**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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##### **FORM 10-KSB**

 

**(Mark One)**
| **ý**                                                                                                                | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**     |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
|                                                                                                                      |       |                                                                                                |
| **FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005**                                                                      |
| ** **                                                                                                                | ** ** | ** **                                                                                          |
| **OR**                                                                                                                    |
| ** **                                                                                                                | ** ** | ** **                                                                                          |
| **o**                                                                                                                     | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                                                      |       |                                                                                                |
| **For the transition period  from       to       ** |

 

**COMMISSIONFILE NUMBER 0-20191**

 

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**Intrusion Inc.**

(Exact name of registrant asspecified in its charter)

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

 

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

 

Securities registered pursuantto Section 12(b) of the Act:

**None**

 

Securities registered pursuantto Section 12(g) of the Act:

 

**CommonStock, $0.01 par value**

(Title of class)

 

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

 

Check whether the issuer (1)  filed allreports required to be filed by Section 13 or 15(d) of the Exchange Actduring the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.  Yes  ý   No  o

 

Check if disclosure of delinquent filers inresponse to Item 405 of Regulation S-B is not contained herein, and willnot be contained, to the best of the registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-KSB or any amendment to this Form 10-KSB.   ý

 

State the issuer’s revenues for its mostrecent fiscal year:  $5,978,000

 

Indicate bycheck mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes oNo ý

 

State the aggregate market value of thevoting and non-voting equity held by non-affiliates of the Registrant computedby reference to the price at which the common equity was last sold, or theaverage bid and asked price of such common equity, as of March 17, 2006:  $9,342,252. As of March 17, 2006, 7,046,213 shares of the Registrant’s CommonStock were outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the Registrant’s definitive ProxyStatement filed in connection with the Registrant’s 2006 Annual Meeting ofStockholders are incorporated by reference into Part III of thisForm 10-KSB.

 

TransitionalSmall Business Disclosure Format (Check one): Yes oNo ý

 

 

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**INTRUSION INC.**

**INDEX**

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

 

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**PART I**

 

**Item 1.**          Description of Business.

 

In addition to the historical informationcontained herein, 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 ofnetwork intrusion prevention, intrusion detection, regulated informationcompliance, 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 througha direct sales force to end-users, distributors and numerous domestic andinternational system integrators, managed service providers and value-addedresellers. Our end-user customers include high technology, e-commerce,manufacturing, government agencies, military, financial institutions,telecommunications, retail, transportation, healthcare, insurance,entertainment, utilities, energy companies, and academic institutions.  Essentially, our end-user can be defined as ‘anyend-user requiring network security solutions for protecting their missioncritical data’.

 

We were organized in Texas inSeptember 1983 and reincorporated in Delaware in October 1995. Formore than 15 years, we provided local area networking equipment and wereknown as Optical Data Systems or ODS Networks. On April 17, 2000, weannounced plans to sell, or otherwise dispose of, our networking divisions,which included our Essential Communications division and our local areanetworking assets. On June 1, 2000, we changed our name from ODSNetworks, Inc. to Intrusion.com, Inc., and our Nasdaq 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 locatedat 1101 East Arapaho Road, Richardson, Texas 75081, and our telephone number is(972) 234-6400.  Our website URL iswww.intrusion.com.  References to “we”, “us”,“our” or “Intrusion Inc.” refer to Intrusion Inc. and itssubsidiaries.  ComplianceCommanderTM, SecureNetTM, TraceCopTM and SpySnareTM are registered trademarks ofIntrusion Inc.

 

On March 25, 2004, we completed a $5.0million private 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 amendmentto our certificate of incorporation to effect a one-for-four (1:4) reverse stocksplit of our common stock.  The reversestock split became effective on March 29, 2004.  All outstanding share numbers and relatedcommon stock numbers, such as earnings per share and outstanding options,included in this report are set forth on a post-split basis.

 

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On March 28, 2005, we completed a privateplacement of 1,065,200 shares of our Series 2 5% Convertible Preferred Stockand warrants to purchase 532,600 shares of our common stock for gross proceedsof $2,663,000.  The preferred shares maybe converted into 1,065,200 shares of common stock at an initial conversionprice of $2.50 per share, and the warrants may be exercised at a price of $2.77per share 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 anadditional private placement of 564,607 shares of our Series 3 5% ConvertiblePreferred Stock and warrants to purchase 282,306 shares of our common stock forgross proceeds of $1,230,843.  Thepreferred shares may be converted into 564,607 shares of common stock at aninitial conversion price of $2.18 per share, and the warrants may be exercisedat a price of $2.58 per share during the five-year period commencing on June 2,2006.  In connection with theclosing of this private placement, we issued warrants to purchase 27,531 sharesof our common stock at an exercise price of $2.58 per share to employees of ourfinancial advisor for the private placement.

 

On March 29,2006, we established a $1,000,000 line of credit with Silicon Valley Bank whichmay increase to $2,000,000 if we have EBITDA of at least $200,000 for twoconsecutive quarters.  Under the terms ofthis 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 goods 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, 2007.

 

**Product Transition**

 

We have continued to transition our businessfrom sales of our hardware-based PDS and SecureCom network security products toour higher margin software-based SecureNet, Compliance Commander, SpySnare andTraceCop products. Our product families include intrusion prevention anddetection, spyware and regulated information compliance and entity identificationproducts.

 

During this transition, our sales havedeclined from $7.8 million in 2002 to $6.5 million in 2003 and $6.0 million in2004 and 2005 as sales of our new software products have not been sufficient tooffset reduced sales of our hardware products. Accordingly, we restructured our business to reflect our focus on oursales and to reduce our expenses.  Theseefforts resulted in a reduction in our operating loss from ($22.8) million in2002 to ($9.8) million in 2003 to ($4.6) million in 2004 and to ($3.4) millionin 2005.

 

We plan to continue to focus our businessstrategy on sales of our higher margin software products, which includeSecureNet, Compliance Commander, SpySnare and TraceCop.  We believe that changing regulatory requirementsfor obtaining and retaining information along with an increased need for dataprotection and network security will increase market demand for and marketacceptance of our products, thus increasing our revenues and operating margins.

 

**Government Sales**

 

In December 2002, our SecureNet networksecurity products became the first product of their kind to receive CommonCriteria Certification under the National Information Assurance Partnership(NIAP) Common Criteria Evaluation and Validation Scheme, which is designed tofurther the goals of the government and commercial sectors to improve securityin commercial 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 technologysecurity, in an effort to increase the level of trust government and commercialconsumers have in information systems and related networking products.

 

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Sales to U.S. government customers accountedfor 70.7% of our revenues for the year ended December 31, 2005, comparedto 53.6% of our revenue in 2004.  Weexpect to continue to derive a substantial portion of our revenues from salesto governmental entities in the future as we continue to market our CommonCriteria Certified network security products as well as government use of ourregulated information compliance system products and entity identificationproducts.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including potential disruption dueto appropriation and spending patterns, delays in approving a federal budgetand the government’s reservation of the right to cancel contracts and purchaseorders for its convenience.

 

Generally, we make our sales under purchaseorders rather than long-term contracts. Our customers, including government customers may cancel their orderswith little or no prior notice without penalty.  Although we transact business with variousgovernment entities, we do not believe that the cancellation of any particularorder would have a material effect on our financial results.  In addition, we do not believe that any ofour revenues with government customers are subject to renegotiation ofprofits.  However, because we derive andexpect to continue to derive a substantial portion of our revenue from sales togovernment entities, a large number of cancelled or renegotiated governmentorders could have a material adverse effect on our financial results.  Currently, we are not aware of any proposedcancellation or renegotiation of any of our existing arrangements withgovernment entities, and, historically, government entities have not cancelledor renegotiated orders which had a material adverse effect on our business.

 

**Industry Background**

 

With the permeation of the Internet as abusiness enabler over the last decade, network security has changed from beinga technology 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 and processesin place.

 

As a result, enterprises are adopting avariety of security solutions to meet the challenge posed by external andinternal threats. To be effective, organizations require enterprise-wideinformation risk management solutions that are broadly deployed and centrallymanaged. Organizations seek systems with the optimal combination ofbest-of-breed capabilities and total cost of ownership. It is our belief thatsecuring the enterprise 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 primaryingredients of network security within a single device for overall networksecurity and for the protection of specific classified, confidential or customerinformation assets.

 

**Products**

 

The Intrusion SecureNet, ComplianceCommander, SpySnare and TraceCop systems can operate standalone or with ourProvider Management System.

 

Sensors are appliances or software componentsthat are connected to the network and monitor the traffic searching for matchesto signatures 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.

 

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The Provider Management System controls theSensors and displays events produced by the Sensors.  The Intrusion Provider is a three-tierenterprise management and monitoring system. Provider is for enterprise deploymentswith no license limitations placed on architecture, freeing the enterprise tobuild the management system required. Provider follows the workflow of thesecurity analyst with a highly productive environment for response, research,resolution and decision support. The Provider suite includes applications forevent monitoring, policy creation and tuning and centralized softwaredeployment — making up the complete suite of tools required to manage andmonitor a SecureNet System from five sensors to more than 100.

 

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 flow optionsfor high-end deployments.

 

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

 

# *Intrusion Compliance CommanderProducts*

# * *

Compliance Commander provides protectionagainst the loss and misuse of regulated, classified and commercially sensitivedata.  Loss of information assets thatcontain customer data has spawned a multitude of federal and state legislationto set a standard 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 ofclassified or commercially sensitive data, and are seeking proactive solutionsto deal with these issues.

 

The Intrusion Compliance Commander productsleverage the same Management systems as SecureNet NIP&DS products. OurCompliance Commander solutions are currently designed to address the securityand confidentiality issues in the following industries and customers:

 

•              Healthcarecompanies (including healthcare providers, insurance companies and medical equipmentmanufacturers) 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 provideaccuracy through our Dynamic Data Dictionary (D3) technology, which securelyconnects directly to the customer’s database housing the confidential,classified, or regulated information. The Compliance Commander stays up to datewith the database to match network traffic to the information that is residentin the database. This provides an automated accurate mechanism to identifyleaks and misuse of information assets. By using the customer’s own data, the Compliance Commander virtuallyeliminates any potential for false positives. Users not only benefit from the highly accurate data protection, butalso quickly realize the low-cost of ownership by the fully automated updatingfeature.

 

*Intrusion SpySnare Product*

 

“Spyware” is software that gathers user informationwithout their knowledge through their Internet connection.  Most spyware programs are independentexecutable files that take on the authorization abilities of the victim.  They include

auto-install and auto-update capabilities and canreport on any attempts to remove or modify them.  Spyware can install Dynamic Link Library andother executable files.  Spyware can alsoread, write and delete files and even reformat your hard drive and do thiswhile sending a steady stream of information back to the advertising andmarketing companies or hackers.

 

Usually bundled as a hiddencomponent with software downloaded for free from or shared via the Internet,spyware monitors user activity on the Internet and transmits that information suchas email addresses, Internet use, passwords and credit card numbers to someoneelse.  Because spyware uses the hostcomputer’s memory and system resources while other computer programs arerunning, it can often lead to system crashes or instability.  In fact, according to Microsoft, spyware isresponsible for half of all PC crashes (*InformationWeek, April 26, 2004)*.

 

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OurSpySnare product utilizes our high-performance, low-latency network analysisengine to implement deep-packet inspections in order to determine if spywaresignatures are attempting to get into the customer’s network.   In addition to spyware signatures, SpySnarealso includes P2P file sharing signatures which may be an unwanted source forspyware insertions.  Once the userconnects to a P2P site, a spyware program can unknowingly get returned to theuser’s PC along with the intended file or application.  By using specific signatures for knownspyware, SpySnare provides real-time awareness of network traffic which removesmuch of the guesswork involved in establishing the necessary network defensesand preventing spyware infections.  OnceSpySnare detects a spyware signature match, it flags and drops the spywaretraffic and alerts the administrator.

 

Anotherbenefit of our SpySnare product is its ability to block outbound spywarenotification attempts.  For example, whena traveling laptop gets infected with spyware and returns to connect to thecompany network, the spyware program will notify the spyware host website ofits presence.  SpySnare will detect theoutbound “phone-home” attempt and will likewise block the spyware traffic atthe perimeter.

 

# *Intrusion SecureNetNIP&DS Products*

# * *

Webelieve a primary advantage of the SecureNet NIP&DS is that with a singlelicense purchase, the consumer may choose to deploy the system for intrusionprevention (IPS) or intrusion detection (IDS), providing a superior level offlexibility and simple migration from passive detection to active preventionwithout additional licensing cost.

 

Our Network Intrusion Detection System (NIDS)product provides detection of specific exploit and misuse patterns in thetraffic that the firewall allows.  NIDSdetects known exploits and misuse patterns, suspicious activities and anomaloustraffic or behavior within both inbound and outbound traffic. This addedvisibility provides a checking mechanism for the efficacy of the firewall’srule base.

 

Our Network Intrusion Prevention System(NIPS) product provides network monitoring and analysis functionality likeNIDS, with the added ability to block malicious network traffic. NIPS activelyregulates inbound and outbound traffic based on specific users’ access whilecontrolling what they can do with that access on a granular, per-conversationbasis.

 

Our SecureNet NIP&DS products provideuser customizable, protocol decode detection technology for up to Gigabitnetworks. While Intrusion SecureNet Sensors are in the top-tier of the marketfor detection 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 areavailable as Software Sensors and Hardware Sensors with performance and pricingappropriate for networks ranging from 10Mb/s to Gigabit with a Common CriteriaEAL2 certified Gigabit appliance.

 

# *Intrusion TraceCopProducts*

 

Our TraceCop product assists in identifyingand locating network attackers who use, abuse and probe an enterprisenetwork.  TraceCop utilizes a databasehaving worldwide IP addresses.  TheTraceCop database is regularly updated.

 

**Third-Party Products**

 

We believe that it is beneficial to work withthird parties with complementary technologies to provide integrated solutionsto our customers. 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.

 

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**Customer Services**

 

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

 

**Product Development**

 

The network security industry ischaracterized by rapidly changing technology, standards, economy and customerdemands. We believe that our future success depends in large part upon thetimely enhancement of existing products as well as the development oftechnologically advanced new products that meet industry standards, performsuccessfully and simplify the users’ tasks so that they can do more with fewerresources.  We are currently marketingSecureNet, Compliance Commander, SpySnare and TraceCop products to meetemerging market requirements and are continuously engaged in testing to ensurethat our products interoperate with other manufacturers’ products, which complywith industry standards.

 

During 2005 and 2004, our research anddevelopment expenditures were $2.6 million and $2.5 million, respectively. Allof our expenditures for research and development have been expensed asincurred.  At December 31, 2005, wehad 18 employees 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 ourtransition from a hardware business to primarily a software business, we expectto reduce our 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.

 

Our external manufacturing operationsconsists of U.S. based hardware assembly and configuration and the loading ofthe appropriate software.  Materials usedin our external manufacturing processes include semiconductors such asmicroprocessors, memory chips and application specific integrated circuits (ASICs),printed circuit boards, power supplies and enclosures.  However, our need for these components isdecreasing as we focus on sales of our software-based products.  We have relationships with variousinterchangeable outsourced assembly operations and do not rely on any oneoperation as the work performed is not specific to the assembler we use.  We do not anticipate any problems with ourcurrent outsourcing operations nor do we believe there will be any problemswith changing or adding to existing operations.

 

**Intellectual Property and Licenses**

 

Our success and our ability to compete aredependent, in part, upon our proprietary technology. While we have applied forcertain patents, we currently rely on a combination of contractual rights,trade secrets and copyright laws to establish and protect our proprietaryrights in our products. We have also entered into non-disclosure agreementswith our suppliers, resellers and certain customers to limit access to anddisclosure of proprietary information. There can be no assurance that the stepstaken by us to protect our intellectual property will be adequate to preventmisappropriation of our technology or that our competitors will notindependently develop technologies that are substantially equivalent or superiorto our technology.

 

We have entered into software and productlicense agreements with various suppliers. These license agreements provide uswith additional 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**

 

***FieldSales Force.*** Our direct sales organization focuses on major account sales, channelpartners including distributors, Value Added Resellers (VARs) and integrators;promotes our products to current and potential customers; and monitors evolvingcustomer requirements. The field sales and technical support force providestraining and technical support to our resellers and end users and assists ourcustomers in designing secure data networking solutions.

 

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We currently conduct sales and marketingefforts from our principal office in Richardson (Dallas), Texas.  In addition, we have sales personnel, salesengineers or sales representatives located in California, Illinois, Maryland,Georgia, Europe and Asia.

 

***Distributors.***  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. Recognition ofsales to distributors and related gross profits are deferred until thedistributors resell the merchandise. However, since we have legally sold the inventoryto the distributor and we no longer have care, custody or control over theinventory, we recognize the trade accounts receivable and reduce inventoryrelated to the sale at the time of shipment to the distributor.

