards that is ultimately expected to vest.  Stock-based compensation expense recognizedin the consolidated statement of operations during 2006 included compensationexpense for stock-based payment awards granted prior to, but not yet vested, asof December 31, 2005 based on the grant date fair value estimated in accordancewith the pro forma provisions of SFAS 148 and compensation expense for thestock-based payment awards granted subsequent to December 31, 2005, based onthe grant date fair value estimated in accordance with SFAS 123(R).  As stock-based compensation expenserecognized in the statement of operations after December 31, 2005 is based onawards ultimately expected to vest, it has been reduced for estimatedforfeitures.  SFAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.  In the pro forma information required underSFAS 148 for the periods prior to 2006, we accounted for forfeitures as theyoccurred.

Byadopting SFAS 123(R) we anticipate recording substantial non-cash stockcompensation expenses. The adoption of SFAS 123(R) is not expected to have asignificant effect on our financial condition or cash flows but is expected tohave a significant, adverse effect on our results of operations.

F-8

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***Effect of Adopting SFAS No.123(R)***

The effect of adoptingSFAS No. 123(R) as of January 1, 2006 for the year ended December 31, 2006 (inthousands, except per share data) is as follows:
|                                                        | ** ** | **For Year Ended   December 31, 2006** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                                   |       |                                                            |       |
| Stock-option compensation  expense recognized          |       |                                                            |       |
| (for stock options only):                              |       |                                                            |       |
| Cost of revenue                                        |       | $                                                               | 26         |   |
| Research and development                               |       | 109                                                             |       |
| Sales and  marketing                                   |       | 178                                                             |       |
| General and administrative                             |       | 128                                                             |       |
| Effect on net loss                                     |       | $                                                               | 441        |   |
| Effect on basic and diluted  earnings per common share |       | $                                                               | (0.06      | ) |

 

***Pro Forma Presentation forPeriods Prior to the Adoption of SFAS 123(R)***

Under the modifiedprospective application method, results for prior periods have not beenrestated to reflect the effects of implementing SFAS No. 123(R).  The following pro forma information wasreported, as required by SFAS No. 148, “Accounting for Stock-Based Compensation— Transition and Disclosure” for the year ended December 31, 2005.
| ** **                                                                                       | ** ** | **For Year Ended**    | ** ** |
|--------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                       | ** ** | **December 31, 2005** | ** ** |
|                                                                                             |       |                            |       |
| Net loss attributable  to common stockholders                                                    |       | $                               | (4,923     | ) |
| Deduct: Total  stock-based compensation determined under fair value-based method for all  awards |       | (831                            | )          |
| Pro forma net loss  attributable to common stockholders                                          |       | $                               | (5,754     | ) |
| Net loss per share  attributable to common stockholders:                                         |       |                            |       |
| as reported  (basic and diluted)                                                                 |       | $                               | (0.77      | ) |
| pro forma (basic  and diluted)                                                                   |       | $                               | (0.90      | ) |
| Weighted-average shares  used in computation:                                                    |       |                            |       |
| Basic and diluted                                                                                |       | 6,424                           |       |

 

***ValuationAssumptions***

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions for fiscalyears ending December 31, 2006 and 2005, respectively:
| ** **                              | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |
| Weighted average  grant date fair value |       | $        | 0.32       |     | $          | 2.34 |   |
| Weighted average  assumptions used:     |       |     |       |     |       |
| Expected dividend yield                 |       | 0.0      | %          | 0.0      | %          |
| Risk-free interest rate                 |       | 4.4      | %          | 3.9      | %          |
| Expected volatility                     |       | 106.0    | %          | 112.4    | %          |
| Expected life  (in years)               |       | 5        |       | 4.4      |       |
|                                         |            |          |            |          |            |  |  |

 

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour employee stock options have characteristics significantly different fromthose of traded options, and because changes in the subjective inputassumptions can materially 

F-9

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affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

Expectedvolatility is based on historical volatility and in part on impliedvolatility.  The expected term considersthe contractual term of the option as well as historical exercise andforfeiture behavior.  The risk-freeinterest rate is based on the rates in effect on the grant date for U.S.Treasury instruments with maturities matching the relevant expected term of theaward.

***Net Loss Per Share***

Wereport two separate earnings per share (“EPS”) numbers, basic EPS and dilutedEPS.  Basic net loss attributable tocommon stockholders per share is computed by dividing net loss attributable tocommon stockholders for the year by the weighted average number of commonshares outstanding for the year.  Dilutednet loss attributable to common stockholders per share is computed by dividingthe net loss attributable to common stockholders for the year by the weightedaverage number of common shares and common stock equivalents outstanding forthe year.  Our common stock equivalentsinclude all common stock issuable upon conversion of convertible preferredstock and the exercise of outstanding options and warrants.  The aggregate number of common stockequivalents excluded from the loss per share calculation at December 31,2006 and 2005 totaled 3,951,223 and 3,892,157, respectively.  Common stock equivalents are not included inthe diluted loss per share for the years ended December 31, 2006 and 2005,as they are anti-dilutive as a result of incurring net losses during theseyears.

