Tableof Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

----

 

##### **FORM 10-K**

 
| **(Mark One)**                                                                                                 | ** **                                                                                               |
|----------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------|
| **x**                                                                                                          | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**     |
| ** **                                                                                                     | ** **                                                                                               |
| **FOR THE  FISCAL YEAR ENDED DECEMBER 31, 2008**                                                          |
| ** **                                                                                                     | ** **                                                                                               |
| **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**

 

----

 

**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, SUITE 200  RICHARDSON, TEXAS**        | ** ** | **75081**                             |
| (Address of principal  executive offices)                        |       | (Zip Code)                            |

 

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

 

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

 

Securities registered pursuant to Section 12(g) ofthe Act:

**CommonStock, $0.01 par value**

(Title of class)

 

----

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o No x

 

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or 15(d) of theExchange Act.

Yes o No x

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the past 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.                                                                                  Yes x No o

 

Indicate by check mark if disclosure of delinquentfilers in response to Item 405 of Regulation S-K is not contained herein,and will not be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K.                                                        Yes x No o

 

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

 
|   | Large  Accelerated Filer o                | Accelerated Filer o    |
|--------|------------------------------------------------|-----------------------------|
|   |                                           |                        |
|   | Non-Accelerated  Filer o                       | Smaller reporting company x |
|   | (Do not check if a smaller  reporting company) |                        |

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

 

State the issuer’s revenues for its most recentfiscal year:  $4,139,529.

 

State the aggregate market value of the voting andnon-voting equity held by non-affiliates computed by reference to the price atwhich the common equity was sold, or the average bid and asked price of suchcommon equity, as of June 30, 2008:  $1,477,624.

 

As of March 20, 2009, 11,638,405 shares of theissuer’s Common Stock were outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the Registrant’s definitive ProxyStatement filed in connection with the Registrant’s 2009 Annual Meeting ofStockholders are incorporated by reference into Part III of this Form 10-K.

 

 

 

----

Tableof Contents

 

**INTRUSION INC.**

**INDEX**

** **
| **PART I**   |                                                                                                               |   |
|-------------------|--------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.           | Business                                                                                                           | 3      |
| Item 1A.          | Risk Factors                                                                                                       | 11     |
| Item 2.           | Properties                                                                                                         | 19     |
| Item 3.           | Legal Proceedings                                                                                                  | 19     |
| Item 4.           | Submission of Matters to a Vote of Security  Holders                                                               | 19     |
| **PART II**  |                                                                                                               |   |
| Item 5.           | Market for Registrant’s Common Equity,  Related Stockholder Matters and Issuer Purchases of Equity Securities | 20     |
| Item 7.           | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                        | 21     |
| Item 8.           | Financial Statements and Supplementary Data                                                                        | 27     |
| Item 9.           | Changes In and Disagreements with  Accountants on Accounting and Financial Disclosure                              | 27     |
| Item 9A(T)        | Controls and Procedures                                                                                            | 28     |
| Item 9B.          | Other Information                                                                                                  | 28     |
| **PART III** |                                                                                                               |   |
| Item 10.          | Directors, Executive Officers and Corporate  Governance                                                            | 28     |
| Item 11.          | Executive Compensation                                                                                             | 28     |
| Item 12.          | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                    | 28     |
| Item 13.          | Certain Relationships and Related  Transactions, and Director Independence                                         | 28     |
| Item 14.          | Principal Accountant Fees and Services                                                                             | 29     |
| **PART IV**  |                                                                                                               |   |
| Item 15.          | Exhibits                                                                                                           | 29     |
| Signatures        |                                                                                                               | 32     |

 

2

----

Tableof Contents

 

**PART I**

 

**Item 1.          Description of Business.**

** **

In addition to the historical informationcontained herein, the discussion in this Form 10-K 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 and strategicfocus;

·                                          new products and product enhancements;

·                                          potential acquisitions and theintegration of acquired businesses, products and technologies;

·                                          strategic relationships and futureeconomic and business conditions.