 

***Resellers.***  Resellers such as domestic and internationalsystem integrators and VARs sell our products as stand-alone solutions to endusers and integrate our products with products sold by other vendors intonetwork security systems that are sold to end users. Our field sales force and technicalsupport organization provide support to these resellers. Our agreements withresellers are non-exclusive, and our resellers generally sell other productsthat may compete with our products. Resellers may place higher priority onproducts of other suppliers who are larger than and have more name recognitionthan us, and there can be no assurance that resellers will continue to sell andsupport our products.

 

***ForeignSales.***  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 andCanada.  Export sales accounted forapproximately 10.7% and 19.2% of total revenue in 2005 and 2004, respectively.  See “Management’s Discussion and Analysis orPlan of Operations” included in this report for a geographic breakdown of ourrevenue in 2005 and 2004. Sales to foreign customers and resellers generallyhave been made in United States dollars.

 

***Marketing.***  We have implemented several methods to marketour products, including public relations and placed articles, regularparticipation in and presenting during trade shows and seminars, advertisementin trade journals, telemarketing, distribution of sales literature and productspecifications and ongoing communication with our resellers and installed baseof end-user customers.

 

***Customers.***  Our end-user customers include governmententities, military, financial institutions, healthcare, high technology,e-commerce, manufacturing, telecommunications, retail, transportation,insurance, entertainment, utilities, energy companies, 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 manycustomers through various distribution channels, no one commercial customer orreseller accounted for 10% or more of our total revenue in any of the pastthree fiscal years.  However, in 2005,70.7% of our revenue was derived from a variety of U.S. government entitiesthrough direct sales and indirectly through system integrators andresellers.  In 2005, 59.7% of our totalrevenues are attributable to three customers, all of which exceed 10% of ourtotal revenues individually. Comparatively, sales to the U.S. Government through direct and indirectchannels totaled 53.6% of total revenues for 2004 and only one of thoseentities represented more than 10% of our total revenues for the year.  A reduction in our sales to U.S. governmententities could have a material adverse effect on our business and operatingresults if not replaced.

 

***Backlog.***  We believe that only a small portion of ourorder backlog is non-cancelable and that the dollar amount associated with thenon-cancelable portion is immaterial. We purchase inventory based upon ourforecast of customer demand and maintain inventories of sub-assemblies andfinished products 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 andoccasional customer-initiated changes in delivery schedules or cancellation oforders that are made without significant penalty, we do not believe that ourbacklog as of any particular date is indicative of future net sales.

 

***CustomerSupport, Service and Warranty.***  We service, repair and provide technicalsupport for our products. Our field sales and technical support force worksclosely with resellers and end-user customers on-site and by telephone toassist with pre- and post-sales support services such as network securitydesign, system installation and technical consulting. By working closely withour customers, our employees increase their understanding of end-userrequirements and provide input to the product development process.

 

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We warrant all of our products againstdefects in materials 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 protectionsecurity solutions 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 advantage withlarge organizations with complex security requirements.

 

There are numerous companies competing invarious segments of the data security markets. Our principal competitors in thenetwork intrusion prevention and detection market include Internet SecuritySystems, Inc., Cisco Systems, Inc., Symantec, Inc., NetscreenTechnologies, Inc., Network Associates, Inc., Tipping Point Technologies, adivision of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu, Port Authority, Vericept, Reconnex, Tablus anda small number of start-up companies that entered the space within the last twoyears. Regarding the spyware prevention market, we currently directly andindirectly compete with a number of host-based spyware detection systems, suchas Ad-Aware, Spybot S&D and Spy Sweeper and some inline proxy solutionssuch 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 securityindustry have expanded their product lines or technologies in recent years as aresult of acquisitions. Further, more companies have developed products whichconform to existing and emerging industry standards and have sought to competeon the basis of price. We anticipate increased competition from largenetworking equipment vendors, which are expanding their capabilities in thenetwork security market. In addition, we anticipate increased competition fromprivate “start-up” companies that have developed or are developing advancedsecurity products. Increased competition in the security industry could resultin significant price competition, reduced profit margins or loss of marketshare, any of which could have a material adverse effect on our business,operating results and financial condition. There can be no assurance that wewill be able to compete successfully in the future with current or newcompetitors.

 

**Employees**

 

As of December 31, 2005, we employed atotal of 43 persons, including 15 in sales, marketing and technical support, 3in manufacturing and operations, 18 in research and product development and 7in administration and finance.

 

None ofour employees are represented by a labor organization, and we are not a partyto any collective bargaining agreement. We have not experienced any workstoppages and consider our relations with our employees to be good.

 

Competition in the recruiting of personnel inthe networking and data security industry is intense. We believe that ourfuture success will depend in part on our continued ability to hire, motivateand retain qualified management, sales and marketing, and technical personnel.To date, we have not experienced significant difficulties in attracting orretaining qualified employees.

 

**Factors That MayAffect Future Results of Operations**

 

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

 

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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.***

 

Thenetwork security industry is characterized by frequent product introductions,rapidly changing technology and continued evolution of new industrystandards.  We must also introduceupgrades to our products rapidly in response to customer needs such as newcomputer viruses or other novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced 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 revenues remainedconstant from 2004 to 2005 at $6.0 million in connection with a shift to salesof our newer product lines. If our network intrusion detection, regulatedinformation compliance, and entity identification products do not achievemarket acceptance, our revenues will suffer.***

 

We havecontinued to transition our sales strategy from our lower margin SecureCom andPDS security appliance products to the development and sales of our highermargin network intrusion detection/prevention, regulated informationcompliance, entity identification and spyware products.  During this transition, sales of our newproducts were not enough to counteract the loss in sales associated with ourolder products.  As a result, our netrevenues remained relatively constant at approximately $6.0 million in 2004 and2005.

 

Our newnetwork security products, regulated information compliance systems, entityidentification and spyware products have only been in the market place for alimited period of time and may have longer sales cycles than our previousproducts.  Although response to ourproducts has been positive, we have not yet received broad marketacceptance.  We cannot assure you thatour present or future products will achieve market acceptance on a sustainedbasis.

 

In orderto achieve market acceptance and achieve future revenue growth, we mustintroduce complementary security products, incorporate new technologies intoour existing product lines and design, develop and successfully commercializehigher performance products in a timely manner. We cannot assure you that we will be able to offer new or complementaryproducts that gain market acceptance quickly enough to avoid decreased revenuesduring current or future product introductions or transitions.

 

***We resemble adevelopmental stage company and our business strategy may not be successful.***

 

From ourfounding in 1983 until 2000, we derived substantially all of our revenue fromthe design, manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, onApril 17, 2000, we announced our plans to sell our local area networkingassets and related networking divisions.

 

As aresult of these sales, we now depend exclusively on revenues generated from thesale of our network security products, which have received limited marketacceptance.  Moreover, we have onlyrecently introduced our regulated information compliance systems, entityidentification products and spyware products, and the market for these productshas only begun to emerge.  Consequently,we resemble a developmental stage company and will face the following inherentrisks and uncertainties:

 

•      the need for our network securityproducts, regulated information compliance systems, entity identificationproducts and spyware products to achieve market acceptance and produce asustainable revenue stream;

 

•      our ability to manage costs and expenses;

 

•      our dependence on key personnel;

 

•      our ability to obtain financing onacceptable terms; and

 

•      our ability to offer greater value thanour competitors.

 

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Ourbusiness strategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products, regulated informationcompliance systems, entity identification products and spyware products, ourbusiness, financial condition and operating results would be materiallyadversely affected.

 

***We had a net loss of $3.3million and an accumulated deficit of $52.1 million as of the year endingDecember 31, 2005.  As a result, wemust generate substantially greater revenues from sales in order to achieveprofitability.***

 

We haveincurred significant operating losses and are uncertain about our futureoperating results.  For the year endedDecember 31, 2005, we incurred a net loss of $3.3 million and had anaccumulated deficit of approximately $52.1 million at December 31,2005.  In addition, our revenues haveremained constant at approximately $6.0 million in 2004 and 2005.  We need to generate and sustain substantiallygreater revenues from the sales of our products if we are to achieveprofitability.  If we are unable toachieve these greater revenues, our losses will continue indefinitely, and wemay never achieve or sustain profitability or generate positive cash flow fromoperations.

 

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

 

Themarket for network security solutions is intensely competitive. There arenumerous companies competing with us in various segments of the data securitymarkets, and their products may have advantages over our products in areas suchas conformity to existing and emerging industry standards, interoperabilitywith networking and other security products, management and securitycapabilities, performance, price, ease of use, scalability, reliability,flexibility, product features and technical support.

 

Our principal competitors in the networkintrusion prevention and detection market include Internet SecuritySystems, Inc., Cisco Systems, Inc., Symantec, Inc., NetscreenTechnologies, Inc., Network Associates, Inc., Tipping Point Technologies, adivision of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu, Port Authority, Vericept, Reconnex, Tablus anda small number of start-up companies that entered the space within the last twoyears. Regarding the spyware prevention market, we currently directly andindirectly compete with a number of host-based spyware detection systems, suchas Ad-Aware, Spybot S&D and Spy Sweeper and some inline proxy solutionssuch as Blue Coat Systems, Inc.  Ourcurrent and potential competitors may have one or more of the followingsignificant advantages over us:

 

•      greater financial, technical andmarketing resources;

 

•      better name recognition;

 

•      more comprehensive security solutions;

 

•      better or more extensive cooperativerelationships; and

 

•      larger customer base.

 

Althoughwe believe that our focus on the network perimeter with market leadingtechnology and network visibility technology that reduce the total cost ofownership provides us with an advantage with large organizations with complexsecurity requirements, we cannot assure you that our products will achievemarket acceptance or that we will be able to compete successfully with ourexisting or new competitors.

 

***Military actions maydisrupt our business by reducing spending on our products, increasing our costsand affecting our international operations.***

 

UnitedStates military actions or other events occurring in response to or inconnection with them, including future terrorist attacks, actual conflictsinvolving the United States or its allies or military or trade disruptionscould impact our operations 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.

 

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

 

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

 

The saleand implementation of our products to large companies and government entitiestypically involves a lengthy education process and a significant technicalevaluation and commitment of capital and other resources.  This process is also subject to the risk ofdelays associated with customers’ internal budgeting and other procedures forapproving capital expenditures, deploying new technologies within theirnetworks and testing and accepting new technologies that affect keyoperations.  As a result, sales andimplementation cycles for our products can be lengthy, and we may expend significanttime and resources before we receive any revenues from a customer or potentialcustomer.  Our quarterly and annualoperating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

***Our cash, cashequivalents, and investments increased from $2.4 million at December 31,2004 to $3.3 million at December 31, 2005 due to two private placementsduring the year totaling $3.9 million in gross proceeds. However, excluding theprivate placement funds, our cash, cash equivalents and investments havegenerally decreased as a result of operations.  As a result of our expected continuing net cash outflows, we may nothave sufficient cash to operate our business and may not be able to maintainour Nasdaq listing.***

 

As of December 31, 2005, we had cash, cashequivalents and investments in the amount of approximately $3.3 million, upfrom approximately $2.4 million as of December 31, 2004.  Although we believe the additional$1.2 million in gross proceeds we received in connection with a privateplacement of preferred stock and warrants we completed on December 2, 2005along with our available line of credit we secured on March 29, 2006 willprovide us with sufficient cash resources to finance our operations for thenext twelve months, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  In addition, thepayment of accrued dividends on our outstanding preferred stock may reduce ouravailable cash resources.  Moreover,despite our actions to reduce costs and improve profitability, we expect ournet operating losses and net operating cash outflows to continue through atleast the first quarter of 2006.  As a result,our stockholders’ equity could fall below $2.5 million.  If this occurs, we would not be in compliancewith the Nasdaq listing requirements, and we could face delisting.  We do not currently have anyfurther arrangements for financing, and we may not be able to secure additionaldebt or equity financing on terms that are acceptable to us, or at all, at thetime when we need this financing.  If ourbusiness does not generate sufficient cash flow from operations and sufficientfinancing resources are not available, we may not be able to operate or growour business, pay our expenses when due or fund our other liquidity needs.  We may not have sufficient availability under ourcredit line when we need additional funds. Furthermore, we may not be able to secure additional debt or equityfinancing on terms that are acceptable to us, or at all, on a timelybasis.  Therefore, if our business doesnot generate sufficient cash flow from operations and sufficient financingresources are not available, we may not be able to operate or grow our business,pay our expenses when due, fund our other liquidity needs or maintain ourlisting on The Nasdaq Capital Market.

 

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

 

Since webegan restructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. The objective of ourrestructuring plan was to reduce our cost structure to a sustainable level thatis consistent with our current cash resources and the general economicclimate.  We have also implemented otherstrategic initiatives to strengthen our operations, such as reductions in ourwork force and facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty 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.

 

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

 

Several ofour competitors have acquired security companies with complementarytechnologies in the past.  We expectconsolidation in the network security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess 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.

 

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***Revenues from government entities accountedfor 70.7% of our revenues for the year ended December 31, 2005.  Government customers involve unique risks,which could adversely impact our revenues.***

 

Wederived 70.7% of our revenues from sales to various U.S. government entitiesfor the year ended December 31, 2005. We expect to continue to derive a substantial portion of our revenuesfrom U.S. government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns, delays in approving a federal budget andthe government’s right to cancel contracts and purchase orders for itsconvenience.  General political andeconomic conditions, which we cannot accurately predict, directly andindirectly may affect the quantity and allocation of expenditures by federaldepartments.  In addition, obtaininggovernment contracts may involve long purchase and payment cycles, competitivebidding, qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulations withwhich we must comply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

 

***We derived 10.7% of our revenues frominternational customers for the year ended December 31, 2005.  Our ability to sell our productsinternationally is subject to certain risks, which could harm our business.***

 

Revenuesfrom foreign customers accounted for approximately 10.7% of our revenues forthe year ended December 31, 2005. We expect sales to foreign customers to continue to represent asignificant portion of our revenues in the future.  Our international operations are subject tomany inherent risks that may adversely affect our business, financial conditionand operating results, including:

 

•      political, social and economicinstability;

 

•      trade restrictions;

 

•      increases in duty rates and otherpotentially adverse tax consequences;

 

•      exposure to different legal standards,particularly with respect to the protection of intellectual property;

 

•      burdens of complying with a variety offoreign laws;

 

•      unexpected changes in regulatoryrequirements;

 

•      import and export license requirementsand restrictions of the United States and each other country where we operate;

 

•      fluctuations in currency exchange rates;and

 

•      changes in local purchasing practices,including seasonal fluctuations in demand.

 

***Sales through indirectchannels accounted for 36.2% of our revenues for the year endedDecember 31, 2005.  Our revenueswill suffer if we do not expand our sales or receive the anticipated benefitsfrom our sales through indirect sales channels.***

 

Wederived 36.2% of our revenues for the year ended December 31, 2005 fromsales through indirect sales channels, such as distributors, value addedresellers, system integrators, original equipment manufacturers and managedservice providers.  We believe we mustexpand our sales through these indirect channels in order to increase ourrevenues.  Although we are activelypursuing a strategy to increase the percentage of our revenues generatedthrough these indirect sales channels, we cannot assure you that our productswill gain market acceptance in these indirect sales channels or that salesthrough these indirect sales channels will increase our revenues asexpected.  Further, many of our competitorsare also trying to sell their products through these indirect sales channels,which could result in lower prices and reduced profit margins for sales of ourproducts.

 

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

 

We relyon a combination of patent, copyright, trademark and trade secret laws,confidentiality procedures and non-disclosure agreements to protect ourproprietary technology.  However,unauthorized parties may attempt to copy or reverse-engineer aspects of ourproducts or to obtain and use information that we regard as proprietary.  Policing unauthorized use of our products isdifficult, and we cannot be certain that the steps we have taken will preventmisappropriation of our intellectual property. This is particularly true in foreign countries where the laws may notprotect proprietary rights to the same extent as the laws of the United Statesand may not provide us with an effective remedy against unauthorized use.  If our protection of our intellectualproperty proves to be inadequate or unenforceable, others may be able to useour proprietary developments without compensation to us, resulting in potentialcost advantages to our competitors.