***Revenue Recognition***

Wegenerally recognize product revenue upon shipment.  These products include both hardware andperpetual software licenses, as we do not currently offer software on asubscription basis.  We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience.  There is a risk thattechnical issues on new products could result in unexpected warranty costs andreturns.  However, as we migrate to moreof a software-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve will decrease. To the extent that our warranty costs exceed our expectations, we willincrease our warranty reserve to compensate for the additional expense expectedto be incurred.  We review theseestimates periodically and determine the appropriate reserve percentage.  However, to date, warranty costs and salesreturns have not been material.  Thecustomer may return a product only under very limited circumstances during thefirst thirty days from delivery for a replacement if the product is damaged orfor a full refund if the product does not perform as intended.  Historically, most or our sales returns wererelated to hardware-based products.  Aswe continue to migrate away from the hardware-based products, these returnshave declined.  In addition, the costrelated to returns for repair and refurbishment have also declined, as ourhardware costs and assembly costs have declined.  Most of our returns have been related toinventory held at distributors, as they have stock rotation privileges.  Since these returns are not related to sales,as they are maintained in deferred revenue until the distributors sell theproduct, these returns have not impacted our sales return allowancemethodology.

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No.104, “Revenue Recognition” whereby revenue from the licensing of our productsis not recognized until all four of the following have been met:i) execution of a written agreement; ii) delivery of the product hasoccurred; iii) the fee is fixed and determinable; andiv) collectibility is probable. Bundled hardware and software productrevenue is recognized at time of delivery, as our licenses are not sold on asubscription basis.  In the case ofproduct sales, which include maintenance and customer support, a Vendor SpecificObjective Evidence analysis would be performed to appropriately determine theamount of revenue derived from each deliverable.  All of our product offering and serviceoffering market values are readily determined based on current and priorstand-alone sales.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

Wegenerally recognize service revenue upon delivery of the contractedservice.  Service revenue, primarilyincluding maintenance, training and installation are recognized upon deliveryof the service and typically are unrelated to product sales.  These services are not essential to thefunctionality of the delivered product. To date, training and installation revenue has not been material.  These revenues are included in net customersupport and maintenance revenues in the statement of operations.

F-10

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Ournormal payment terms offered to customers, distributors and resellers are net30 days domestically and net 45 days internationally.  We do not offer payment terms that extendbeyond one year and rarely do we extend payment terms beyond our normalterms.  If certain customers do not meetour credit standards, we do require payment in advance to limit our creditexposure.

Shippingand handling costs are billed to the customer and included in productrevenue.  Our costs of shipping andhandling are included in product cost of revenue.

***Research and Development Costs***

Weincur research and development costs that relate primarily to the developmentof new security software, appliances and integrated solutions, and majorenhancements to existing services and products. Research development costs arecomprised primarily of salaries and related benefits expenses, contract laborand prototype and other related expenses.

Softwaredevelopment costs are included in research and development and are expensed asincurred. SFAS 86, “Accounting for the Costs of Computer Software to Be Sold,Leased, or Otherwise Marketed,” requires that software development costsincurred subsequent to reaching technological feasibility be capitalized, ifmaterial. If the process of developing a new product or major enhancement doesnot include a detailed program design, technological feasibility is determinedonly after completion of a working model. To date, the period between achievingtechnological feasibility and the general availability of such software hasbeen short, and the software development costs qualifying for capitalizationhave been insignificant.

***Severance Charges***

Inconnection with our continued shift to our new intrusion detection and securityappliance product lines, we streamlined operations and activities that are notaligned with these core markets and strategies. During 2006, we recorded $10 thousand for severance as a result ofreductions in force.  During 2005, werecorded $0.1 million for severance as a result of reductions in force.  Severance obligations were paid prior toDecember 31, 2006 and 2005 for the respective reporting periods, and wewere not receiving further benefit from the severed individuals afterDecember 31, 2006 and 2005, respectively.

***Use of Estimates***

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities atthe date of the financial statements and the reported amounts of revenue andexpenses during the reporting period. Estimates are used for, but not limitedto, the accounting for doubtful accounts, sales discounts, sales returns,revenue recognition, warranty costs, inventory obsolescence, depreciation andtaxes. Actual results could differ from these estimates.

***Income Taxes***

Weaccount for income taxes pursuant to SFAS No. 109, “Accounting for IncomeTaxes,” which uses the liability method to calculate deferred income taxes.Deferred tax assets and liabilities are recognized for the expected taxconsequences of temporary differences between the tax basis of assets andliabilities and their reported amounts. The realization of deferred tax assetsis based on historical tax positions and expectations about future taxableincome. The liability method also requires the recognition of future taxbenefits such as net operating loss carryforwards, to the extent thatrealization of such benefits is more likely than not.  Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be realized.

***Recent Accounting Pronouncements***

**FASB Interpretation No. 48 - Accountingfor Uncertainty in Income Taxes**

In July 2006, the FASB issued FIN 48, “Accounting for Uncertainty inIncome Taxes - an interpretation of FASB Statement No. 109” (FIN 48). FIN 48clarifies the recognition threshold and measurement of a tax position taken ona tax return. FIN 48 is effective for fiscal years beginning after December 15,2006 (January 1, 2007 for us). FIN 48 also requires expanded disclosure withrespect to the uncertainty in income taxes. We are currently evaluating theimpact, if any, the adoption of FIN 48 will have on our financial statements.