·                                          The cautionary statements made in this Form 10-Kshould be read as being applicable to all related forward-looking statementswhenever they appear in this Form 10-K. Our actual results could differmaterially from the results discussed in the forward-looking statements.Factors that could cause or contribute to such differences include, but are notlimited to, those discussed under the section captioned “Factors That May AffectFuture Results of Operations” in Item 1 of this Form 10-K as well as thosecautionary statements and other factors set forth elsewhere herein.

 

**General**

 

We develop, market and support a family of entityidentification, regulated information compliance, data privacy protection andnetwork intrusion prevention/detection products.  Our product families include:

 

·                                          TraceCop for identity discovery anddisclosure,

·                                          Compliance Commander for regulatedinformation and data privacy protection,

·                                          Intrusion SecureNet for network intrusionprevention and detection.

 

We market and distribute our products through adirect sales force to:

 

·                                          end-users,

·                                          distributors and system integrators,

·                                          managed service providers, and

·                                          value-added resellers.

 

Our end-user customers include:

 

·                                          banks,

·                                          credit unions,

·                                          other financial institutions,

·                                          U.S. federal government entities,

·                                          foreign government entities,

·                                          local government entities,

·                                          hospitals and other healthcare providers.

 

Essentially, our end-users can be defined as ‘any end-user requiringnetwork security solutions for protecting their mission critical data’.

 

We were organized in Texas in September 1983and reincorporated in Delaware in October 1995. For more than15 years, we provided local area networking equipment and were known asOptical Data Systems or ODS Networks. On April 17, 2000, we announcedplans to sell, or otherwise dispose of, our networking divisions, whichincluded our Essential Communications division and our local area networkingassets. On June 1, 2000, we changed our name from ODS Networks, Inc.to Intrusion.com, Inc., and our ticker symbol from ODSI to INTZ to reflectour focus on intrusion prevention and detection solutions, along withinformation compliance and data privacy protection products. On November 1,2001, we changed our name from Intrusion.com, Inc. to Intrusion Inc.

 

3

----

Table of Contents

 

Our principal executive offices are locatedat 1101 East Arapaho Road, Suite 200, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400. Our website URL is www.intrusion.com. References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries. Compliance CommanderTM, SecureNetTM and TraceCopTM are 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) reversestock split of our common stock.  Thereverse stock 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.

 

On March 28, 2005, we completed a privateplacement of 1,065,200 shares of our Series 2 5% Convertible PreferredStock and warrants to purchase 532,600 shares of our common stock for grossproceeds of $2,663,000.  The preferredshares may be converted into 1,065,200 shares of common stock at an initialconversion price of $2.50 per share, and the warrants may be exercised at aprice of $2.77 per share during the five-year period commencing on September 28,2005.  In connection with theclosing of this private placement, we issued warrants to purchase 60,390 sharesof our common stock at an exercise price of $2.77 per share to employees of ourfinancial advisor 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 $0.40 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 entered into a Loan andSecurity Agreement (the “Loan Agreement”) with Silicon Valley Bank (“SVB”) toestablish a $1.0 million line of credit with SVB (the “2006 Credit Line”).  On June 30, 2008, we entered into anAmended and Restated Loan and Security Agreement (the “Amended and RestatedLoan Agreement”) with SVB to, among other things, replace the 2006 Credit Linewith a new $2.5 million line of credit (the “Current Line of Credit”).  Our obligations under the Amended andRestated Loan Agreement are secured by substantially all of our assets,including all of our intellectual property. Borrowings under the Current Line of Credit are based on advances (each,an “Advance”) against certain of our accounts receivable that are approved bySVB (each an “Eligible Account”).  SVBmay make an Advance of up to eighty percent (80%) of each Eligible Account, orsuch other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance chargecalculated as a daily rate that is based on a 360-day annual rate of (a) thegreater of the prime rate or 5.25%, plus (b) 1.5% or 2.0%, depending oncertain qualifying financial factors specified in the Amended and Restated LoanAgreement.  Finance charges are payableat the same time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.25% or 0.5% of all outstanding Advances, depending on certain qualifyingfinancial factors specified in the Amended and Restated Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Amended and Restated LoanAgreement, or (c) the date on which any “Adjustment” (as defined in theAmended and Restated Loan Agreement) is asserted to the Eligible Account.  On June 29, 2009, the Amended andRestated Loan Agreement terminates and all outstanding advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Amended and Restated Loan Agreement and relateddocuments.  We have no borrowingsoutstanding under the Current Line of Credit as of December 31, 2008 andhad borrowings available of $48,000.