 

***We may incur substantial expenses defendingourselves against claims of infringement.***

 

There arenumerous patents held by many companies relating to the design and manufactureof network security systems.  Although weare not aware of any instances in which our products violate the intellectualproperty rights of others or inappropriately use their technology, it ispossible that third parties in the future may claim that our products infringeon 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 results have varied significantly fromquarter to quarter in the past, and we expect our operating results to varyfrom quarter to quarter in the future due to a variety of factors, many ofwhich are outside of our control. Although our revenues are subject to fluctuation, significant portionsof our expenses are not variable in the short term, and we cannot reduce themquickly to respond to decreases in revenues. Therefore, if revenues are below our expectations, this shortfall islikely to adversely and 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 commonstock has been volatile in the past and may continue to be volatile in thefuture due to factors outside of our control.***

 

Themarket price of our common stock has been highly volatile in the past and maycontinue to be volatile in the future. For example, in fiscal year 2005, the market price of our common stockon The Nasdaq Capital Market fluctuated between $1.87 and $6.20 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside 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.

 

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***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 relyupon the continued service of a relatively small number of key technical, salesand senior management personnel.  Ourfuture success depends on retaining our key employees and our continuingability to attract, train and retain other highly qualified technical, salesand managerial personnel.  We do not haveemployment agreements with our key technical, sales and senior managementpersonnel.  As a result, our employeescould resign with little or no prior notice. We may not be able to attract, assimilate or retain other highlyqualified technical, sales and managerial personnel in the future.  The loss of any of our key technical, salesand senior management personnel or our inability to attract, train and retainadditional qualified personnel could seriously harm our business.

 

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

 

We cannot issue shares of capital stock with rights senior to those ofour existing 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 5% preferred stock.  Inaddition, holders of the Series 3 5% preferred stock who are not executiveofficers or directors have the right to purchase a pro rata portion of certainfuture issuances of securities by us. 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.

 

***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.***

 

On March 25, 2004, we completed a $5,000,000 private placement inconnection with which we issued 1,000,000 shares of our 5% ConvertiblePreferred Stock and warrants to acquire 556,619 shares of our commonstock.  The conversion price for thepreferred stock and the exercise price of the warrants is $3.144 pershare.  We also issued our placementagent a warrant for 64,408 shares of our common stock at an exercise price of$3.144 per share.  As of February 28,2006, there were 259,696 shares of 5% preferred stock, representingapproximately 413,003 shares of common stock upon conversion, and warrants topurchase 621,027 shares of common stock outstanding.

 

In addition, on March 28, 2005, we completed a $2,663,000 privateplacement in connection with which we issued 1,065,200 shares of our Series 25% Convertible Preferred Stock and warrants to acquire 532,600 shares of ourcommon stock.  We also issued twoaffiliates of our placement agent warrants to purchase an aggregate of 60,390shares of common stock.  The conversionprice for the preferred stock is $2.50 per share and the exercise price of thewarrants is $2.77 per share.  As ofFebruary 28, 2006, there were 460,000 shares of Series 2 5% preferred stock,representing 460,000 shares of common stock upon conversion, and warrants topurchase 592,990 shares of common stock outstanding.

 

Finally, on December 2, 2005, we completed a $1,230,843 privateplacement in connection with which we issued 564,607 shares of our Series 3 5%preferred stock and warrants to acquire 282,306 shares of our commonstock.  We also issued two affiliates ofour placement agent warrants to purchase an aggregate of 27,531 shares ofcommon stock.  The conversion price ofthe preferred stock is $2.18 per share and the exercise price of the warrantsis $2.58 per share.  As of February 28,2006, there were 468,735 shares of Series 3 5% preferred stock, representing468,735 shares of common stock upon conversion, and warrants to purchase309,837 shares of common stock outstanding.

 

On February 28, 2006, we had 7,046,213 shares of common stockoutstanding.  We expect the privateplacements to result in a further dilution to holders of our common stock uponconversion of the preferred stock and exercise of the warrants of 2,865,592shares of common stock, or an approximately 40.7% increase in the number ofshares of our common stock outstanding.

 

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Further, the occurrence of certain events entitle holders of our Series3 5% preferred stock to require us to redeem their shares for a number ofshares of our common stock equal to the redemption price divided by 75% of theten-day average of the volume weighted average price of our common stock endingon the day immediately preceding the holder’s election to redeem, subject to afloor of $0.87 per share.  Holders of ourSeries 2 5% preferred stock have similar redemption rights without afloor.  The redemption price for theshares of Series 3 5% preferred stock equals the sum of (1) the greater of$2.834 and the volume weighted average price of our common stock on the tradingday immediately preceding the redemption event multiplied by $2.18 divided bythe conversion price of the Series 3 5% preferred stock then in effect plus (2)any accrued but unpaid dividends on the Series 3 5% preferred stock plus(3) any unpaid liquidated damages or other amounts payable to the holdersof the Series 3 5% preferred stock.  Theredemption price for the shares of Series 2 5% preferred stock equals the sumof (1) the greater of $3.25 and the volume weighted average price of our commonstock on the trading day immediately preceding the redemption event multipliedby $2.50 divided by the conversion price of the Series 2 5% preferred stockthen in effect plus (2) any accrued but unpaid dividends on the Series 2 5%preferred stock plus (3) any unpaid liquidated damages or other amountspayable to the holders of the Series 2 5% preferred stock.  As a result, assuming we have paid allliquidated damages and other amounts to the holders, accrued but unpaiddividends on February 28, 2006 of $29,760, a volume weighted average price of$1.97, which was the ten-day volume weighted average closing price of ourcommon stock on February 28, 2006, and our 7,046,213shares of common stock outstanding on February 28,2006, we would issue approximately 1,931,069 shares of our common stock if aspecified redemption event occurs and all holders of Series 3 5% preferredstock and Series 2 5% preferred stock elected to redeem their shares for commonstock.  This would represent an increaseof approximately 27.4% in the number of shares of our common stock as ofFebruary 28, 2006.

 

***The payment of accrued dividends on our preferred stock maystrain our cash resources.***

 

Shares of our 5% preferred stock accrue cash dividends equal to $0.25per share per annum, payable in arrears on March 31 and September 30 of eachyear, shares of our Series 2 5% preferred stock accrue cash dividends equal to$0.125 per share per annum, payable in arrears on the first business day ofMarch, June, September and December of each year and shares of our Series 3 5%preferred stock accrue cash dividends equal to $0.109 per share per annum,payable in arrears on the first business day of March, June, September andDecember of each year.  The amount of thedividends on our Series 2 5% preferred stock may increase to $0.45 per shareper annum and the amount of the dividends on our Series 3 5% preferred stockmay increase to $0.3294 per share per annum upon the occurrence of certainevent entitling the holders of these shares to redemption.

During 2005, wepaid $123 thousand in dividends related to our 5% convertible preferred stockand $63 thousand in dividends related to our Series 2 5% preferred stock.  At December 31, 2005, we have dividendsaccrued of $17,516 related to our 5% preferred stock, $21,260 related to ourSeries 2 5% preferred stock and $5,058 related to our Series 3 5%preferred stock.

 

Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years ended as of December 31, 2005. 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.  Moreover,the payment of these dividends could strain our available cash resources, whichcould adversely affect our ability to operate or grow our business.  In addition, our inability to pay dividendscould require us to redeem outstanding shares of Series 2 5% preferred stockand Series 3 5% preferred stock for shares of our common stock issued at aprice equal to 75% of the average of the volume weighted average price of ourcommon stock for the ten days ending on the day immediately preceding anelection to redeem, subject, in the case of the Series 3 5% preferred stock, toa floor of $0.87.  As a result, theissuance, or potential issuance, of these additional shares of common stockcould cause our stock price to decline. Furthermore, our inability to pay dividends could adversely affect ourability to raise equity financing in the future if required.

 

***The conversion ofpreferred stock or exercise of warrants we issued in the private placements maycause the price of our common stock to decline.***

 

Theholders of the shares of our 5% preferred stock and warrants we issued onMarch 25, 2004, may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto an effective registration statement we filed on August 6, 2004.  As of February 28, 2006, 740,304 shares ofpreferred stock had converted into 1,177,327 shares of common stock.

 

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The holdersof the shares of Series 2 5% preferred stock and warrants we issued onMarch 28, 2005, may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto an effective registration statement we filed on May 5, 2005.  As of February 28, 2006, 605,200 shares ofSeries 2 5% preferred stock had converted into 605,200 shares of common stock.

 

Theholders of the shares of Series 3 5% preferred stock and warrants we issued onDecember 2, 2005, may freely convert their shares of preferred stock andexercise their warrants and sell the underlying shares of common stock pursuantto an effective registration statement we filed on January 5, 2006.  As of February 28, 2006, 95,872 shares ofSeries 3 5% preferred stock had converted into 95,872 shares of common stock.

 

For thefour weeks ended on March 17, 2006, the average daily trading volume of ourcommon stock on The Nasdaq Capital Market was 24,216 shares.  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.

 

***The percentage of our revenues attributableto sales of our PDS products integrated with software of Check Point SoftwareTechnologies decreased from 9.7% in 2004 to 5.3% in 2005.  Because sales of our newer products may notoffset the reduced sales of our PDS products, a change in our relationship withCheck Point could have a negative effect on our operating results.***

 

Our PDSfamily of security appliances, which are integrated with Check Point SoftwareTechnologies’ market-leading VPN-1®/FireWall-1® software, represented 5.3% ofour revenues for the year ended December 31, 2005.  These percentages are down from 9.7% of ourrevenues for the year ended December 31, 2004.  We expect the percentage of our salesattributable to our PDS products to decline in the future; however, ourreliance on newer product sales may not replace the anticipated decline inrevenue from sales of our PDS products. Although we are a certified appliance partner of Check Point and our PDSproducts have received Check Point certification, we have no long-term agreementor exclusive relationship with Check Point. As a result, the loss or significant change in our relationship withCheck Point, the failure of our PDS products to maintain or receive Check Pointcertification, the business failure of Check Point or its acquisition by or oneof our competitors and the loss of market share of Check Point or marketacceptance of its products could each have a material adverse effect on ourbusiness, financial condition and results of operations.

 

***Our acquisition ofcomplementary products or businesses may adversely affect our financialcondition.***

 

We have made acquisitions in the past and, in thefuture we may acquire or invest in additional companies, business units,product lines or technologies to accelerate the development of products andsales channels complementary to our existing products and sales channels.  Negotiation of potential acquisitions andintegration of acquired products, technologies or businesses could divert ourmanagement’s time and resources.  Futureacquisitions could cause us to issue equity securities that would dilute yourownership of us, incur debt or contingent liabilities, amortize intangibleassets or write off in-process research and development, goodwill and otheracquisition-related expenses that could seriously harm our financial conditionand operating results.  Further, if weare not able to properly integrate acquired products, technologies orbusinesses with our existing products and operations, train, retain andmotivate personnel from the acquired business or combine potentially differentcorporate cultures, we may not receive the intended benefits of ouracquisitions, which could adversely affect our business, operating results andfinancial condition.

 

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

 

Certainof our data security products incorporate encryption and other technology thatmay require clearance and export licenses from the U.S. Department of Commerceunder United States export regulations. Any inability to obtain these clearances or licenses or any foreignregulatory approvals, if required, on a timely basis could delay sales and havea material adverse effect on our operating results.

 

18

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***Provisions of our charterdocuments and Delaware law may have anti-takeover effects.***

 

Certainprovisions of our certificate of incorporation and bylaws, such as our abilityto offer “blank check” preferred stock and the inability of our stockholders toact by written consent, could make it more difficult for a third party toacquire us, even if doing so would be beneficial to our stockholders.  We are also subject to the provisions ofSection 203 of the Delaware General Corporation Law, which restricts certainbusiness combinations with interested stockholders and could inhibit anon-negotiated merger or other business combination.

 

***Our management and larger stockholdersexercise significant control over our company and may approve or take actionsthat may be adverse to your interests.***

 

As ofMarch 17, 2006, our executive officers, directors and preferredstockholders beneficially own approximately 23.5% of our voting power.  As a result, these stockholders will be ableto exercise significant control over all matters requiring stockholderapproval, including the election of directors and approval of significantcorporate transactions, which could delay or prevent someone from acquiring ormerging with us.  These stockholders mayuse their influence to approve or take actions that may be adverse to yourinterests.

** **

**Item 2.**          Description of Property.

** **

Our headquarters are located in a two-storybuilding in Richardson, Texas.  We occupyapproximately 30,000 square feet of floor space in this facility. This facilityincludes our corporate administration, operations, marketing, research anddevelopment, sales and technical support personnel.  The lease for this 30,000 square feet in thisfacility extends through February 2010.

 

Approximatelyone-half of our security software research and development staff is located ina 6,464 square foot leased property in San Diego, California.  This lease was renewed in August 2004and will expire in August 2006. Research and development personnel occupy this facility.

 

We believe that the existing facilities atDecember 31, 2005 will be adequate to meet our requirements through2006.  See Note 4 of Notes toConsolidated Financial Statements for additional information regarding ourobligations under leases.

 

**Item 3.**          Legal Proceedings.

** **

We are subject to legal proceedings andclaims that arise in the ordinary course of business.  We do not believe that any claims exist wherethe outcome of such matters would have a material adverse affect on ourconsolidated financial position, operating results or cash flows.  However, there can be no assurance such legalproceedings will not have a material impact on future results.

 

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

** **

There were no matters submitted to a vote ofour security holders during the fourth quarter of 2005.

 

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**PART II**

## ** **

**Item 5.**          Market for Common Equity and Related Stockholder Matters.

** **

On March 18, 2004, at a special meeting,our stockholders approved an amendment to our certificate of incorporation toeffect a four-for-one (4:1) reverse stock split of our common stock.  The reverse stock split became effective onMarch 29, 2004.  All outstandingshare numbers and related common stock numbers, such as earnings per share andoutstanding options, included in this report are set forth on a post-splitbasis.

 

Our common stock trades on The Nasdaq CapitalMarket, where it is currently listed under the symbol “INTZ.”  As of February 28, 2006, there wereapproximately 113 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 NasdaqStock Market.  Market values throughFirst Quarter 2004 have been retroactively adjusted to give effect to theone-for-four reverse stock split effective March 29, 2004.

 
| ** **      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-----------------|------------|----------|------------|----------|------------|
| ** **      | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|            |       |     |       |     |       |   |   |   |   |
| First  Quarter  |       | $        | 6.20       |     | $          | 2.10 |   | $ | 4.40 |   | $ | 1.60 |   |
| Second  Quarter |       | 4.15     |       | 1.92     |       | 3.88 |   | 1.44 |   |
| Third  Quarter  |       | 3.59     |       | 2.61     |       | 2.00 |   | 0.86 |   |
| Fourth  Quarter |       | 3.29     |       | 1.87     |       | 3.75 |   | 1.30 |   |
|                 |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

We havenot declared or paid cash dividends on our common stock in our two most recentfiscal years.  We intend to retain anyearnings for use in our business and do not anticipate paying any cashdividends on our common stock in the foreseeable future.  Future dividends on common stock, if any,will be determined by our Board of Directors. However, shares of our 5% convertible preferred stock accrue cashdividends equal to $0.25 per share per annum, payable in arrears onMarch 31 and September 30 of each year, and shares of our Series 2and Series 3 5% convertible preferred stock accrue cash dividends equal to$0.125 per share per annum payable in arrears on the first business day ofMarch, June, September and December of each year.  We paid $186 thousand in dividends related toall of our 5% convertible preferred stock during 2005 and at December 31,2005, we have dividends accrued related to all of our 5% convertible preferredstock of $44 thousand.

 

Delawarelaw provides that we may only pay dividends out of our capital surplus or, ifno surplus is available, out of our net profits for the fiscal year thedividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years, and as of December 31, 2005. 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 commonstock is reserved for issuance have previously been approved by ourshareholders. The following table provides summary information as ofDecember 31, 2005 for all of our stock option plans (in thousands, exceptper share data). See Note 7 to our consolidated financial statements foradditional 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     |       | 891                                                                                        | (1)        | $                                                                                           | 5.48       |                                                                         | 460        | (2) |
| Equity compensation plans not approved by  security holders |       | —                                                                                     |       | —                                                                                      |       | —                                                                       |       |
| Total                                                       |       | 891                                                                                        |       | $                                                                                           | 5.48       |                                                                         | 460        |   |

 

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(1)   Includedin the outstanding options are 290,000 from the 2005 Plan, 567,343 from the1995 Plan, 850 from the 1987 Plan and 32,500 from the 1995 Non-EmployeeDirector Plan.

 

(2)   Doesnot include Employee Stock Purchase Plan. At December 31, 2005, 79,298shares were available for future issuance under this plan.

 

**Item 6.****          Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

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

 

This Annual Report, other than historicalinformation, may include forward-looking statements, including statements withrespect to financial results, product introductions, market demand, sales channels,industry trends, sufficiency of cash resources and certain other matters. Thesestatements are made under the “safe harbor” provisions of the PrivateSecurities Litigation Reform Act of 1995 and involve risks and uncertaintieswhich could cause actual results to differ materially from those in theforward-looking statements, including those discussed in thesection entitled “Factors That May Affect Future Results of Operations” inItem 1 and elsewhere in this Annual Report on Form 10-KSB and other filingswith the Securities and Exchange Commission.