F-11

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**SFAS No. 157 -Fair Value Measurements**

In September 2006, the FASB issued SFAS No. 157, “FairValue Measurements” (SFAS 157), which provides guidance on how to measureassets and liabilities that use fair value. SFAS 157 will apply wheneveranother US GAAP standard requires (or permits) assets or liabilities to bemeasured at fair value but does not expand the use of fair value to any newcircumstances. This standard also will require additional disclosures in bothannual and quarterly reports. SFAS 157 will be effective for fiscal yearsbeginning after November 15, 2007 (January 1, 2008 for us).  We are currently evaluating the impact, ifany, the adoption of FIN 157 will have on our financial statements.

**3.Balance Sheet Detail (in thousands)**

**Inventories**

|                       | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Finished products     |       | $                     | 180        |   | $ | 290 |   |
| Work in process       |       | 8                     |       | 8 |   |
| Demonstration systems |       | 21                    |       | 75 |   |
|                  |       | $                     | 209        |   | $ | 373 |   |

 

**OtherAccrued Expenses**

|                            | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2006**              | ** ** | **2005** | ** ** |
|                       |       |                  |       |   |   |
| Accrued sales  commissions |       | $                     | 10         |   | $ | 26 |   |
| Accrued payroll            |       | 115                   |       | 141 |   |
| Accrued property taxes     |       | 26                    |       | 63 |   |
| Accrued sales taxes        |       | 34                    |       | 139 |   |
| Other                      |       | 98                    |       | 46 |   |
|                       |       | $                     | 283        |   | $ | 415 |   |

 

**4.Commitments and Contingencies**

***Leases***

Welease office space for our corporate headquarters in Richardson, Texas under anoperating lease, the base term of which expires in February 2010.  We lease office space in San Diego,California for a portion of our security software research and development staffunder an operating lease that expired in August 2006 and has continued ona month to month basis.

  The Company’s lease for the headquartersfacility contains escalation provisions. In accordance with SFAS 13 “Accounting for Leases,” FASB TechnicalBulletin 88-1 “Issues Relating to Accounting for Leases,” and FASB TechnicalBulletin 85-3 “Accounting for Operational Leases with Scheduled Rent Increases,”the Company records rent expense on facility leases on a straight-linebasis.  Real estate taxes, insurance andmaintenance expenses are the obligations of the Company.  Rent expense totaled approximately $486,000and $600,000 for the years ended December 31, 2006 and 2005, respectively.

Futureminimum lease payments consisted of the following on December 31, 2006 (inthousands):

| 2007   |   | $   | 378    |   |
|--------|--------|-----|--------|--------|
| 2008   |   | 393 |   |
| 2009   |   | 409 |   |
| 2010   |   | 68  |   |
|   |   | $   | 1,248  |   |

 

F-12

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***Legal Proceedings***

We aresubject to legal proceedings and claims that arise in the ordinary course ofbusiness. We do not believe that the outcome of those matters will have amaterial adverse affect on our consolidated financial position, operatingresults or cash flows. However, there can be no assurance such legalproceedings will not have a material impact.

We arenot aware of any material claims outstanding or pending against Intrusion Inc.at December 31, 2006.

**5.Employee Benefit Plans**

***Employee Stock Purchase Plan***

OnApril 24, 1997, we adopted an Employee Stock Purchase Plan (the “PurchasePlan”) under which 125,000 shares of common stock have been reserved forissuance. Eligible employees may designate not more than 10% of theircompensation to be deducted each pay period for the purchase of common stockunder the Purchase Plan. The Purchase Plan was amended January 17, 2001 toincrease the maximum number of shares that can be purchased per participantfrom 500 shares to 1,000 shares per offering. Each participant maypurchase up to 2,000 shares in any one calendar year. On January 31and July 31 of each calendar year, shares of common stock are purchased withthe employees’ payroll deductions over the immediately preceding six months ata price per share of 85% of the lesser of the market price of the common stockon the purchase date or the market price on the first day of the six-monthperiod. The Purchase Plan will terminate no later than April 24, 2007. Noshares were purchased under the Purchase Plan in the years ended December 31,2006 and December 31, 2005.  A totalof 45,702 shares have been issued under the Purchase Plan and 79,298 shares areavailable for purchase as of December 31, 2006.

***Employee 401(k) Plan***

Weadopted a plan known as the Intrusion Inc. 401(k) Savings Plan (the “Plan”)to provide retirement and incidental benefits for our employees.  The Plan covers substantially all employeeswho meet minimum age and service requirements. As allowed under Section 401(k) of the Internal Revenue Code, thePlan provides tax deferred salary deductions for eligible employees.

Employeesmay contribute from 1% to 25% of their annual compensation to the Plan, limitedto a maximum amount as set by the Internal Revenue Service.  Participants who are over the age of 50 maycontribute an additional amount of their salary per year, as defined annuallyby the Internal Revenue Service.  Wematch employee contributions at the rate of $0.25 per each $1.00 ofcontribution on the first 4% of compensation. Matching contributions to the Plan were approximately $23,000 and$24,000 for the years ended December 31, 2006 and 2005, respectively.