 

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

 

On June 27, 2007, we completed a privateplacement of 1,111,111 shares of our Common Stock for gross proceeds of$500,000.

 

4

----

Tableof Contents

 

On September 26, 2007, we completed aprivate placement of 1,190,476 shares of our Common Stock for gross proceeds of$500,000.

 

On January 30, 2008, and extended on October 24,2008 and March 19, 2009, the Company entered into a revolving promissorynote to borrow up to $700,000 from G. Ward Paxton, the Company’s Chairman,President and Chief Executive Officer through March 2010.

 

On March 20, 2008 and extended on November 7, 2008, wereceived a written commitment from our Chief Executive Officer to investup to an additional $1,500,000 in the Company until March 31, 2010, shouldsuch funding be required by the Company, on terms and conditions yet to bedetermined.

 

**Government Sales**

 

Sales to U.S. government customers accountedfor 86.2% of our revenues for the year ended December 31, 2008, comparedto 73.2% of our revenue in 2007.  Weexpect to continue to derive a substantial portion of our revenues from salesto governmental entities in the future as we continue to market our entityidentification products, our regulated compliance and data leakage preventionproducts and our network intrusion prevention products to the government.  Sales to the government presents risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including potential disruption due toirregularities in or interruptions to appropriation and spending patterns,delays in approving a federal budget and the government’s reservation of theright to cancel contracts and purchase orders for its convenience.

 

Generally, we make our sales under purchaseorders and contracts.  Our customers,including government customers, may cancel their orders or contracts withlittle or no prior notice and without penalty. Although we transact business with various government entities, webelieve that the cancellation of any particular order in itself could have amaterial effect on our financial results. However, because we derive and expect to continue to derive a substantialportion of our revenue from sales to government entities, a large number ofcancelled or renegotiated government orders or contracts could have a materialadverse effect on our financial results. Currently, we are not aware of any proposed cancellation orrenegotiation of any of our existing arrangements with government entities,and, historically, government entities have not cancelled or renegotiatedorders which had a material adverse effect on our business.

 

**Industry Background**

 

With the Internet becoming a virtual businessnecessity over the last decade, the network security technology that was oncedeployed only by the government and the most sophisticated or securityconscious of companies is now employed by businesses of all sizes as a criticalcomponent of all mission critical systems. Today, email, instant messengers,World Wide Web access, web sites, web-based applications and e-commerce areintegral components of communications and operations for business as well asgovernment, and the protection of the information communicated through orstored in these applications is crucial. Although the Internet has manybusiness advantages, its openness and accessibility makes it a potential threatto the networks and systems that are attached to it. Computer hackers, curiousor disgruntled employees, competitors, or even employees who might make themost innocent of mistakes may compromise or destroy information assets ordisrupt the normal operations and jeopardize the brand equity of the enterprise.In addition, new regulations and mandates by the government to protectPersonally Identifiable Information (PII) have made it imperative thatcompanies have real-time data security products and processes in place.

 

As a result, enterprises are adopting avariety of security solutions to meet the challenge posed by external andinternal threats. To be effective in securing its data, organizations requireenterprise-wide information risk management solutions that are broadly deployedand centrally managed. It is our belief that securing the enterprise networkrequires the  key elements of control andvisibility.  We see these as embodyingthe following:

 

·                                          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 primaryelements of network security within a single product for overall networksecurity and for the protection of specific classified, confidential orcustomer information assets.