 

**Overview**

 

We develop, market and support a family ofnetwork intrusion prevention, intrusion detection, regulated informationcompliance, 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 for governmentand enterprise networks.

 

We market and distribute our products througha direct sales force to end-users, distributors and numerous domestic andinternational system integrators, managed service providers and value-addedresellers. Our end-user customers include high technology, e-commerce,manufacturing, government entities, military, financial institutions,telecommunications, retail, transportation, healthcare, insurance,entertainment, utilities, energy companies, and academic institutions.  Essentially, our end-user can be defined as ‘anyend-user requiring network security solutions for protecting their missioncritical data’.

 

We wereorganized in 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 Nasdaq tickersymbol from ODSI to INTZ to reflect our focus on intrusion prevention anddetection solutions, along with information compliance and data privacyprotection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

Our principal executive offices are locatedat 1101 East Arapaho Road, Richardson, Texas 75081, and our telephone number is(972) 234-6400.  Our website URL iswww.intrusion.com.  References to “we”, “us”,“our” or “Intrusion Inc.” refer to Intrusion Inc. and itssubsidiaries.  ComplianceCommanderTM, SecureNetTM, TraceCopTM and SpySnareTM are registered trademarks ofIntrusion Inc.

 

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Our revenues have decreased over the past fewyears due primarily to the change in our product focus from networking hardwareto network security software products and a decrease in sales volume related tothis transition.  However, our revenuesremained constant from 2004 to 2005 at $6.0 million.  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 anddiscontinued manufacturing operations. Our global headcount has declined over the past few years in an effortto reduce costs and align our efforts with our core software-basedproducts.  As we continued our migrationaway from the hardware-based products, our global headcount remained relativelyconstant from 2004 to 2005.  At December31, 2004 we employed 41 employees and at December 31, 2005 we employed 43employees.  As a result of our migrationto software-based solutions and the discontinuance of manufacturing operations,our margins have increased over the past two years from 51.0% in 2004, to 58.0%in 2005.  We have also restructured ourpersonnel and operations around the development and sale of our core softwareproducts.  As a result of these efforts,we believe we have reduced operating expenses to a level that will remainconsistent going forward.

 

The reductions to our operating expenses, inparticular research and development expenses, over the past two years have notsignificantly impacted our research and development efforts, as we continue toexpand our product offerings.  We are notallocating resources to hardware development, as in the past, and we are ableto focus on new product offerings related to our software-based products.  We expect our product offerings to continueto expand as we continue to offer new and expanded products for the intrusiondetection, intrusion prevention and regulated information compliance markets.

 

In order for us to operate and grow ourbusiness, we must achieve and sustain operating profits and become cash flowpositive.  This will require us tocounteract reduced sales of our hardware products by generating additionalrevenues from sales of our intrusion detection, intrusion prevention andregulated information compliance software products.  In order to obtain these sales, our productsmust gain acceptance in intensely competitive and emerging markets.  We believe our ability to introduce ourregulated information compliance and entity identification products into themarketplace in a timely manner and our efforts to maintain our reduced spendinglevels will help us achieve these results.

 

**Critical Accounting Policies and Estimates**

 

Management’s discussion and analysis offinancial condition and results of operations are based upon our consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of thesefinancial statements requires us to make estimates and judgments that affectthe reported amounts of assets, liabilities, revenues and expenses, and relateddisclosure of contingent assets and liabilities. On an on-going basis, weevaluate our estimates, including those related to product returns, bad debts,inventories, income taxes, warranty obligations, maintenance contracts andcontingencies. We base our estimates on historical experience and on variousother assumptions that are believed to be reasonable under the circumstances,the results of which form the basis for making judgments about the carryingvalues of assets and liabilities that are not readily apparent from othersources. Actual results may differ from these estimates under differentassumptions or conditions.

 

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 uponshipment of product. We accrue for estimated warranty costs and sales returnsat the time of shipment based on our experience. Revenue from maintenancecontracts is deferred and recognized over the contractual period the servicesare performed, generally one year.  Thereis a risk that technical issues on new products could result in unexpectedwarranty costs and returns.  However, aswe migrate to more of a software-based business model, the warranty costsshould continue to decline.  To the extentthat they do decline, 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.

 

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We recognize software revenue from thelicensing of our 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 andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would 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 the contractperiod, 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 are includedin our obsolescence and slow-moving analysis and are written down according totheir estimated current value.  Thistransaction effectively recognizes expense for the write-down, if any, andincreases the net liability in the deferred revenue account.

 

We generally recognize service revenue upondelivery of the contracted service. Service revenue, primarily including maintenance, training andinstallation, are recognized upon delivery of the service and typically areunrelated to product sales.  Theseservices are not essential to the functionality of the delivered product.  To date, training and installation revenuehas not been material.

 

*Allowance for Doubtful Accounts and Returns*

 

We maintain allowances for doubtful accountsfor estimated losses resulting from the inability of our customers to makerequired payments. Our receivables are uncollaterized and we expect to continuethis policy in the future.  If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.  Historically, our estimatesfor sales returns and doubtful accounts have not differed materially fromactual results.

 

*Inventory*

 

We write down our inventory for estimatedobsolescence or unmarketable inventory equal to the difference between the costof inventory and the estimated market value based upon assumptions about futuredemand and market conditions. If actual market conditions are less favorablethan those projected by management, additional inventory write-downs may berequired.   Historically, our estimatesfor inventory obsolescence have not differed materially from actual results.

 

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**Results of Operations**

 

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

 
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **2005**                         | ** ** | **2004** | ** ** |
|                                              |       |                             |       |   |   |
| Net product  revenue                              |       | 73.2                             | %          | 72.5 | % |
| Net customer  support and maintenance revenue     |       | 26.8                             |       | 27.5 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0 |   |
| Cost of  product revenue                          |       | 39.4                             |       | 46.3 |   |
| Cost of  customer support and maintenance revenue |       | 2.6                              |       | 2.7 |   |
| Total cost  of revenue                            |       | 42.0                             |       | 49.0 |   |
| Gross profit                                      |       | 58.0                             |       | 51.0 |   |
| Operating  expenses:                              |       |                             |       |   |   |
| Sales and marketing                               |       | 52.5                             |       | 61.3 |   |
| Research and development                          |       | 42.7                             |       | 42.4 |   |
| General and administrative                        |       | 18.8                             |       | 19.0 |   |
| Severance costs                                   |       | 1.0                              |       | 4.5 |   |
| Operating  loss                                   |       | (57.0                            | )          | (76.2 | ) |
| Interest  income, net                             |       | 1.4                              |       | 0.7 |   |
| Other  income, net                                |       | 0.0                              |       | 0.3 |   |
| Loss from  operations before income taxes         |       | (55.6                            | )          | (75.2 | ) |
| Income tax  provision                             |       | —                           |       | — |   |
| Net loss                                          |       | (55.6                            | )          | (75.2 | ) |
| Preferred  stock dividends accrued                |       | (2.9                             | )          | (3.2 | ) |
| Beneficial  conversion feature on preferred stock |       | (24.0                            | )          | (15.6 | ) |
| Net loss  attributable to common stockholders     |       | (82.5                            | )%         | (94.0 | )% |

 
| ** **          | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------|------------|----------|------------|----------|------------|
|                |       |     |       |     |       |
| Domestic  revenue   |       | 89.3     | %          | 80.8     | %          |
| Export  revenue to: |       |     |       |     |       |
| Europe              |       | 7.8      |       | 11.2     |       |
| Canada              |       | 0.5      |       | 4.5      |       |
| Asia                |       | 2.3      |       | 3.2      |       |
| Latin America       |       | 0.1      |       | 0.3      |       |
| Net revenue         |       | 100.0    | %          | 100.0    | %          |

 

**2005 compared with 2004**

 

***Net Revenue***

 

Total revenue remained constant at$6.0 million form 2004 to 2005.  Thelack of revenue growth is related to the transition away from ourhardware-based products, which carried higher sales prices and lower margins toour software-based products, which carry lower sales prices and highermargins.  Our customer support andmaintenance revenue decreased 3.1% from $1.7 million in 2004 to $1.6 million in2005.  This decline is mainly due to theexpiration of maintenance contracts related to our legacy products and lowersupport and maintenance revenues associated with our lower pricedsoftware-based products.  In 2005, totalrevenues related to our SecureNet product line increased 4.8% or $0.3 millionfrom $5.4 million in 2004 to $5.7 million in 2005, and our non-core productlines, including our PDS and SecureCom hardware products decreased 94.3% or$0.3 million from $0.6 million in 2004 to $0.3 million in 2005.  Our product revenues remained constant at$4.4 million in 2005.  We expect ourproduct revenues to increase in the future.

 

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Export sales in 2005 decreased to$0.6 million, or 10.7% of net revenue, compared to $1.2 million, or19.2% of net revenue in 2004 primarily due to a continued economic decline, ourfocus on domestic revenues and a decrease in international technologyspending.  As part of our headcountreductions, we have focused most of our sales personnel on the domesticmarket.  Although we do expect tocontinue to derive a significant portion of our revenues from internationalsales, we do not rely on any one country, region or customer for thesesales.  Sales of our productsinternationally may be subject to exchange risk, which may cause our productsto effectively increase in price, if the exchange rate moves significantly andthe dollar gains value over the foreign currency.

 

Historically,due to the timing of our sales cycle, a significant portion of our monthlysales occurs in the second half of the month. Accordingly, our receivables increase at the end of each month, whichcauses a higher accounts receivable balance at month end. This monthly trendalso causes an inflated comparative relationship between revenue and accountsreceivable. We believe that this monthly trend will continue because monthlysales forecast and planning meetings are held in the first week of every month,the middle of the month is focused on sales calls to customers and the laterhalf of the month on closing sales.

 

***Gross Profit***

 

Gross profit increased 12.8% to$3.5 million in 2005 from $3.1 million in 2004. As a percentage ofnet revenue, gross profit increased to 58.0% for 2005 from 51.0% in 2004. Thisincrease is primarily associated with a more profitable product mix in2005.  Gross profit on products increasedfrom 36.1% in 2004 to 46.1% in 2005 due to the shift in a more profitableproduct mix, namely our software-based products.  Gross profit on customer support andmaintenance increased from 90.1% in 2004 to 90.2% in 2005.  The increase in gross profit on customer supportand maintenance was only slight and should continue at this level as ourhardware-related repair costs in conjunction with our strategic decision tomove towards software-based solutions should remain low.  As we continue to migrate from our older hardware-basedproducts to our newer software-based products, we expect our product margins tocontinue to increase.

 

Gross profit as a percentage of net revenueis impacted 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 15.0%to $3.1 million in 2005 from $3.7 million in 2004 as we focused oursales force domestically, including headcount reductions, to respond to thedecline in sales. As a percentage of net revenue, sales and marketing expensesdecreased to 52.5% in 2005 from 61.3% in 2004. We expect sales and marketingexpenses to remain relatively constant in 2006 compared to 2005 as we believewe have recognized the full benefit from restructuring actions taken inprevious years.  We also expect sales andmarketing expenses, as a percentage of net revenue, to decrease in 2006compared to 2005 as we expect an increase in revenue in 2006.

 

***Research and Development***

 

Research and development expenses increasedslightly to $2.6 million, or 42.7% of net revenue, in 2005 compared to$2.5 million, or 42.4% of net revenue, in 2004.  Our research and development costs areexpensed in the period in which they are incurred. We expect research anddevelopment expenses to remain relatively constant in 2006 compared to2005.  We expect research and development,as a percentage of net revenue, also to decrease in 2006 compared to 2005 asour revenue increases.

 

***General and Administrative***

 

General and administrative expenses remainedconstant at $1.1 million from 2004 to 2005.  As a percentage of net revenue, general andadministrative expenses decreased slightly to 18.8% in 2005 from 19.0% in2004.  We expect general andadministration expenses to remain relatively constant in 2006 compared to 2005.

 

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***Severance Costs***

 

In connection with our strategic alignment ofour sales force domestically and our continued shift to our new intrusiondetection and security appliance product lines during 2004, we streamlinedoperations and activities that are not aligned with these core markets andstrategies. During 2005 we recorded severance charges of $55 thousand, comparedto $0.3 million in 2004.  Allseverance obligations related to the 2005 expense were paid prior to December31, 2005.  All severance obligationsrelated to the 2004 expense were paid prior to December 31, 2004.  We were not receiving any benefits from thosesevered individuals subsequent to the year of the applicable expense.

 

***Interest Income, Net***

 

Net interest income increased 100.0% to $84thousand in 2005 from $42 thousand in 2004 primarily due to an increase inaverage cash and interest-bearing investment balances. We expect net interestincome to remain consistent in 2006 compared to 2005.  However, we do expect interest rates toremain low, which could result in a lower return on investment. Net interestincome will vary in the future based on our cash flow and rate of return oninvestments.

 

***Income Taxes***

 

Our effective income tax rate was 0% in 2005and 2004 as valuation allowances have been recorded for the entire amount ofthe net deferred 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, 2005 were $2.8 million of cash and cash equivalents and$0.5 million of short-term investments. As of December 31, 2005, wedo not hold investments with a stated maturity beyond one year. Working capitalat December 31, 2005 was $2.7 million compared to $2.5 million as ofDecember 31, 2004.

 

Net cash used in operations in 2005 was$2.3 million, primarily due to an operating loss of $3.3 million for theyear, a decrease in accounts payable and accrued expenses of $0.5 million, adecrease in deferred revenue of $0.3 million, and a change in the provision fordoubtful accounts of $0.4 million, offset by depreciation and amortization of$0.2 million, a decrease in accounts receivable of $1.2 million, inventories of$0.6 million and other assets of $0.2 million. Future fluctuations in accounts receivable, inventory balances andaccounts payable will be dependent upon several factors, including quarterlysales, timely collection of accounts receivable, and the accuracy of ourforecasts of product demand and component requirements.

 

Net cash used in investing activities in 2005was $0.6 million, which consisted primarily of the net purchases of$0.4 million of available for sale securities and the purchase of propertyand equipment of $0.2 million.

 

Net cash provided by financing activities in 2005was $3.4 million, consisting of net financing proceeds from private placementsof $3.6 million and dividends paid on preferred stock of $0.2 million.

 

At December 31, 2005, we did not haveany material commitments for capital expenditures. Operating lease commitmentsof $1.7 million are detailed below. During 2005, 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 25% and our Series 3 5% convertible preferred stock.

 

As of December 31, 2005, we had cash, cash equivalents andinvestments in the amount of approximately $3.3 million, up fromapproximately $2.4 million as of December 31, 2004.  However, throughout 2005, we continued toreduce expenses and realize the benefit of cost-cutting actions taken inprevious years.

 

On March 28, 2005, we closed a $2.66 million private placement ofSeries 2 5% Convertible Preferred Stock and warrants, the proceeds of which weintend to use for general corporate and working capital purposes.  On December 2, 2005, we closed a $1.23million private placement of Series 3 5% Convertible Preferred Stock andwarrants, the proceeds of which we intend to use for general corporate andworking capital purposes.

 

26

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On March 29, 2006, we established a $1,000,000 line of credit withSilicon Valley Bank.  Under the terms ofthis agreement, we may borrow an amount equal up to 80% of eligible accountsreceivable balances.  In addition, we mayobtain inventory advances equal to 35% of finished good inventory, capped atthe lesser of the inventory availability, $300,000 or 35% of our totalborrowing base.  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.  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, 2007.  Our ability to receiveadvances under this credit line will increase as we generate additionalreceivables and inventory from the sale of our products.  We have not currently borrowed any fundsunder this credit line.  However,assuming eligible receivables and inventory equal to the $443,000 of netaccounts receivable and the $290,000 of finished goods inventory we had atDecember 31, 2005, we could borrow up to $455,900 under our credit line.

 

Based on projections for increased revenues in 2006, we believe thatour available credit line and available cash resources will provide sufficientcash resources to finance our operations and expected capital expenditures forthe next twelve months.  The sufficiencyof our cash resources may depend to a certain extent on general economic,financial, competitive or other factors beyond our control.  In addition, the payment of accrued dividendson our outstanding preferred stock and accrued interest on any funds advancedto us under our credit line may reduce our available cash resources.  We do not currently have any further arrangementsfor financing, and we may not have sufficient available funds under our creditline and may not be able to secure additional debt or equity financing on termsthat are acceptable to us, or at all, at the time when we need such funding. Ifour business does not generate sufficient cash flow from operations andsufficient financings are not available, we may not be able to operate or growour business, pay our expenses when due, fund our other liquidity needsor remain in compliance with Nasdaq’s continued listing requirement of at least$2.5 million of stockholders’ equity.