**6.Line of Credit**

OnMarch 29, 2006, we established a $1,000,000 line of credit with Silicon ValleyBank which may increase to $2,000,000 if we have EBITDA of at least $200,000for two consecutive quarters.  Under theterms of this agreement, we may borrow an amount equal up to 80% of eligibleaccounts receivable balances.  Inaddition, we may obtain inventory advances equal to 35% of finished goodsinventory, capped at the lesser of the inventory availability, $300,000 or 35%of our total borrowing base.  Thefinancial covenant is a ratio of unrestricted cash on deposit with SiliconValley Bank plus the amount equal to 80% of our eligible accounts receivable tothe amount of the obligations of not less than 1.25:1.00. Beginning on the datethe revolving line increases to $2,000,000 and measured thereafter on a rollingthree (3) month basis as of the end of each month, EBITDA, less the aggregateamount of Permitted Dividends, must be at least $0.00. If our credit lineincreases to $2,000,000, inventory advances will be capped at the lesser of theinventory availability, $600,000 or 35% of our borrowing base.  We have current balance due under this creditline of $200,000 at December 31, 2006. Also, assuming eligible receivables and inventory equal to the $844,000of net accounts receivable and the $180,000 of finished goods inventory we hadat December 31, 2006, we could borrow up to an additional $139,000 under ourcredit line at December 31, 2006. Amounts we borrow under the credit line accrue interest at an annualrate of prime plus 1% and are secured by a lien on all of our assets.  As described in Note 12, the line of creditwas renewed on March 29, 2007, accrued interest on all outstanding amounts ispayable monthly in arrears and all outstanding principal and accrued but unpaidinterest on the amounts we borrow are due on March 28, 2008.

F-13

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**7.Income Taxes**

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. There are no deferred tax liabilitiesas of December 31, 2006 and 2005. Significant components of our deferred tax assets as ofDecember 31, 2006 and 2005 are as follows (in thousands):

 

|                                                           | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **2006**             | ** ** | **2005** | ** ** |
| ** **                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net operating  loss carryforwards                         |       | $                    | 30,462     |   | $ | 29,355 |   |
| Net operating  loss carryforwards of foreign subsidiaries |       | 374                  |       | 374 |   |
| Book over tax  depreciation                               |       | 94                   |       | 87 |   |
| Intangibles                                               |       | 939                  |       | 1,118 |   |
| FAS 123 options  expense                                  |       | 162                  |       | — |   |
| Vacation accrual                                          |       | 78                   |       | 97 |   |
| Allowance for  doubtful accounts and returns              |       | 24                   |       | 26 |   |
| Warranty accrual                                          |       | 18                   |       | 18 |   |
| Inventory  allowance                                      |       | 69                   |       | 51 |   |
| Other                                                     |       | 1,553                |       | 1,587 |   |
| Deferred tax assets                                       |       | 33,773               |       | 32,713 |   |
| Valuation  allowance for deferred tax assets              |       | (33,773              | )          | (32,713 | ) |
| Deferred tax  assets, net of allowance                    |       | $                    | —     |   | $ | — |   |

 

Deferredtax assets are required to be reduced by a valuation allowance if it is morelikely than not that some portion or all of the deferred tax assets will not berealized.  Realization of the futurebenefits related to the deferred tax assets is dependent on many factors,including the Company’s ability to generate taxable income within the near tomedium term.  Management has consideredthese factors in determining the valuation allowance for 2006 and 2005.

Thedifferences between the provision for income taxes and income taxes computedusing the federal statutory rate for the years ended December 31, 2006 and2005 are as follows (in thousands):

|                                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Reconciliation  of income tax benefit to statutory rate: |       |     |       |     |       |
| Income tax  benefit at statutory rate                    |       | $        | (1,028     | )        | $          | (1,129 | ) |
| State income  taxes, net of federal income tax benefit   |       | (80      | )          | (87      | )          |
| Change in  valuation allowance                           |       | 1,060    |       | 1,205    |       |
| Other                                                    |       | 48       |       | 11       |       |
|                                                     |       | $        | —     |     | $          | — |   |

 

AtDecember 31, 2006, we had federal net operating loss carryforwards of$83.1 million for income tax purposes that begin to expire in 2008 and aresubject to the ownership change limitations under Internal Revenue CodeSection 382. We also had $96.5 million of state net operating losscarryforwards.  Net operating losscarryforwards of the foreign subsidiaries of $0.4 million at December 31,2006 are available indefinitely for offset only against taxable incomegenerated by the foreign subsidiaries.

Wemade no federal tax payments during 2006 and 2005, and did not receive anyfederal income tax refunds in 2006 or 2005 for income taxes paid in previousyears.

**8.Stock Options**

AtDecember 31, 2006, we had three stock-based compensation plans, which aredescribed below. These plans were developed to retain and attract key employeesand directors.

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common 

F-14

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stock. The 1995 Plan provides for the issuance of bothnon-qualified and incentive stock options to our employees, officers, andemployee-directors. The 1995 Plan expired by its terms on March 21, 2005 and nooptions were available for future issuance after the expiration.  At December 31, 2006, 67,365 employee optionshave been exercised and employee options to purchase a total of398,631 shares of common stock are outstanding.  A total of 2,290,295 options have beengranted pursuant to the 1995 Plan, of which, 1,824,299 have been cancelled.

In 1995, we adopted the 1995 Non-Employee DirectorStock Option Plan (the “1995 Non-Employee Director Plan”).  The 1995 Non-Employee Director Plan providedfor the issuance of non-qualified stock options to non-employee directors. The1995 Non-Employee Director Plan was amended in April 2002 to increase thenumber of shares available for issuance to 65,000 from 40,000 shares. The1995 Non-Employee Director Plan expired by its terms on March 21, 2005 and nooptions were available for future issuance after the expiration.  No options have been exercised under the 1995Non-Employee Director Plan.  Non-employeeoptions to purchase a total of 32,500 shares of common stock areoutstanding at December 31, 2006. A total of 62,500 options have beengranted to directors pursuant to the 1995 Non-Employee Director Plan, of which,30,000 have been cancelled.

On March 17, 2005, the Board approved the 2005 StockIncentive Plan (the “2005 Plan”), which was approved by the stockholders onJune 14, 2005.  The 2005 Plan serves as areplacement for the 1995 Non-Employee Director Plan and the 1995 Option Planwhich expired by their terms on March 21, 2005.  The approval of the 2005 Plan had no effecton the 1995 Plans or any options granted pursuant to either plan.  All options will continue with their existingterms and will be subject to the 1995 Non-Employee Director Plan or the 1995Plan, as applicable.  Further, theCompany will not be able to re-issue any option which is cancelled orterminated under the 1995 Non-Employee Director Plan or the 1995 OptionPlan.  The 2005 Plan provides for theissuance of up to 750,000 shares of common stock upon exercise of optionsgranted pursuant to the 2005 Plan.  The2005 Plan consists of three (3) separate equity incentive programs: theDiscretionary Option Grant Program; the Stock Issuance Program; and theAutomatic Option Grant Program for non-employee Board members.  Officers and employees, non-employee Boardmembers and independent contractors are eligible to participate in theDiscretionary Option Grant and Stock Issuance Programs.  Participation in the Automatic Option GrantProgram is limited to non-employee members of the Board.  Each non-employee Board member will receivean option grant for 10,000 shares of Common Stock upon initial election orappointment to the Board, provided that individual has not previously beenemployed by the Company in the preceding six (6) months.  In addition, on the date of each annualstockholders meeting, each Board member will automatically be granted an optionto purchase 5,000 shares of Common Stock, provided he or she has served as anon-employee Board member for at least six (6) months.  At December 31, 2006, no 2005 planoptions have been exercised and employee and non-employee Board member optionsto purchase a total of 654,500 shares of common stock are outstanding.  A total of 726,500 options have been grantedunder the 2005 Plan, of which 72,000 have been cancelled and options for95,500 shares remain available for future grant.  No shares have been issued pursuant to theStock Issuance Program.

Commonshares reserved for future issuance, including conversions of preferred stock,warrants, outstanding options and options available for future grant under allof the stock option plans and employee stock purchase plans total approximately4,126,021 million shares at December 31, 2006 as follows:

| (In thousands)              | ** ** | **Outstanding** | ** ** | **Available for  Future Grant** | ** ** |
|----------------------------------|------------|-----------------|------------|-------------------------------------------|------------|
|                             |       |            |       |                                      |       |
| Preferred Stock                  |       | 1,342           |       | —                                    |       |
| Warrants                         |       | 1,524           |       | —                                    |       |
| 1995 Plan                        |       | 399             |       | —                                    |       |
| 1995  Non-Employee Director Plan |       | 32              |       | —                                    |       |
| 2005 Plan                        |       | 655             |       | 96                                        |       |
| Employee Stock  Purchase Plan    |       | —          |       | 79                                        |       |
| Total                            |       | 3,952           |       | 175                                       |       |

 

TheCompensation Committee of our Board of Directors determines for all employeeoptions, the term of each option, option exercise price within limits set forthin the plans, number of shares for which each option is granted and the rate atwhich each option is exercisable (generally ratably over one, three or fiveyears from grant date). However, the exercise price of any incentive stockoption may not be less than the fair market value of the shares on the dategranted (or less than 110% of the fair market value in the case of optioneesholding more than 10% of our voting stock of the Company), and the term cannotexceed ten years (five years for incentive stock options granted to holders ofmore than 10% of our voting stock).