 

We intend to explore the possibleacquisitions of businesses, products and technologies that are complementary toour existing business. We are continuing to identify and prioritize additionalsecurity technologies, which we may wish to develop, either internally orthrough the licensing or acquisition of products from third parties. While weengage from time to time in discussions with respect to potential acquisitions,there can be no assurances that any such acquisitions will be made or that wewill be able to successfully integrate any acquired business. In order tofinance such acquisitions, it may be necessary for us to raise additional fundsthrough public or private financings. Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders.

 

### **Contractual Obligations**

### ** **

The following table sets forth certain information concerning thefuture contractual obligations under our operating leases at December 31,2005.  We have no other significantcontractual obligations at December 31, 2005.

 

**Future minimum lease payments consisted ofthe following on December 31, 2005 (in thousands):**

 
| 2006   |   | $   | 431    |   |
|--------|--------|-----|--------|--------|
| 2007   |   | 378 |   |
| 2008   |   | 393 |   |
| 2009   |   | 409 |   |
| 2010   |   | 68  |   |
|   |   | $   | 1,679  |   |

 

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

### ** **

As of December 31, 2005, we did not have any significantoff-balance sheet arrangements, as defined in Item 303(c)(2) of Regulation S-B.

 

27

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**Quantitative and Qualitative DisclosuresAbout Market Risk.**

 

Foreign Exchange.  Our revenueoriginating outside the U.S. in 2005 and 2004 was 10.7% and 19.2% of totalrevenues, respectively.  Revenuesgenerated from the European region in 2005 and 2004 were 7.8% and 11.2% oftotal revenues, respectively.  Revenuesgenerated from the Asia region in 2005 and 2004 were 2.3% and 3.2% of totalrevenues, respectively.  Internationalsales are generated primarily from our foreign sales subsidiaries in the localcountries and are typically denominated in U.S. dollars.  These subsidiaries incur substantially all oftheir expenses in the local currency.

 

Our international business is subject to risks typical of aninternational business, including differing economic conditions, changes inpolitical climate, differing tax structures, import and export regulations,other regulations 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.

 

Interest Rates.  We invest ourcash in a variety of investment grade financial instruments, including banktime deposits, fixed rate obligations of corporations, municipalities, andstate and national governmental entities and agencies.  These investments are denominated in U.S.dollars.  Cash balances in foreigncurrencies overseas are operating balances and are invested in short-term timedeposits of the local operating bank.

 

Interest income on our investments is carried in “Interest income, net”.We account for our investment instruments in accordance with Statement ofFinancial Accounting Standards No. 115, “Accounting for CertainInvestments in Debt and Equity Securities”. All of the cash equivalents and short-term investments are treated asavailable-for-sale under SFAS 115.

 

Investments in fixed-rate interest-earning instruments carry a degreeof interest rate risk.  Fixed-ratesecurities may have their fair market values adversely impacted due to a risein interest rates.  Due in part to thesefactors, our future investment income may fall short of expectations due tochanges in interest rates or we may suffer losses in principal if forced tosell securities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  The weighted-average interest rate oninvestment securities at December 31, 2005 was 5.3%. The fair value ofinvestments held at December 31, 2005 approximated amortized cost.

 

**Item7.****          FinancialStatements.**

 

The information required by this item is included in Part III Item13.

 

**Item8.****          ChangesIn and Disagreements with Accountants on Accounting and Financial Disclosure.**

 

None.

### ** **

### **Item8A.**      Controls and Procedures

### ** **

We have carried out an evaluation, under the supervision and theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of December 31, 2005 pursuant to Rule 13a-15(b) under theExchange Act.  Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in ensuring thatinformation required to be disclosed is recorded, processed, summarized andreported in a timely manner.

 

We have carried out an evaluation, under the supervision andparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of any changes in our internal controls over financialreporting that occurred during the quarterly period ended December 31,2005, and our Chief Executive Officer and Chief Financial Officer haveconcluded that there was no change during the quarterly period endedDecember 31, 2005 that has a materially affected or is reasonably expectedto materially affect our internal control over financial reporting.

 

**Item8B.****       OtherInformation**

 

Not applicable.

 

28

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**PARTIII**

 

Certain information required by Part III is omitted from thisForm 10-KSB because we will file a definitive Proxy Statement for our2005 annual meeting of stockholders pursuant to Regulation 14A (the “ProxyStatement”) no later than 120 days after the end of the fiscal yearcovered by this Form 10-KSB, and certain information to be includedtherein is incorporated herein by reference.

 

**Item9.****          Directorsand Executive Officers of Intrusion Inc.**

 

The information required regarding Directors and Executive Officers ofIntrusion Inc. appearing under the captions “Election of Directors”, “Compliancewith Section 16 Reporting Requirements” and “Executive Officers” containedin the Proxy Statement is incorporated herein by reference.

 

**Item10.****        ExecutiveCompensation.**

 

The information set forth under the caption “Executive Compensation”contained in the Proxy Statement is incorporated herein by reference.

 

*Compensation Committee Interlocks and Insider Participation*

 

The members of the Compensation Committee of our Board of Directors forthe entire 2005 fiscal year were J. Fred Bucy, Jr. (Chairman), Donald M.Johnston, and James F. Gero, each of whom is an independent director.

 

No member of our Board of Directors or any committees of the Board,including the Compensation Committee, has an interlocking relationship with theboard (or member of such board) or any committee (or member of such committee)of a board of any other company.

 

*March 25, 2004 Private Placement*

 

On March 25, 2004, we completed a $5,000,000 private placement of1,000,000 shares of our 5% convertible preferred stock and warrants to purchase556,619 shares of our common stock at an initial exercise price of $3.144 pershare to various purchasers.  Mr. Gero, adirector and one of the members of the Compensation Committee, invested$300,000 in the private placement in consideration for 60,000 shares ofpreferred stock and warrants 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.

 

As part of this private placement, we entered into a RegistrationRights Agreement, pursuant to which we are required to file a registrationstatement to register the shares of common stock issuable upon the conversionof the preferred stock and upon the exercise of the warrants issued to theinvestors in the private placement.  Wefailed to file the registration statement by April 24, 2004 and did nothave the registration 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 foreach thirty-day period, pro rated for any shorter period, that the filing oreffectiveness of the registration statement is delayed.  Mr. Gero waived his right for any liquidateddamages related to our late filing of the registration statement.  In accordance with this obligation, we fileda registration statement on Form S-3 including these shares of common stock onApril 20, 2004.  The registrationstatement includes the 128,817 shares of common stock underlying the preferredstock and warrants purchased by Mr. Gero in the private placement as well as125,000 shares previously acquired by Mr. Gero in a private transaction with athird party.

 

29

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*March 28, 2005 Private Placement*

 

On March 28, 2005, we completed a $2,663,000 private placement of1,065,200 shares of our Series 2 5% convertible preferred stock and warrants topurchase 532,600 shares of our common stock at an initial exercise price of$2.77 per share to various purchasers. Mr. Gero invested $150,000 in this private placement in considerationfor 60,000 shares of preferred stock and warrants to purchase 30,000 shares ofcommon stock.  Mr. Gero participated inthe private placement on the same terms and conditions as other investorsexcept that he is not entitled to a preemptive right to purchase a pro rataportion of certain future sales of securities by us or to receive liquidateddamages under the provisions of the Registrations Rights Agreement we executedin connection with this private placement.

 

*December 2, 2005 Private Placement*

 

On December 2, 2005, we completed a $1,230,843 private placement of564,607 shares of our Series 3 5% convertible preferred stock and warrants topurchase 282,306 shares of our common stock at an initial exercise price of$2.58 per share to various purchasers. Mr. Gero invested $60,000 in this private placement in consideration for27,523 shares of preferred stock and warrants to purchase 13,762 shares ofcommon stock.  Mr. Gero participated inthe private placement on the same terms and conditions as other investorsexcept that he is not entitled to a preemptive right to purchase a pro rataportion of certain future sales of securities by us or to receive liquidateddamages under the provisions of the Registrations Rights Agreement we executedin connection with this private placement. In addition, Mr. Gero will not be able to convert his shares ofpreferred stock into, or exercise his warrants for, shares of common stockunless and until approved by our stockholders to the extent required by Nasdaq.

 

**Item11.****        SecurityOwnership of Certain Beneficial Owners and Management.**

 

The information set forth under the caption “Security Ownership ofCertain Beneficial Owners and Management” contained in the Proxy Statement isincorporated herein by reference.

 

**Item12.****        CertainRelationships and Related Transactions.**

 

The information set forth under “Certain Transactions with Management”contained in the Proxy Statement is incorporated herein by reference.

 

**Item13.****        Exhibits.**

 

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

 

The following consolidated financial statements of Intrusion Inc.and subsidiaries, 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, 2005 and 2004                                            | F-2 |
| Consolidated Statements of Operations for the years ended  December 31, 2005, and 2004               | F-3 |
| Consolidated Statements of Stockholders’ Equity for the years ended  December 31, 2005 and 2004 | F-4 |
| Consolidated Statements of Cash Flows for the years ended  December 31, 2005 and 2004                | F-5 |
| Notes to Consolidated Financial Statements                                                                | F-6 |

 

30

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(b)**           Exhibits**

 

The followingExhibits are filed herewith pursuant to Item 601 of Regulation S-B orincorporated herein by reference to previous filings as noted:

 
| **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                        |
| 10.7(4)             |       | Amended and Restated 401(k) Savings Plan of the Registrant                                                                                                        |

 

31

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| 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                                                                         |
| 21(5)     |   | List of Subsidiaries of Registrant                                                                                                                                                                   |
| 23.1(15)  |   | Consent of KBA Group LLP, Independent Registered Public Accounting  Firm                                                                                                                             |
| 31.1(15)  |   | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)  of the Exchange Act                                                                                                             |
| 31.2(15)  |   | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)  of the Exchange Act                                                                                                             |
| 32.1(15)  |   | 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(15)  |   | 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, as amended(File No. 33-6899), which was declared effective on May 21, 1992, bythe Securities and Exchange Commission, which Exhibit is incorporated herein byreference.

 

(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)           Filed as an Exhibit tothe Registrant’s Definitive Proxy Statement on Schedule 14A in connectionwith the solicitation of proxies for its 2002 Annual Meeting of Stockholders,which Exhibit is incorporated herein by reference.

 

(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.

 

(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

 

32

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(11)         Filed as an Exhibit to the Registrant’sCurrent Report on Form 8-K dated December 6, 2005, which Exhibit isincorporated 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)         Filedherewith.

 

### **Item14.**        Principal Accountant Fees andServices

### ** **

The information set forth under “Fees Paid to Independent PublicAccountants” contained in the Proxy Statement is incorporated herein byreference.

 

33

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**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities Exchange Act of1934, the Registrant has duly caused this report to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
| Dated: March 29, 2006 | 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 Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title**                                    | ** ** | **Date**            |
|------------------------|------------|----------------------------------------------|------------|---------------------|
|                   |       |                                         |       |                |
| /s/ G. WARD PAXTON     |       | Chairman, President,                         |       | March 29, 2006 |
| G. Ward Paxton         |       | Chief Executive Officer, and Director        |       |
|                   |       |                                         |       |                |
| /s/ T. JOE HEAD        |       | Vice Chairman, Vice President                |       | March 29, 2006 |
| T. Joe Head            |       | and Director                                 |       |
|                   |       |                                         |       |                |
|                   |       | Vice President, Chief Financial              |       | March 29, 2006 |
| /s/ MICHAEL L. PAXTON  |       | Officer, Treasurer and Secretary             |       |
| Michael L. Paxton      |       | (Principal Financial and Accounting Officer) |       |
|                   |       |                                         |       |                |
| /s/ JAMES F. GERO      |       | Director                                     |       | March 29, 2006 |
| James F. Gero          |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ J. FRED BUCY, JR.  |       | Director                                     |       | March 29, 2006 |
| J. Fred Bucy, Jr.      |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ DONALD M. JOHNSTON |       | Director                                     |       | March 29, 2006 |
| Donald M. Johnston     |       |                                         |       |                |

 

34

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**ANNUAL REPORT ON FORM 10-KSB**

**ITEM 7**

**FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2005 and 2004**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

----

 

**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

The Board of Directors and Stockholders

Intrusion Inc.

 

We have audited the accompanying consolidated balance sheets ofIntrusion Inc. and subsidiaries (the “Company”) as of December 31,2005 and 2004, 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.

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  The Company is not required to have nor werewe engaged to perform, audits of their internal control over financialreporting.  Our audits includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the consolidated financial positionof Intrusion Inc. and subsidiaries as of December 31, 2005 and 2004,and the consolidated results of their operations and their cash flows for theyears then ended in conformity with accounting principles generally accepted inthe United States of America.

 

 
| /s/ KBA Group LLP                                                                     |   |
|---------------------------------------------------------------------------------------|--------|
| Dallas, Texas                                                                         |
| February 3, 2006, except for Notes 1 and 10 to which the date is  March 29, 2006 |

 

F-1

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(In thousands, except par value amounts)**

 
| ** **                                                                                                           | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                           | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                           |       |                  |       |   |   |
| Current  Assets:                                                                                                     |       |                  |       |   |   |
| Cash and cash equivalents                                                                                            |       | $                     | 2,844      |   | $ | 2,315 |   |
| Short-term investments                                                                                               |       | 500                   |       | 75 |   |
| Accounts receivable, net of allowance for  doubtful accounts and returns of $102 in 2005 and $508 in 2004            |       | 443                   |       | 1,220 |   |
| Inventories, net                                                                                                     |       | 373                   |       | 950 |   |
| Prepaid expenses                                                                                                     |       | 191                   |       | 393 |   |
| Total current  assets                                                                                                |       | 4,351                 |       | 4,953 |   |
| Property and  Equipment:                                                                                             |       |                  |       |   |   |
| Equipment                                                                                                            |       | 650                   |       | 942 |   |
| Furniture and fixtures                                                                                               |       | 48                    |       | 46 |   |
| Leasehold improvements                                                                                               |       | 101                   |       | 100 |   |
|                                                                                                                 |       | 799                   |       | 1,088 |   |
| Accumulated depreciation and amortization                                                                            |       | (543                  | )          | (789 | ) |
|                                                                                                                 |       | 256                   |       | 299 |   |
| Other assets                                                                                                         |       | 41                    |       | 64 |   |
| **TOTAL  ASSETS**                                                                                                    |       | $                     | 4,648      |   | $ | 5,316 |   |
|                                                                                                                 |       |                  |       |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                       |       |                  |       |   |   |
| Current  Liabilities:                                                                                                |       |                  |       |   |   |
| Accounts payable, trade                                                                                              |       | $                     | 415        |   | $ | 791 |   |
| Accrued vacation expense                                                                                             |       | 263                   |       | 256 |   |
| Accrued warranty expense                                                                                             |       | 49                    |       | 125 |   |
| Other accrued expenses                                                                                               |       | 415                   |       | 495 |   |
| Deferred revenue                                                                                                     |       | 527                   |       | 799 |   |
| Total  current liabilities                                                                                           |       | 1,669                 |       | 2,466 |   |
| **TOTAL  LIABILITIES**                                                                                               |       | 1,669                 |       | 2,466 |   |
| ** **                                                                                                           |       |                  |       |   |   |
| **Commitments  and Contingencies**                                                                                   |       |                  |       |   |   |
| ** **                                                                                                           |       |                  |       |   |   |
| Stockholders’  Equity:                                                                                          |       |                  |       |   |   |
| Preferred stock, $0.01 par value:                                                                                    |       |                  |       |   |   |
| Authorized shares — 5,000                                                                                       |       |                  |       |   |   |
| Series 1 shares issued and outstanding —  260 in 2005 and 840 in 2004  Liquidation preference of $1,316 in 2005 |       | 918                   |       | 2,968 |   |
| Series 2 shares issued and outstanding —  500 in 2005  Liquidation preference of $1,271 in 2005                 |       | 787                   |       | — |   |
| Series 3 shares issued and outstanding —  565 in 2005  Liquidation preference of $1,236 in 2005                 |       | 805                   |       | — |   |
| Common stock, $0.01 par value:                                                                                       |       |                  |       |   |   |
| Authorized shares — 80,000                                                                                      |       |                  |       |   |   |
| Issued shares — 6,919 in 2005  and 5,431 in 2004 Outstanding shares — 6,909 in 2005 and 5,421 in 2004      |       | 69                    |       | 54 |   |
| Common stock held in treasury, at cost—10  shares                                                               |       | (362                  | )          | (362 | ) |
| Additional paid-in-capital                                                                                           |       | 52,994                |       | 49,095 |   |
| Accumulated deficit                                                                                                  |       | (52,053               | )          | (48,732 | ) |
| Accumulated other comprehensive loss                                                                                 |       | (179                  | )          | (173 | ) |
| Total  stockholders’ equity                                                                                     |       | 2,979                 |       | 2,850 |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                 |       | $                     | 4,648      |   | $ | 5,316 |   |

 

See accompanying notes.