F-15

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***StockIncentive Plan Summary***

Asummary of our stock option activity and related information for the yearsended December 31, 2006 and 2005 is as follows:
| ** **                          | ** ** | **2006**                                         | ** ** | **2005**                               | ** ** |
|-------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | ** **                                       | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at  beginning of year   |       | 891                                              |       | $                                      | 5.48       |   | 404 |   | $ | 11.08 |   |
| Granted at price =  market value    |       | 367                                              |       | .44                                    |       | 579 |   | 3.01 |   |
| Granted at price >  market value |       | 60                                               |       | .33                                    |       | — |   | — |   |
| Exercised                           |       | (1                                               | )          | .76                                    |       | (1 | ) | 2.02 |   |
| Forfeited                           |       | (69                                              | )          | 2.75                                   |       | (63 | ) | 2.45 |   |
| Expired                             |       | (162                                             | )          | 8.42                                   |       | (28 | ) | 41.73 |   |
|                                |       |                                             |       |                                   |       |   |   |   |   |
| Outstanding at end of  year         |       | 1,086                                            |       | $                                      | 3.23       |   | 891 |   | $ | 5.48 |   |
| Options exercisable at end of year  |       | 554                                              |       | $                                      | 5.47       |   | 307 |   | $ | 10.29 |   |

 

***StockOptions Outstanding and Exercisable***

Information related to stock options outstanding atDecember 31, 2006, is summarized below:
| ** **                                  | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**                           | ** ** |
|---------------------------------------------|------------|------------------------------|------------|--------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **                   | ** ** | **Outstanding at  12/31/06 (in  thousands)** | ** ** | **Weighted  Average  Remaining   Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable at  12/31/06 (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $0.30-$2.00                                 |       | 526                          |       | 8.51 years                                             |       | $ | 0.62 |   | 97 |   | $ | 1.46 |   |
| $2.01-$5.00                                 |       | 484                          |       | 7.90 years                                             |       | $ | 3.02 |   | 382 |   | $ | 3.06 |   |
| $5.01-$10.00                                |       | 39                           |       | 4.81 years                                             |       | $ | 5.97 |   | 38 |   | $ | 5.97 |   |
| $10.01-$20.00                               |       | 17                           |       | 4.02 years                                             |       | $ | 19.21 |   | 17 |   | $ | 19.21 |   |
| $20.01-$63.00                               |       | 20                           |       | 3.32 years                                             |       | $ | 57.78 |   | 20 |   | $ | 57.78 |   |
|                                        |       | 1,086                        |       | 7.94 years                                             |       | $ | 3.23 |   | 554 |   | $ | 5.47 |   |
|                                             |            |                              |            |                                                        |            |  |  |  |  |  |  |  |  |  |  |

 

Summarizedinformation about outstanding stock options as of December 31, 2006, that arefully vested and those that are expected to vest in the future as well as stockoptions that are fully vested and currently exercisable, are as follows:
| ** **                                  | ** ** | **Outstanding Stock  Options (Fully Vested  and Expected to Vest)*** | ** ** | **Options that  are Exercisable** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **As of  December 31, 2006**                | ** ** | ** **                                                                                         | ** ** | ** **                                  | ** ** |
| Number of outstanding options               |       | 1,084                                                                                              |       | 554                                         |       |
| Weighted average remaining contractual life |       | .76                                                                                                |       | 7.04                                        |       |
| Weighted average exercise price per share   |       | $                                                                                                  | 3.24       |                                        | $          | 5.47 |   |
| Intrinsic value                             |       | $                                                                                                  | 58.6       |                                        | $          | 0 |   |

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*                    Includeseffects of expected forfeitures 

Theexercisable options detailed in the table above have a $0 intrinsic value asthe fair market value on December 31, 2006 is less than the exercise prices ofall of the exercisable options. As of December 31, 2006, the total unrecognizedcompensation cost related to non-vested options not yet recognized in thestatement of operations totaled approximately $139 thousand (including expectedforfeitures) and the weighted period over which these awards are expected tovest was 1.56 years.

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**9.Preferred Stock**

***5%Preferred Stock***

On March 25, 2004, we completed a $5.0 millionprivate placement of our 5% convertible preferred stock and warrants.  In the private placement, we sold 1,000,000shares of our 5% preferred stock at a price of $5.00 per share for grossproceeds of $5.0 million, less $275,000 of issuance costs.  The 5% preferred shares were initiallyconvertible into 1,590,331 shares of common stock at a conversion price of$3.144 per share.  Holders of the 5% convertible preferred stockinclude 140,000 shares purchased by our CEO and 60,000 shares purchased by adirector of the Company.

The 5%dividends related to the 5% preferred stock are paid semi-annually on the lastbusiness day in March and September of each year, beginning withSeptember 2004.  Preferred stockholdersvote together with common stockholders on an as converted to common stockbasis.  Based on the conversion rate ofthe preferred stock, holders of our 5% preferred stock will receive 1.5903votes per share rounded to the nearest whole number.  The liquidation preference for the 5%preferred stock is an amount equal to $5.00 per share plus any accrued andunpaid dividends.  Holders of our 5%preferred stock have liquidation preference rights over common stockholders.

Includedin this transaction were warrants to purchase 556,619 shares of common stock atan exercise price of $3.144 per share.  Warrant holders include 80,000 held by our CEO and30,000 held by a director of the Company. In connection with the closing of this private placement, weissued warrants to purchase 64,408 shares of our common stock at an exerciseprice of $3.144 per share to our financial advisor for assistance with theprivate placement.  All of the warrantswere immediately exercisable and expire on March 25, 2009.  These 621,027 warrants were valued at $1.2million using the Black-Scholes model and have been treated as a discount tothe 5% Preferred Stock and recorded as an increase in additional paid incapital.  The issuance of the warrantsresulted in a beneficial conversion feature to the 5% preferred stock valued at$0.9 million.  In accordance with EITF 98-5, the beneficial conversion feature wasfully amortized in the first quarter of 2004, as the preferred stock does nothave a stated maturity and is immediately convertible into common stock.  This beneficial conversion feature isincluded in the net loss attributed to common stockholders.

The 5%preferred stock was recorded as the financing proceeds of $5.0 million less$275,000 issuance costs and the fair value of the warrants issued inconjunction with the 5% preferred stock of $1.2 million.

Wehave the right to redeem any or all of the outstanding 5% preferred stock at aprice of $5.00 per share plus accrued dividends at any time afterSeptember 25, 2004 if certain conditions are met.

During2005, 580,304 shares of our 5% preferred stock were converted into 922,875shares of our common stock.  There wereno conversions of our 5% preferred stock during 2006.  At December 31, 2006 there are 259,696shares of our 5% preferred stock outstanding.

***Series2 5% Preferred Stock***

On March 28, 2005, we completed a$2.7 million private placement of Series 2 5% convertible preferred stock andwarrants.  In the private placement, wesold 1,065,200 shares of preferred stock at a price of $2.50 per share forgross proceeds of $2.7 million, less $173,000 of issuance costs.  The shares of Series 2 5% preferred stock areconvertible into 1,065,200 shares of common stock at an initial conversionprice of $2.50 per share.  Holders of theSeries 2 5% preferred stock include 160,000 shares purchased by our CEO and60,000 shares purchased by a director of the Company.

The 5% dividends accruing on theSeries 2 5% preferred stock are required to be paid quarterly on the firstbusiness day in March, June, September and December of each year, beginningwith June 2005.  The liquidationpreference for the preferred stock is an amount equal to $2.50 per share plusany accrued and unpaid dividends. Holders of our Series 2 5% preferred stock have liquidation preferencerights over our 5% preferred stock holders as well as our commonstockholders.  The holders of the Series2 5% preferred stock are not entitled to vote on any matter, except asotherwise required by law or with respect to certain limited matters specifiedin the Certificate of Designations creating the Series 2 5% preferred stock.

Included in this transaction werewarrants to purchase 532,600 shares of common stock at an exercise price of$2.77 per share.  Warrant holders include80,000 held by our CEO and 30,000 held by a director of the Company.  The relative fair value of these warrants wasvalued at $0.7 million using the Black-Scholes model and has been recorded as adiscount to the 

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Series 2 5% preferred stock and an increase inadditional paid-in capital.  The issuanceof these warrants also resulted in a beneficial conversion feature to theSeries 2 5% preferred stock valued at $0.9 million.  In accordance with EITF 98-5, the beneficialconversion feature was fully amortized in the first quarter of 2005, as thepreferred stock does not have a stated maturity and is immediately convertibleinto common stock.  This beneficialconversion feature is included in the net loss attributed to common stockholders.  In connection with the closing of thisprivate placement, we issued warrants to purchase 60,390 shares of our commonstock at an exercise price of $2.77 per share to two affiliates of ourfinancial advisor for assistance with the private placement.  These warrants were valued at $0.1 millionusing the Black-Scholes model and have been recorded as a reduction to theSeries 2 5% preferred stock and an increase to additional paid-in capital.

The Series 2 5% preferred stockwas recorded as the net of the proceeds of $2.7 million less $173,000 issuancecosts and the fair value of the warrants issued in conjunction with the Series2 5% preferred stock totaling $0.8 million.

Holdersof Series 2 5% preferred stock have the right to require us to redeem any orall of the their shares upon the occurrence of certain events within theCompany’s control that are defined in Certificate of Designation at a priceequal the sum of (1) the greater of $3.25****andthe product of the volume weighted average price of our common stock on thetrading day immediately preceding the event multiplied by $2.50 divided by theconversion price then in effect plus (2) any accrued but unpaid dividends onthe Series 2 5% preferred stock plus (3) all liquidated damages or otheramounts payable to the holders of Series 2 5% preferred stock.

During2005, 565,200 shares of Series 2 5% preferred stock were converted into 565,200shares of our common stock.  During 2006,40,000 shares of Series 2 5% preferred stock were converted into 40,000 sharesof our common stock.  AtDecember 31, 2006 there are 460,000 shares of Series 2 5% preferred stockoutstanding.

***Series3 5% Preferred Stock***

On December 2, 2005, we completeda $1.2 million private placement of Series 3 5% convertible preferred stock andwarrants.  In the private placement, we sold564,607 shares of preferred stock at a price of $2.18 per share for grossproceeds of $1.2 million, less $100,000 of issuance costs.  The shares of Series 3 5% preferred stock areconvertible into 564,607 shares of common stock at an initial conversion priceof $2.18 per share.  Holders of theSeries 3 5% preferred stock include 55,046 shares purchased by our CEO and27,523 shares purchased by a director of the Company.