 

F-2

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(In thousands, except per share amounts)**

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                         | ** ** | **2004** | ** ** |
|                                                                        |       |                             |       |   |   |
| Net product  revenue                                                        |       | $                                | 4,375      |   | $ | 4,364 |   |
| Net customer  support and maintenance revenue                               |       | 1,603                            |       | 1,655 |   |
| Total  revenue                                                              |       | 5,978                            |       | 6,019 |   |
| Cost of product  revenue                                                    |       | 2,357                            |       | 2,787 |   |
| Cost of  customer support and maintenance revenue                           |       | 157                              |       | 163 |   |
| Total cost  of revenue                                                      |       | 2,514                            |       | 2,950 |   |
| Gross profit                                                                |       | 3,464                            |       | 3,069 |   |
| Operating  expenses:                                                        |       |                             |       |   |   |
| Sales and marketing                                                         |       | 3,137                            |       | 3,690 |   |
| Research and development                                                    |       | 2,553                            |       | 2,549 |   |
| General and administrative                                                  |       | 1,126                            |       | 1,146 |   |
| Severance costs                                                             |       | 55                               |       | 273 |   |
| Operating  loss                                                             |       | (3,407                           | )          | (4,589 | ) |
| Interest  income, net                                                       |       | 84                               |       | 42 |   |
| Other  income, net                                                          |       | 2                                |       | 19 |   |
| Loss from  operations before income taxes                                   |       | (3,321                           | )          | (4,528 | ) |
| Income tax  provision                                                       |       | —                           |       | — |   |
| Net loss                                                                    |       | (3,321                           | )          | (4,528 | ) |
| Preferred  stock dividends accrued                                          |       | (168                             | )          | (192 | ) |
| Beneficial  conversion feature on preferred stock                           |       | (1,434                           | )          | (938 | ) |
| Net loss  attributable to common stockholders                               |       | $                                | (4,923     | ) | $ | (5,658 | ) |
|                                                                        |       |                             |       |   |   |
| Net loss per  share attributable to common stockholders (basic and diluted) |       | $                                | (0.77      | ) | $ | (1.09 | ) |
| Weighted  average common shares outstanding (basic and diluted)             |       | 6,424                            |       | 5,177 |   |

 

See accompanying notes.

 

F-3

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF STOCKHOLDERS’EQUITY**

**(In thousands)**

 
| ** **                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                         | ** ** | **2005**                    | ** ** | **2004** | ** ** |
| **NUMBER  OF PREFERRED SHARES—ISSUED AND OUTSTANDING**                                        |       |                        |       |   |   |
| Balance, beginning of year                                                                         |       | 840                         |       | — |   |
| Issuance of preferred shares pursuant to  private placement                                        |       | 1,630                       |       | 1,000 |   |
| Conversion of preferred shares to common  shares                                                   |       | (1,145                      | )          | (160 | ) |
| Balance, end of year                                                                               |       | 1,325                       |       | 840 |   |
| **PREFERRED  STOCK**                                                                               |       |                        |       |   |   |
| Balance, beginning of year                                                                         |       | $                           | 2,968      |   | $ | — |   |
| Issuance of preferred shares pursuant to  private placement, net of warrants and transaction costs |       | 2,480                       |       | 3,534 |   |
| Conversion of preferred shares to common  shares                                                   |       | (2,938                      | )          | (566 | ) |
| Balance, end of year                                                                               |       | $                           | 2,510      |   | $ | 2,968 |   |
| **NUMBER  OF COMMON SHARES—ISSUED**                                                           |       |                        |       |   |   |
| Balance, beginning of year                                                                         |       | 5,431                       |       | 5,173 |   |
| Issuance of common shares under stock  options and purchase plans                                  |       | —                      |       | 4 |   |
| Conversion of preferred shares to common  shares                                                   |       | 1,488                       |       | 254 |   |
| Balance, end of year                                                                               |       | 6,919                       |       | 5,431 |   |
| **COMMON  STOCK**                                                                                  |       |                        |       |   |   |
| Balance, beginning of year                                                                         |       | $                           | 54         |   | $ | 52 |   |
| Conversion of preferred shares to common  shares                                                   |       | 15                          |       | 2 |   |
| Balance, end of year                                                                               |       | $                           | 69         |   | $ | 54 |   |
| **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                                                                         |       | $                           | 49,095     |   | $ | 47,526 |   |
| Issuance of warrants with preferred stock  private placement                                       |       | 1,141                       |       | 1,191 |   |
| Conversion of preferred shares to common  shares                                                   |       | 2,926                       |       | 564 |   |
| Issuance of common shares under stock  options                                                     |       | —                      |       | 6 |   |
| Preferred stock dividends accrued                                                                  |       | (168                        | )          | (192 | ) |
| Balance, end of year                                                                               |       | $                           | 52,994     |   | $ | 49,095 |   |
| **ACCUMULATED  DEFICIT**                                                                           |       |                        |       |   |   |
| Balance, beginning of year                                                                         |       | $                           | (48,732    | ) | $ | (44,204 | ) |
| Net loss                                                                                           |       | (3,321                      | )          | (4,528 | ) |
| Balance, end of year                                                                               |       | $                           | (52,053    | ) | $ | (48,732 | ) |
| **ACCUMULATED  OTHER COMPREHENSIVE LOSS**                                                          |       |                        |       |   |   |
| Balance, beginning of year                                                                         |       | $                           | (173       | ) | $ | (228 | ) |
| Foreign currency translation adjustment                                                            |       | (6                          | )          | 55 |   |
| Balance, end of year                                                                               |       | $                           | (179       | ) | $ | (173 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                               |       | $                           | 2,979      |   | $ | 2,850 |   |
| **TOTAL  COMPREHENSIVE LOSS**                                                                      |       | $                           | (3,327     | ) | $ | (4,473 | ) |

 

See accompanying notes.

 

F-4

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Operating  Activities:                                                          |       |                             |       |   |   |
| Net loss                                                                        |       | $                                | (3,321     | ) | $ | (4,528 | ) |
| Adjustments  to reconcile net loss to net cash used in operating activities:    |       |                             |       |   |   |
| Depreciation and amortization                                                   |       | 185                              |       | 201 |   |
| Provision for doubtful accounts                                                 |       | (405                             | )          | (66 | ) |
| Loss on disposal of property and equipment                                      |       | —                           |       | 7 |   |
| Changes in  operating assets and liabilities:                                   |       |                             |       |   |   |
| Accounts receivable                                                             |       | 1,182                            |       | (182 | ) |
| Inventories                                                                     |       | 577                              |       | 336 |   |
| Other assets                                                                    |       | 225                              |       | 69 |   |
| Accounts payable and accrued expenses                                           |       | (503                             | )          | (584 | ) |
| Deferred revenue                                                                |       | (272                             | )          | 11 |   |
| Net cash  used in operating activities                                          |       | (2,332                           | )          | (4,736 | ) |
| Investing  Activities:                                                          |       |                             |       |   |   |
| Purchases of short-term investments                                             |       | (2,850                           | )          | (3,100 | ) |
| Maturities of short-term investments                                            |       | 2,425                            |       | 4,730 |   |
| Proceeds from sale of property and  equipment                                   |       | 2                                |       | 17 |   |
| Purchases of property and equipment                                             |       | (144                             | )          | (227 | ) |
| Net cash  provided by (used in) investing activities                            |       | (567                             | )          | 1,420 |   |
| Financing  Activities:                                                          |       |                             |       |   |   |
| Proceeds from exercise of employee stock  options                               |       | —                           |       | 6 |   |
| Proceeds from the issuance of preferred stock  and warrants, net                |       | 3,620                            |       | 4,725 |   |
| Dividends paid on preferred stock                                               |       | (186                             | )          | (129 | ) |
| Net cash  provided by financing activities                                      |       | 3,434                            |       | 4,602 |   |
| Effect of  foreign currency translation adjustment on cash and cash equivalents |       | (6                               | )          | 55 |   |
| Net increase  in cash and cash equivalents                                      |       | 529                              |       | 1,341 |   |
| Cash and  cash equivalents at beginning of year                                 |       | 2,315                            |       | 974 |   |
| Cash and  cash equivalents at end of year                                       |       | $                                | 2,844      |   | $ | 2,315 |   |
|                                                                            |       |                             |       |   |   |
| SUPPLEMENTAL  CASHFLOW INFORMATION:                                             |       |                             |       |   |   |
| Interest  paid                                                                  |       | $                                | —     |   | $ | — |   |
| Income taxes  paid                                                              |       | $                                | —     |   | $ | — |   |
|                                                                            |       |                             |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                      |       |                             |       |   |   |
| Fair value  of warrants issued in connection with sale of preferred stock       |       | $                                | 1,141      |   | $ | 1,191 |   |
| Amortization  of preferred stock beneficial conversion feature                  |       | $                                | 1,434      |   | $ | 938 |   |
| Preferred  stock dividends accrued but not paid                                 |       | $                                | 44         |   | $ | 63 |   |

 

See accompanying notes.

 

F-5

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

We develop, market and support a family ofnetwork intrusion prevention, intrusion detection, regulated informationcompliance, 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 direct sales force toend-users, distributors and numerous domestic and international systemintegrators, managed service providers and value-added resellers. Our end-usercustomers include high technology, e-commerce, manufacturing, governmententities, military, financial institutions, telecommunications, retail,transportation, healthcare, insurance, entertainment, utilities, energycompanies, 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 organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we sold, or otherwise disposed 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 Nasdaq tickersymbol from ODSI to INTZ to reflect our focus on intrusion prevention anddetection solutions, along with information compliance and data privacyprotection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

Our principal 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,TraceCopTM and SpySnareTM are registered trademarks of Intrusion Inc.

 

As of December 31, 2005, we had cash, cash equivalents andinvestments in the amount of approximately $3.3 million, up fromapproximately $2.4 million as of December 31, 2004.  On March 28, 2005, we closed a $2.66 millionprivate placement of Convertible Preferred Stock and warrants.  On December 2, 2005, we closed a $1.23million private placement of Convertible Preferred Stock and warrants.  On March 29, 2006, we established a $1.0million line of credit with Silicon Valley Bank.  With our existing cash resources, our line ofcredit and our projections for increased revenues in 2006, we believe that wehave sufficient cash resources to finance our operations and expected capitalexpenditures for the next twelve months. The sufficiency of our cash resources may depend to a certain extent ongeneral economic, financial, competitive or other factors beyond our control.  In addition, the payment of dividends on ouroutstanding preferred stock may reduce our available cash resources.  Moreover, despite actions to reduce our costsand improve our profitability, we expect our operating losses and net operatingcash outflows to continue through at least the first quarter of 2006.  In addition, we believe we will needto seek additional equity financing in order to remain in compliance withNasdaq’s continued listing requirement of at least $2.5 million of stockholders’equity.  We do not currently haveany arrangements for financing, and we may not be able to secure additionaldebt or equity financing on terms that are acceptable to us, or at all, at thetime when we need such funding.  Additionally, we may not have sufficientavailability under our credit line when we need additional funds.  If our business does not generatesufficient cash flows from operations and sufficient financings are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due, fund our other liquidity needs ormaintain our listing on The Nasdaq Capital Market.

 

**2. Summary of Significant Accounting Policies**

 

***Principlesof Consolidation***

 

Our consolidated financial statements include our accounts and those ofour wholly owned subsidiaries. Intercompany balances and transactions have beeneliminated in consolidation.

 

F-6

----

 

***Cashand Cash Equivalents***

 

Cash and all highly liquid investments purchased with an originalmaturity of less than three months are considered to be cash and cashequivalents.

 

***Short-termInvestments***

 

Short-term investments consist of U.S. government obligations andcorporate securities with maturities between 90 days and one year as ofthe balance sheet date. Short-term investments are classified as available forsale.  These investments are valued atmarket value, which approximates amortized cost.  The difference between fair market value andamortized cost is not significant. Realized gains and losses from the sale of short-term investments areincluded in other income, net and are derived using the specific identificationmethod for determining the cost of securities.

 

***RiskConcentration***

 

Financial instruments, which potentially subject us to concentrationsof credit risk, are primarily cash and cash equivalents, investments andaccounts receivable.  Cash and cashequivalent deposits are at risk to the extent that they exceed Federal DepositInsurance Corporation insured amounts.  Tominimize risk, we place our investments in U.S. government obligations, corporatesecurities and money market funds. Substantially all of our cash, cash equivalents and investments aremaintained with two major U.S. financial institutions.

 

We sell our products to customers in diversified industries worldwide,primarily in North America, Europe, Asia and Latin America.  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.

 

While we believe that many of the materials used in the production ofour products are generally readily available from a variety of sources, certaincomponents are 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.

 

***AccountsReceivable and Allowance for Doubtful Accounts***

 

Trade accounts receivable are stated at the amount we expect tocollect.  We maintain allowances fordoubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments. Management considers the following factors when determining thecollectibility of specific customer accounts: 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 customerswere to deteriorate, adversely affecting their ability to make payments,additional allowances would be required. Based on management’s assessment, we provide for estimated uncollectibleamounts through a charge to earnings and a credit to a valuationallowance.  Balances that remainoutstanding after we have used reasonable collection efforts are written offthrough a charge to the valuation allowance and a credit to accounts receivable.

 

***Inventoriesand Change in Method for Valuing Inventory***

 

Inventories are stated at the lower of cost or market. EffectiveApril 1, 2004, we changed our method of valuing inventories from standardcost to average cost, which approximates actual cost on a first-in, first-outbasis. The effect of this change in accounting method is minimal, as thestandard cost used previously also approximated actual cost.  Our management estimates the allowancerequired to state inventory at the lower of cost or market. There is a riskthat we will forecast demand for our products and market conditions incorrectlyand maintain excess inventories. Therefore, there can be no assurance that wewill not maintain excess inventory and incur inventory lower of cost or marketcharges in the future.

 

F-7

----

 

***Propertyand Equipment***

 

Equipment is stated at cost less accumulated depreciation and isdepreciated on a straight-line basis over the estimated useful lives of theassets.  Such lives vary from 1 to3 years.  Furniture and fixtures arestated 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 5 years.  Leasehold improvements are stated at costless accumulated amortization and are amortized on a straight-line basis overthe shorter of estimated useful lives of the assets or the remaining terms ofthe leases.  Such lives vary from 2 to 5years.  Expenditures for major renewalsand betterments that extend the useful lives of property and equipment arecapitalized.  Repair and maintenancecosts are expensed as incurred. Depreciation and amortization expense totaledapproximately $185,000 and $200,000 for the years ended December 31, 2005and 2004, respectively.

 

***Long-Lived Assets***

 

We follow the guidance in SFAS 144 “Accounting for the Impairment orDisposal of Long-Lived Assets” and review long-lived assets, including propertyand equipment for impairment whenever events or changes in circumstancesindicate that 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, 2005 and 2004, there was no impairment of long-lived assets.

 

***ForeignCurrency Translation***

 

Our international subsidiaries use the United States dollar as theirfunctional currency.  Although, ourinternational offices pay operating expenses in their local currency, they arefully funded by us in United States dollars, and we exchange the United Statesdollars locally to settle operating expenses incurred.  As outlined in SFAS 52, assets andliabilities are translated at the exchange rate in effect at the balance sheetdate, and income and expense accounts at average exchange rates during theyear.  Resulting translation adjustmentstotaling approximately $36,000 and $33,000 were recorded as operating expensesin the statement of operations during 2005 and 2004, respectively.  Additionally, we recorded approximately $6,000and $55,000 in operating expenses in 2005 and 2004, respectively, whichrepresents the accumulated foreign currency translation related to foreignoffices that were closed during those years. These amounts also represent the yearly change in the accumulated othercomprehensive loss during 2005 and 2004.

 

***Accountingfor Stock Options***

 

At December 31, 2005, we had four stock-based employee compensationplans, which are described in more detail in Note 7.  We account for those plans under therecognition and measurement principles of Accounting Principles Board (“APB”)Opinion No. 25, “Accounting for Stock Issued to Employees” and have adopted thedisclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation”and SFAS No. 148, “Accounting for Stock-Based Compensation — Transition andDisclosure — an Amendment of FASB Statement No. 123.”  No compensation expense related to stockoptions is reflected in net loss for the years ended December 31, 2005 and2004, as all options granted under those plans had exercise prices equal to orgreater than the market value of the underlying common stock on the grant date.

 

F-8

----

 

The following table summarizes relevant information as to the reportedresults under our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision ofSFAS 123 had been applied for the years ended December 31, 2005 and2004 (in thousands, except per share data):

 
| ** **                                                                                           | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                 |       |     |       |     |       |
| Net loss attributable to common  stockholders                                                        |       | $        | (4,923     | )        | $          | (5,658 | ) |
| (Deduct): Total stock-based compensation  determined under fair value- based method for all awards   |       | (831     | )          | (228     | )          |
| Add: Total stock-based compensation credit  determined under fair value-based methods for all awards |       | —   |       | —   |       |
| Pro forma net loss attributable to common  stockholders                                              |       | $        | (5,754     | )        | $          | (5,886 | ) |
|                                                                                                 |       |     |       |     |       |
| Net loss per share attributable to common  stockholders:                                             |       |     |       |     |       |
| As reported (basic and diluted)                                                                      |       | $        | (0.77      | )        | $          | (1.09 | ) |
| Pro forma (basic and diluted)                                                                        |       | $        | (0.90      | )        | $          | (1.14 | ) |
| Weighted-average common shares used in  computation:                                                 |       |     |       |     |       |
| Basic and diluted                                                                                    |       | 6,424    |       | 5,177    |       |

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), which replaces SFAS 123 and supersedes APB Opinion No.25. SFAS 123R requires all share-based payments to employees, including grantsof employee stock options, to be recognized in the financial statements basedon their fair values. The pro forma disclosures previously permitted under SFAS123 no longer will be an alternative to financial statement recognition. Forthe Company, SFAS 123R is effective for periods beginning afterDecember 15, 2005. We plan to adopt SFAS 123R on January 1, 2006using the modified prospective application method described in the statement.Under the modified prospective application method, we will apply the standardto new awards and to awards modified, repurchased, or cancelled after the requiredeffective date. Additionally, compensation cost for the unvested portion ofawards outstanding as of the required effective date will be recognized ascompensation expense as the requisite service is rendered after the requiredeffective date.

 

We are evaluating the impact of adopting SFAS 123R and expect that wewill record substantial non-cash stock compensation expenses in 2006.  The adoption of SFAS 123R is not expected tohave a significant effect on our financial condition or cash flows but isexpected to have a significant, adverse effect on our results ofoperations.  The future impact of theadoption of SFAS 123R cannot be predicted at this time because it will dependon levels of share-based payments granted by us in the future.  However, had we adopted SFAS 123R in priorperiods, the impact of that standard would have approximated the impact of SFAS123 as described in the disclosure of pro forma net loss attributable to commonstockholders included above.  As a resultof the adoption of SFAS 123R, we may reduce the amount of options granted on anannual basis and look for other stock-based compensation alternatives ratherthan using the current stock option plans.

 

***NetLoss Per Share***

 

We report two separate earnings per share (“EPS”) numbers, basic EPSand diluted EPS.  Basic net lossattributable to common stockholders per share is computed by dividing net lossattributable to common stockholders for the year by the weighted average numberof common shares outstanding for the year. Diluted net loss attributable to common stockholders per share iscomputed by dividing the net loss attributable to common stockholders for theyear by the weighted average number of common shares and common stockequivalents outstanding for the year.  Ourcommon stock equivalents include all common stock issuable upon conversion ofconvertible preferred stock and the exercise of outstanding options andwarrants.  The aggregate number of commonstock equivalents excluded from the loss per share calculation atDecember 31, 2005 and 2004 totaled 3,892,157 and 2,360,987,respectively.  Common stockequivalents are not included in the diluted loss per share for the years endedDecember 31, 2005 and 2004, as they are anti-dilutive as a result ofincurring net losses during these years.

 

F-9

----

 

***RevenueRecognition***

 

We generally recognize product revenue upon shipment.  These products include both hardware andperpetual software licenses, as we do not currently offer software on a subscriptionbasis.  We accrue for estimated warrantycosts and sales returns at the time of shipment based on our experience.  There is a risk that technical issues on newproducts could result in unexpected warranty costs and returns.  However, as we migrate to more of asoftware-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.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followinghave been met: i) execution of a written agreement; ii) delivery ofthe product has occurred; 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 VendorSpecific Objective Evidence analysis would be performed to appropriatelydetermine the amount 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 and recognizemaintenance and support revenue over the term of the contract period, which isgenerally one year.

 

We generally 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.

 

Our normal payment terms offered to customers, distributors andresellers are net 30 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.

 

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

 

We have signed distribution agreements with distributors in the UnitedStates, 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 by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accountsreceivable and reduce inventory related to the sale at the time of shipment tothe distributor. We did not have any deferred revenue at distributors atDecember 31, 2005.  Net deferred revenuerelated to distributors at December 31, 2004 was approximately$0.1 million.  At December 31, 2004,this balance is comprised of the net amounts related to the accounts receivableof $0.2 million and inventory held by distributors of $0.1 million.

 

F-10

----

 

***Researchand Development Costs***

 

We incur research and development costs that relate primarily to thedevelopment of new security software, appliances and integrated solutions, andmajor enhancements to existing services and products. Research developmentcosts are comprised primarily of salaries and related benefits expenses,contract labor and prototype and other related expenses.

 

Software development costs are included in research and development andare expensed as incurred. SFAS No. 86, “Accounting for the Costs ofComputer Software to Be Sold, Leased, or Otherwise Marketed,” requires thatsoftware development costs incurred subsequent to reaching technologicalfeasibility be capitalized, if material. If the process of developing a newproduct or major enhancement does not include a detailed program design,technological feasibility is determined only after completion of a workingmodel. To date, the period between achieving technological feasibility and thegeneral availability of such software has been short, and the softwaredevelopment costs qualifying for capitalization have been insignificant.

 

***SeveranceCharges***

 

In connection with our continued shift to our new intrusion detectionand security appliance product lines, we streamlined operations and activitiesthat are not aligned with these core markets and strategies.  During 2005, we recorded $0.1 million forseverance as a result of reductions in force. During 2004, we recorded $0.3 million for severance as a result ofreductions in force.  Severanceobligations were paid prior to December 31, 2005 and 2004 for therespective reporting periods, and we were not receiving further benefit fromthe severed individuals after December 31, 2005 and 2004, respectively.

 

***Useof Estimates***

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period. Estimates are used for, butnot limited to, the accounting for doubtful accounts, sales discounts, salesreturns, revenue recognition, warranty costs, inventory obsolescence,depreciation and taxes. Actual results could differ from these estimates.

 

***IncomeTaxes***

 

We account for income taxes pursuant to SFAS No. 109, “Accountingfor Income Taxes,” which uses the liability method to calculate deferred incometaxes. 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 AccountingPronouncement***

 

SFAS No. 154, “Accounting Changes and Error Corrections, a replacementof APB Opinion No. 20 and FASB Statement No. 3,” was issued in June 2005.  SFAS No. 154 required retrospectiveapplication to financial statements of prior periods for changes in accountingprinciple that are not adopted prospectively. The statement also applies to changes required by an accountingpronouncement that does not include specific transaction provisions.  This statement is effective January 1, 2006.

 

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

 

**Inventories**

 
| ** **             | ** ** | **December 31,** | ** ** |
|------------------------|------------|-----------------------|------------|
| ** **             | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Finished  products     |       | $                     | 290        |   | $ | 743 |   |
| Work in  process       |       | 8                     |       | 18 |   |
| Demonstration  systems |       | 75                    |       | 189 |   |
|                   |       | $                     | 373        |   | $ | 950 |   |

 

F-11

----

 

**Other Accrued Expenses**

 
| ** **                 | ** ** | **December 31,** | ** ** |
|----------------------------|------------|-----------------------|------------|
| ** **                 | ** ** | **2005**              | ** ** | **2004** | ** ** |
|                       |       |                  |       |   |   |
| Accrued  sales commissions |       | $                     | 26         |   | $ | 75 |   |
| Accrued  payroll           |       | 141                   |       | 137 |   |
| Accrued  property taxes    |       | 63                    |       | 122 |   |
| Accrued  sales taxes       |       | 139                   |       | 59 |   |
| Other                      |       | 46                    |       | 102 |   |
|                       |       | $                     | 415        |   | $ | 495 |   |

 

**4. Commitments and Contingencies**

 

***Leases***

 

We lease office space for our corporateheadquarters in Richardson, Texas under an operating lease, the base term ofwhich 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 expires in August 2006. In addition, welease office space for our U.S. and international sales and engineeringoffices.

 

All leases expire prior to March 2010 and theCompany does not have any obligations that extend beyond five years fromDecember 31, 2005. The Company’s lease for the headquarters facility containsescalation provisions. In accordance with SFAS No. 13 “Accounting for Leases,”FASB Technical Bulletin 88-1 “Issues Relating to Accounting for Leases,” and FASBTechnical Bulletin 85-3 “Accounting for Operational Leases with Scheduled RentIncreases,” the Company records rent expense on facility leases on astraight-line basis. Real estate taxes, insurance and maintenance expenses arethe obligations of the Company. Rent expense totaled approximately $600,000 and$500,000 for the years ended December 31, 2005 and 2004, respectively.

 

The following table sets forth certaininformation concerning our contractual obligations at December 31, 2005and outlines the expected future payments to be made under such obligations andcommitments.

 

Future minimum lease payments consisted ofthe following on December 31, 2005 (in thousands):

 
| 2006   |   | $   | 431    |   |
|--------|--------|-----|--------|--------|
| 2007   |   | 378 |   |
| 2008   |   | 393 |   |
| 2009   |   | 409 |   |
| 2010   |   | 68  |   |
|   |   | $   | 1,679  |   |

 

F-12

----

 

***Legal Proceedings***

 

We are subject to legal proceedings andclaims that arise in the ordinary course of business. We do not believe thatthe outcome of those matters will have a material adverse affect on ourconsolidated financial position, operating results or cash flows. However,there can be no assurance such legal proceedings will not have a materialimpact.

 

We are not aware of any material claimsoutstanding or pending against Intrusion Inc. at December 31, 2005.

 

**5. Employee Benefit Plans**

 

***Employee Stock Purchase Plan***

 

On April 24, 1997, we adopted anEmployee Stock Purchase Plan (the “Purchase Plan”) under which 125,000 sharesof common stock have been reserved for issuance. Eligible employees may designatenot more than 10% of their compensation to be deducted each pay period for thepurchase of common stock under the Purchase Plan. The Purchase Plan was amendedJanuary 17, 2001 to increase the maximum number of shares that can bepurchased per participant from 500 shares to 1,000 shares peroffering. Each participant may purchase up to 2,000 shares in any onecalendar year. On January 31 and July 31 of each calendar year,shares of common stock are purchased with the employees’ payroll deductionsover the immediately preceding six months at a price per share of 85% of thelesser of the market price of the common stock on the purchase date or themarket price on the first day of the six-month period. The Purchase Plan willterminate no later than April 24, 2007. No shares were purchased under thePurchase Plan in the year ended December 31, 2005 and 500 shares were purchasedin the year ended December 31, 2004. A total of 45,702 shares have beenissued under the Purchase Plan and 79,298 shares are available for purchase asof December 31, 2005.

 

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

 

We adopted a plan known as theIntrusion Inc. 401(k) Savings Plan (the “Plan”) to provide retirement andincidental benefits for our employees. The Plan covers substantially allemployees who meet minimum age and service requirements. As allowed underSection 401(k) of the Internal Revenue Code, the Plan provides taxdeferred salary deductions for eligible employees.

 

Employees may contribute from 1% to 25% oftheir annual compensation to the Plan, limited to a maximum amount as set bythe 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. We match employee contributions at the rate of$0.25 per each $1.00 of contribution on the first 4% of compensation. Matchingcontributions to the Plan were approximately $24,000 and $18,000 for the yearsended December 31, 2005 and 2004, respectively.

 

**6. Income Taxes**

 

Deferred income taxes reflect the net taxeffects of temporary differences between the carrying amounts of assets andliabilities for financial reporting purposes and the amounts used for incometax purposes. There are no deferred tax liabilities as of December 31, 2005and 2004. Significant components of our deferred tax assets as ofDecember 31, 2005 and 2004 are as follows (in thousands):

 

F-13

----

 
| ** **                                                | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net operating loss carryforwards                          |       | $                    | 29,355     |   | $ | 27,780 |   |
| Net operating loss carryforwards of foreign  subsidiaries |       | 374                  |       | 374 |   |
| Book over tax depreciation                                |       | 87                   |       | 67 |   |
| Intangibles                                               |       | 1,118                |       | 1,298 |   |
| Equity investments                                        |       | —               |       | 458 |   |
| Vacation accrual                                          |       | 97                   |       | 94 |   |
| Allowance for doubtful accounts and returns               |       | 26                   |       | 140 |   |
| Warranty accrual                                          |       | 18                   |       | 46 |   |
| Inventory allowance                                       |       | 51                   |       | 73 |   |
| Other                                                     |       | 1,587                |       | 1,178 |   |
| Deferred tax assets                                       |       | 32,713               |       | 31,508 |   |
| Valuation allowance for deferred tax assets               |       | (32,713              | )          | (31,508 | ) |
| Deferred tax assets, net of allowance                     |       | $                    | —     |   | $ | — |   |

 

Deferred tax assets are required to bereduced by a valuation allowance if it is more likely than not that someportion or all of the deferred tax assets will not be realized. Realization ofthe future benefits related to the deferred tax assets is dependent on manyfactors, including the Company’s ability to generate taxable income within thenear to medium term. Management has considered these factors in determining thevaluation allowance for 2005 and 2004.

 

The differences between the provision forincome taxes and income taxes computed using the federal statutory rate for theyears ended December 31, 2005 and 2004 are as follows (in thousands):

 
| ** **                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Reconciliation  of income tax benefit to statutory rate: |       |     |       |     |       |
| Income tax benefit at statutory rate                     |       | $        | (1,129     | )        | $          | (1,539 | ) |
| State income taxes, net of federal income  tax benefit   |       | (87      | )          | (120     | )          |
| Change in valuation allowance                            |       | 1,205    |       | 1,663    |       |
| Other                                                    |       | 11       |       | (4       | )          |
|                                                     |       | $        | —     |     | $          | — |   |

 

At December 31, 2005, we had federal netoperating loss carryforwards of $82.1 million for income tax purposes thatbegin to expire in 2008 and are subject to the ownership change limitationsunder Internal Revenue Code Section 382. We also had $93.5 million ofstate net operating loss carryforwards. Net operating loss carryforwards of theforeign subsidiaries of $0.4 million at December 31, 2005 are availableindefinitely for offset only against taxable income generated by the foreignsubsidiaries.

 

We made no federal tax payments during 2005and 2004, and did not receive any federal income tax refunds in 2005 or 2004for income taxes paid in previous years.

 

**7. Stock Options and Warrants**

 

At December 31, 2005, we had fourstock-based compensation plans, which are described below. These plans weredeveloped to retain and attract key employees and directors.

 

In 1987, an Incentive Stock Option Plan wasestablished, which provides for the issuance of options to key employees of theCompany to purchase our common stock. The 1987 Incentive Stock Option Plan wasterminated on January 26, 1997. The 1987 plan provided for the issuance ofup to 300,000 shares of common stock upon exercise of options granted pursuantto the plan. Options to purchase a total of 850 shares of commonstock are outstanding with no options remaining available for issuance underthe 1987 plan.

 

F-14

----

 

In 1995, we adopted our 1995 Stock OptionPlan (the “1995 Plan”), which provides for the issuance of up to 400,000 sharesof common stock upon exercise of options granted pursuant to the 1995 Plan. OnApril 26, 2001, our stockholders increased the overall number of sharesavailable for issuance pursuant to the plan to 825,000 shares of common stock.The 1995 Plan provides for the issuance of both non-qualified and incentivestock options to our employees, officers, and employee-directors. The 1995 Planexpired by its terms on March 21, 2005 and no options were available for futureissuance after the expiration. At December 31, 2005, 66,531 employee optionshave been exercised and employee options to purchase a total of567,343 shares of common stock are outstanding. A total of2,290,295 options have been granted pursuant to the 1995 Plan, of which,1,656,421 have been cancelled.

 

In 1995, we adopted the 1995Non-Employee Director Stock Option Plan (the “1995 Non-Employee DirectorPlan”). The 1995 Non-Employee Director Plan provided for the issuance ofnon-qualified stock options to non-employee directors. The 1995 Non-EmployeeDirector Plan was amended in April 2002 to increase the number of sharesavailable for issuance to 65,000 from 40,000 shares. The 1995 Non-EmployeeDirector Plan expired by its terms on March 21, 2005 and no options wereavailable for future issuance after the expiration. No options have beenexercised under the 1995 Non-Employee Director Plan. Non-employee options topurchase a total of 32,500 shares of common stock are outstanding atDecember 31, 2005. A total of 62,500 options have been granted todirectors pursuant to the 1995 Non-Employee Director Plan, of which, 30,000have been cancelled.