The 5% dividends accruing on theSeries 3 5% preferred stock are required to be paid quarterly on the firstbusiness day in March, June, September and December of each year, beginningwith March 1, 2006.  The liquidationpreference for the preferred stock is an amount equal to $2.18 per share plus anyaccrued and unpaid dividends.  Holders ofour Series 3 5% preferred stock have liquidation preference rights over holdersof our 5% preferred, Series 2 5% preferred stock and common stock.  The holders of the Series 3 5% preferredstock are not entitled to vote on any matter, except as otherwise required bylaw or with respect to certain limited matters specified in the Certificate ofDesignations creating the Series 3 5% preferred stock.

Included in this transaction werewarrants to purchase 282,306 shares of common stock at an exercise price of$2.58 per share.  Warrant holders include27,523 held by our CEO and 13,762 held by a director of the Company.  The relative fair value of these warrants wasvalued at $0.3 million using the Black-Scholes model and has been recorded as adiscount to the Series 3 5% preferred stock and an increase in additionalpaid-in capital.  The issuance of thesewarrants also resulted in a beneficial conversion feature to the Series 3 5%preferred stock valued at $0.5 million. In accordance with EITF 98-5, the beneficial conversion feature wasfully amortized on the grant date, as the preferred stock does not have astated maturity and is immediately convertible into common stock.  This beneficial conversion feature is includedin the net loss attributed to common stockholders.  In connection with the closing of thisprivate placement, we issued warrants to purchase 27,531 shares of our commonstock at an exercise price of $2.58 per share to an affiliate of our financialadvisor for assistance with the private placement.  These warrants were valued at $37,000 usingthe Black-Scholes model and have been recorded as a reduction to the Series 35% preferred stock and an increase to additional paid-in capital.

The Series 3 5% preferred stockwas recorded as the net of the proceeds of $1.2 million less $100,000 issuancecosts and the fair value of the warrants issued in conjunction with the Series3 5% preferred stock totaling $0.3 million.

Holdersof Series 3 5% preferred stock have the right to require us to redeem any orall of the their shares upon the occurrence of certain events within theCompany’s control that are defined in Certificate of Designation at a priceequal the sum of (1) the greater of $2.834****andthe product of the volume weighted average price of our common stock on thetrading day immediately preceding the event multiplied by $2.18 divided by theconversion price then in effect plus (2) any accrued 

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but unpaid dividends on the Series 3 5% preferredstock plus (3) all liquidated damages or other amounts payable to the holdersof Series 3 5% preferred stock.

During2006, 95,872 shares of Series 3 5% preferred stock were converted into 95,872shares of our common stock.  AtDecember 31, 2006 there are 468,735 shares of Series 3 5% preferred stockoutstanding.

**10.Common Stock Private Placement**

On December 28, 2006, we completed a private placementof 1,250,000 shares of our Common Stock for gross proceeds of $500,000. G.WardPaxton, our Chairman, President and Chief Executive Officer purchased 1,000,000shares for a total of $400,000. Michael L.Paxton, our Vice President and ChiefFinancial Officer purchased 250,000 shares for a total of $100,000.

Asdescribed in Note 12, on March 15, 2007, we completed an additional privateplacement of 925,926 shares of our Common Stock for gross proceeds of$500,000.  G. Ward Paxton, our Chairman,President and Chief Executive Officer purchased 833,333 shares for a total of$450,000. Michael L. Paxton, our Vice President and Chief Financial Officerpurchased 92,593 shares for a total of $50,000.

**11.Segments, Major Customers and Geographic Information**

Our operationsare concentrated in one area—security software and appliances.  Sales to the U.S. Government through directand indirect channels totaled 73.6% of total revenues for 2006 and 70.7% oftotal revenues for 2005.  During 2006approximately 65.6% of total revenues are attributable to three governmentcustomers.  During 2005 approximately59.7% of total revenues are attributable to three government customers.  There were no individual commercial customersin 2006 or 2005 that exceeded 10% of total revenues for that year.  Our similar product and service offerings arenot viewed as individual segments, as our management analyzes the business as awhole and expenses are not allocated to each product offering.

Exportsales (based on our customers location), primarily to Europe, Asia and Canada,were $0.5 million in 2006 and $0.6 million in 2005. No significantlong-lived assets are deployed outside of the United States.  Our foreign operations act only as salessupport offices in those regions.

**12.Subsequent Events**

OnMarch 29, 2007, we renewed our existing $1,000,000 line of credit with SiliconValley Bank.  Under the terms of thisagreement, we may borrow an amount equal up to 80% of eligible accountsreceivable balances.  In addition, we mayobtain inventory advances equal to 35% of finished goods inventory, capped atthe lesser of the inventory availability, $300,000 or 35% of our totalborrowing base.  The line of credit willincrease to $2,000,000 upon achieving two consecutive quarters of $200,000 in positiveEBITDA.  If the credit line increases to$2,000,000, inventory advances will be capped at the lesser of the inventoryavailability, $600,000 or 35% of our borrowing base.  Amounts we borrow under the credit lineaccrue interest at an annual rate of prime plus 1% and are secured by a lien onall of our assets.  Accrued interest onall outstanding amounts is payable monthly in arrears and all outstandingprincipal and accrued but unpaid interest on the amounts we borrow are due onMarch 28, 2008.

On March 15, 2007, we completed an additional privateplacement of 925,926 shares of our Common Stock for gross proceeds of $500,000.

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