 

On March 17, 2005, the Boardapproved the 2005 Stock Incentive Plan (the “2005 Plan”), which was approved bythe stockholders on June 14, 2005. The 2005 Plan serves as a replacement forthe 1995 Non-Employee Director Plan and the 1995 Option Plan which expired bytheir 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 optionswill continue with their existing terms and will be subject to the 1995Non-Employee Director Plan or the 1995 Plan, 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 Option Plan.The 2005 Plan provides for the issuance of up to 750,000 shares of common stockupon exercise of options granted pursuant to the 2005 Plan. The 2005 Planconsists of three (3) separate equity incentive programs: the DiscretionaryOption Grant Program; the Stock Issuance Program; and the Automatic OptionGrant Program for non-employee Board members. Officers and employees,non-employee Board members and independent contractors are eligible toparticipate in the Discretionary Option Grant and Stock Issuance Programs.Participation in the Automatic Option Grant Program is limited to non-employeemembers of the Board. Each non-employee Board member will receive an optiongrant for 10,000 shares of Common Stock upon initial election or appointment tothe Board, provided that individual has not previously been employed by theCompany in the preceding six (6) months. In addition, on the date of eachannual stockholders meeting, each Board member will automatically be granted anoption to purchase 5,000 shares of Common Stock, provided he or she has servedas a non-employee Board member for at least six (6) months. AtDecember 31, 2005, no 2005 plan options have been exercised and employeeand non-employee Board member options to purchase a total of 290,000 sharesof common stock are outstanding. A total of 300,000 options have been grantedunder the 2005 Plan, of which 10,000 have been cancelled and options for460,000 shares remain available for future grant. No shares have beenissued pursuant to the Stock Issuance Program.

 

Common shares reserved for future issuance,including conversions of preferred stock, warrants, outstanding options, underall of the stock option plans and employee stock purchase plans totalapproximately 3,892,157 million shares at December 31, 2005 asfollows:

 
| **(In thousands)**               | ** ** | **Outstanding** | ** ** | **Available for  Future Grant** | ** ** |
|----------------------------------|------------|-----------------|------------|---------------------------------|------------|
|                             |       |            |       |                            |       |
| Preferred  Stock                 |       | 1,478           |       | —                          |       |
| Warrants                         |       | 1,524           |       | —                          |       |
| 1987 Plan                        |       | 1               |       | —                          |       |
| 1995 Plan                        |       | 567             |       | —                          |       |
| 1995  Non-Employee Director Plan |       | 32              |       | —                          |       |
| 2005 Plan                        |       | 290             |       | 460                             |       |
| Employee  Stock Purchase Plan    |       | —          |       | 79                              |       |
| Total                            |       | 3,892           |       | 539                             |       |

 

F-15

----

 

The Compensation Committee of our Board ofDirectors determines for all employee options, the term of each option, optionexercise price within limits set forth in the plans, number of shares for whicheach option is granted and the rate at which each option is exercisable(generally ratably over one, three or five years from grant date). However, theexercise price of any incentive stock option may not be less than the fairmarket value of the shares on the date granted (or less than 110% of the fairmarket value in the case of optionees holding more than 10% of our voting stockof the Company), and the term cannot exceed ten years (five years for incentivestock options granted to holders of more than 10% of our voting stock).

 

A summary of our stock option activity andrelated information for the years ended December 31, 2005 and 2004 is asfollows:

 
| ** **                         | ** ** | **2005**                               | ** ** | **2004**                               | ** ** |
|------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                         | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                         | ** ** | ** **                             | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at beginning of year   |       | 404                                    |       | $                                      | 11.08      |   | 374 |   | $ | 15.10 |   |
| Granted                            |       | 579                                    |       | 3.01                                   |       | 162 |   | 1.93 |   |
| Exercised                          |       | (1                                     | )          | 2.02                                   |       | (3 | ) | 1.97 |   |
| Cancelled                          |       | (91                                    | )          | 14.59                                  |       | (129 | ) | 11.43 |   |
|                               |       |                                   |       |                                   |       |   |   |   |   |
| Outstanding at end of year         |       | 891                                    |       | $                                      | 5.48       |   | 404 |   | $ | 11.08 |   |
| Options exercisable at end of year |       | 307                                    |       | $                                      | 10.29      |   | 214 |   | $ | 18.56 |   |

 

Informationrelated to stock options outstanding at December 31, 2005, is summarizedbelow:

 
| ** **                   | ** ** | **Options Outstanding**                      | ** ** | **Options Exercisable**                             | ** ** |
|------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Outstanding at  12/31/05 (in  thousands)** | ** ** | **Weighted  Average  Remaining   Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable at  12/31/05 (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                         |       |                                         |       |                                                |       |   |   |   |   |   |   |
| $ 0.76-$2.00            |       | 142                                          |       | 7.37 years                                          |       | $ | 1.45 |   | 121 |   | $ | 1.44 |   |
| $ 2.08-$4.44            |       | 624                                          |       | 8.94 years                                          |       | $ | 3.00 |   | 61 |   | $ | 2.93 |   |
| $ 5.08-$10.00           |       | 57                                           |       | 5.72 years                                          |       | $ | 6.19 |   | 57 |   | $ | 6.19 |   |
| $ 17.52-$30.00          |       | 40                                           |       | 4.51 years                                          |       | $ | 20.84 |   | 40 |   | $ | 20.84 |   |
| $ 38.00-$93.00          |       | 28                                           |       | 4.16 years                                          |       | $ | 57.40 |   | 28 |   | $ | 57.40 |   |
|                         |       | 891                                          |       | 8.14 years                                          |       | $ | 5.48 |   | 307 |   | $ | 10.29 |   |
|                              |            |                                              |            |                                                     |            |  |  |  |  |  |  |  |  |  |

 

Pro forma information regarding net loss andnet loss per share, as disclosed in Note 2, has been determined as if wehad accounted for employee stock-based compensation plans and other stockoptions under the fair value method of SFAS 123. The fair value for theseoptions was estimated at the date of grant using a Black-Scholes option-pricingmodel with the following weighted average assumptions used for grants under theoption plans:

 
| ** **                | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------|------------|----------|------------|----------|------------|
|                      |       |     |       |     |       |
| Expected  dividend yield  |       | 0.0      | %          | 0.0      | %          |
| Risk-free  interest rate  |       | 3.9      | %          | 2.7      | %          |
| Expected  volatility      |       | 112.4    | %          | 154.5    | %          |
| Expected  life (in years) |       | 4.4      |       | 4.5      |       |

 

The Black-Scholes option valuation model wasdeveloped for use in estimating the fair value of traded options that have novesting restrictions and are fully transferable. In addition, option valuationmodels require the input of highly subjective assumptions including theexpected stock price volatility. Because our employee stock options havecharacteristics significantly different from those of traded options, andbecause changes in the subjective input assumptions can materially affect thefair value estimate, in management’s opinion, the existing models do notnecessarily provide a reliable single measure of the fair value of its employeestock options.

 

F-16

----

 

Information relating to the fair value ofoption grants made during 2005 and 2004 is as follows:

 
| ** **                                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                         |       |     |       |     |       |
| Options granted (with exercise price equal  to fair value of common stock):                  |       |     |       |     |       |
| Number of options (in thousands)                                                             |       | 579      |       | 145      |       |
| Weighted average exercise price per share                                                    |       | $        | 3.01       |     | $          | 1.94 |   |
| Weighted average fair value of stock  options grants per Black-Sholes option valuation model |       | $        | 2.34       |     | $          | 1.73 |   |
| Options granted (with exercise price  greater than fair value of common stock):              |       |     |       |     |       |
| Number of options (in thousands)                                                             |       | —   |       | 17       |       |
| Weighted average exercise price per share                                                    |       | $        | —     |     | $          | 1.89 |   |
| Weighted average fair value of stock  options grants per Black-Sholes option valuation model |       | $        | —     |     | $          | 1.47 |   |

 

**8. Preferred Stock**

 

***5% Preferred Stock***

 

On March 25, 2004, we completed a $5.0million private placement of our 5% convertible preferred stock and warrants.In the private placement, we sold 1,000,000 shares of our 5% preferred stock ata price of $5.00 per share for gross proceeds of $5.0 million, less $275,000 ofissuance costs. The 5% preferred shares were initially convertible into1,590,331 shares of common stock at a conversion price of $3.144 per share.Holders of the 5% convertible preferred stock include 140,000 shares purchasedby our CEO and 60,000 shares purchased by a director of the Company.

 

The 5% dividends related to the 5% preferredstock are paid semi-annually on the last business day in March andSeptember of each year, beginning with September 2004. Preferredstockholders vote together with common stockholders on an as converted to commonstock basis. Based on the conversion rate of the preferred stock, holders ofour 5% preferred stock will receive 1.5903 votes per share rounded to thenearest whole number. The liquidation preference for the 5% preferred stock isan amount equal to $5.00 per share plus any accrued and unpaid dividends.Holders of our 5% preferred stock have liquidation preference rights overcommon stockholders.

 

Included in this transaction were warrants topurchase 556,619 shares of common stock at an exercise price of $3.144 pershare. Warrant holders include 80,000 held by our CEO and 30,000 held by adirector of the Company. In connection with the closing of this privateplacement, we issued warrants to purchase 64,408 shares of our common stock atan exercise price of $3.144 per share to our financial advisor for assistancewith the private placement. All of the warrants were immediately exercisableand 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 warrants resulted in a beneficial conversionfeature to the 5% preferred stock valued at $0.9 million. In accordance withEITF 98-5, the beneficial conversion feature was fully amortized in the firstquarter of 2004, as the preferred stock does not have a stated maturity and isimmediately convertible into common stock. This beneficial conversion featureis included in the net loss attributed to common stockholders.

 

The 5% preferred stock was recorded as thefinancing proceeds of $5.0 million less $275,000 issuance costs and the fairvalue of the warrants issued in conjunction with the 5% preferred stock of $1.2million.

 

We have the right toredeem any or all of the outstanding 5% preferred stock at a price of $5.00 pershare plus accrued dividends at any time after September 25, 2004 ifcertain conditions are met.

 

During 2005, 580,304 shares of our 5%preferred stock were converted into 922,875 shares of our common stock. AtDecember 31, 2005 there are 259,696 shares of our 5% preferred stockoutstanding.

 

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***Series 2 5% Preferred Stock***

 

On March 28, 2005, we completed a $2.7million private placement of Series 2 5% convertible preferred stock andwarrants. In the private placement, we sold 1,065,200 shares of preferred stockat a price of $2.50 per share for gross proceeds of $2.7 million, less $173,000of issuance costs. The shares of Series 2 5% preferred stock are convertibleinto 1,065,200 shares of common stock at an initial conversion price of $2.50per share. Holders of the Series 2 5% preferred stock include 160,000 sharespurchased by our CEO and 60,000 shares purchased by a director of the Company.

 

The 5% dividends accruing on the Series 2 5%preferred stock are required to be paid quarterly on the first business day inMarch, June, September and December of each year, beginning with June 2005. Theliquidation preference for the preferred stock is an amount equal to $2.50 pershare plus any accrued and unpaid dividends. Holders of our Series 2 5%preferred stock have liquidation preference rights over our 5% preferred stockholders as well as our common stockholders. The holders of the Series 2 5%preferred stock are not entitled to vote on any matter, except as otherwiserequired by law or with respect to certain limited matters specified in theCertificate of Designations creating the Series 2 5% preferred stock.

 

Included in this transaction were warrants topurchase 532,600 shares of common stock at an exercise price of $2.77 pershare. Warrant holders include 80,000 held by our CEO and 30,000 held by adirector of the Company. The relative fair value of these warrants was valuedat $0.7 million using the Black-Scholes model and has been recorded as adiscount to the Series 2 5% preferred stock and an increase in additionalpaid-in capital. The issuance of these warrants also resulted in a beneficialconversion feature to the Series 2 5% preferred stock valued at $0.9 million.In accordance with EITF 98-5, the beneficial conversion feature was fullyamortized in the first quarter of 2005, as the preferred stock does not have astated maturity and is immediately convertible into common stock. Thisbeneficial conversion feature is included in the net loss attributed to commonstockholders. In connection with the closing of this private placement, weissued warrants to purchase 60,390 shares of our common stock at an exerciseprice of $2.77 per share to two affiliates of our financial advisor forassistance with the private placement. These warrants were valued at $0.1million using the Black-Scholes model and have been recorded as a reduction tothe Series 2 5% preferred stock and an increase to additional paid-in capital.

 

The Series 2 5% preferred stock was recordedas the net of the proceeds of $2.7 million less $173,000 issuance costs and thefair value of the warrants issued in conjunction with the Series 2 5% preferredstock 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.

 

During 2005, 565,200 shares of Series 2 5%preferred stock were converted into 565,200 shares of our common stock. AtDecember 31, 2005 there are 500,000 shares of Series 2 5% preferred stockoutstanding.

 

***Series 3 5% Preferred Stock***

 

On December 2, 2005, we completed a $1.2million private placement of Series 3 5% convertible preferred stock andwarrants. In the private placement, we sold 564,607 shares of preferred stockat a price of $2.18 per share for gross proceeds of $1.2 million, less $100,000of issuance costs. The shares of Series 3 5% preferred stock are convertibleinto 564,607 shares of common stock at an initial conversion price of $2.18 pershare. Holders of the Series 3 5% preferred stock include 55,046 sharespurchased by our CEO and 27,523 shares purchased by a director of the Company.

 

The 5% dividends accruing on the Series 3 5%preferred stock are required to be paid quarterly on the first business day inMarch, June, September and December of each year, beginning with March 1, 2006.The liquidation preference for the preferred stock is an amount equal to $2.18per share plus any accrued and unpaid dividends. Holders of our Series 3 5%preferred stock have liquidation preference rights over holders of our 5%preferred, Series 2 5% preferred stock and common stock. The holders of theSeries 3 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 3 5% preferred stock.

 

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Included inthis transaction were warrants to purchase 282,306 shares of common stock at anexercise price of $2.58 per share. Warrant holders include 27,523 held by ourCEO and 13,762 held by a director of the Company. The relative fair value ofthese warrants was valued at $0.3 million using the Black-Scholes model and hasbeen recorded as a discount to the Series 3 5% preferred stock and an increasein additional paid-in capital. The issuance of these warrants also resulted ina beneficial conversion feature to the Series 3 5% preferred stock valued at$0.5 million. In accordance with EITF 98-5, the beneficial conversion featurewas fully amortized on the grant date, as the preferred stock does not have astated maturity and is immediately convertible into common stock. Thisbeneficial conversion feature is included in the net loss attributed to commonstockholders. In connection with the closing of this private placement, weissued warrants to purchase 27,531 shares of our common stock at an exerciseprice of $2.58 per share to an affiliate of our financial advisor forassistance with the private placement. These warrants were valued at $37,000using the Black-Scholes model and have been recorded as a reduction to theSeries 3 5% preferred stock and an increase to additional paid-in capital.

 

The Series 3 5% preferred stock was recordedas the net of the proceeds of $1.2 million less $100,000 issuance costs and thefair value of the warrants issued in conjunction with the Series 3 5% preferredstock 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 but unpaid dividends onthe Series 3 5% preferred stock plus (3) all liquidated damages or otheramounts payable to the holders of Series 3 5% preferred stock.

 

At December 31, 2005 there are 564,607shares of Series 3 5% preferred stock outstanding.

 

**9. Segments, Major Customers and GeographicInformation**

 

Our operations are concentrated in onearea—security software and appliances. Sales to the U.S. Government throughdirect and indirect channels totaled 70.7% of total revenues for 2005 and 53.6%of total revenues for 2004. During 2005 approximately 59.7% of total revenuesare attributable to three government customers. During 2004 approximately 44.7%of total revenues are attributable to three government customers. There were noindividual commercial customers in 2005 or 2004 that exceeded 10% of totalrevenues for that year. Our similar product and service offerings are notviewed as individual segments, as our management analyzes the business as awhole and expenses are not allocated to each product offering.

 

Export sales (based on our customerslocation), primarily to Europe, Asia, Latin America and Canada, were$0.6 million in 2005 and $1.2 million in 2004. No significantlong-lived assets are deployed outside of the United States. Our foreignoperations act only as sales support offices in those regions.

 

**10. Subsequent Events**

 

On March 29, 2006, we established a $1,000,000 line of credit withSilicon Valley Bank. Under the terms of this agreement, we may borrow an amountequal up to 80% of eligible accounts receivable 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 will increase to $2,000,000 upon achievingtwo consecutive quarters of $200,000 in positive EBITDA. If the 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. Amounts weborrow under the credit line accrue interest at an annual rate of prime plus 1%and are secured by a lien on all of our assets. Accrued interest on alloutstanding amounts is payable monthly in arrears and all outstanding principaland accrued but unpaid interest on the amounts we borrow are due on March 28,2007.

 

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