 

5

----

Tableof Contents

 

**Products**

 

*TheProvider Management System.*

 

The Intrusion TraceCop, Compliance Commanderand SecureNet systems can operate standalone or with our Provider ManagementSystem.

 

 “Sensors”are appliances or software components that are connected to the network andmonitor the traffic searching for matches to signatures or database informationas evidence of an external or internal network attack or malicious use thatcould threaten information assets.

 

“Signatures” are patterns, anomalies andtraffic flows that match known attacks or indicate suspicious activities.

 

The Provider Management System controls theSensors and displays events produced by the Sensors.  When the Sensor matches traffic to a specific“Signature” or customer defined database record it will detect, protect, block(if desired) and report to the Provider Management System.

 

The Intrusion Provider Management System is athree-tier enterprise management and monitoring system. The Provider ManagementSystem is designed for enterprise deployments with no license limitationsplaced on architecture, which frees the enterprise to build the requiredmanagement system for its individual specifications. The Provider ManagementSystem follows the workflow of the security analyst with a highly productiveenvironment for response, research, resolution and decision support. TheProvider Management System suite includes applications for event monitoring, policy creation and tuningand centralized software deployment — making up the complete suite of toolsrequired to manage and monitor a SecureNet or Compliance Commander system fromone Sensor to more than 100 Sensors.

 

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

 

Our systems are “plug-and-protect”****and can be connected to a network without interfering withthe network operations by using the Intrusion Passive and Inline taps**.**

 

# *Intrusion Compliance CommanderProducts*

# * *

Compliance Commander Products provideprotection against the loss and misuse of customer data, which can beespecially important if such data is subject to regulation, is classified or isotherwise commercially sensitive data. Loss of information assets that contain customer data has spawned amultitude of federal and state legislation to set a standard of care, use andprotection for customer information, including, the Health InsurancePortability and Accountability Act of 1996 (“HIPAA), the Gramm-Leach-Bliley Act(the “GLBA”), the GLBA’s equivalent in the United Kingdom, the “Privacy Act of1998”, and California SB 1386.  If aperson or business is subject to these or other regulations regarding thesafe-guarding of information, then they are likely under pressure to becompliant with such regulations and laws within whatever regulatory complianceguidelines may apply to their particular situation.  In addition to strict regulatory compliance,no governmental, commercial, or private organization wants to be the next “poster-child”for what could have, should have or would have been a preventable  information breach which results in the mis-appropriation of, or loss of,  classified information, commerciallysensitive data, or personally identifiable information.

 

Our Intrusion Compliance Commander productsleverage the same Management systems as SecureNet NIP&DS products.  Our Compliance Commander products arecurrently designed to provide security for the confidential information andproprietary data in the following industries and customers:

 

·                                          healthcarecompanies who are working to comply with HIPAA, including healthcare providers,insurance companies and medical equipment manufacturers, and

 

·                                          financialinstitutions and e-commerce enterprises working to comply with the customerconfidentiality provisions of GLBA and California’s SB 1386.

 

6

----

Tableof Contents

 

Our Compliance Commander products provideaccuracy through our Dynamic Data Dictionary (D3) technology, which securelyconnects directly to the customer’s database housing the confidential,classified, or regulated information. Our Compliance Commander products arekept up-to-date with the database to match network traffic to the informationthat is resident in the database. This provides an automated accurate mechanismto identify leaks and misuse of information assets.  By using the customer’s own data, ourCompliance Commander products virtually eliminate any potential for falsepositives.  Our users not only benefitfrom the highly accurate data protection, but also quickly realize the low-costof ownership by the fully automated updating feature.

 

# *Intrusion SecureNetNetwork Intrusion Prevention/Detection System (“NIP/DS”) Products*

# * *

Webelieve a primary advantage of the SecureNet NIP/DS is that with a singlelicense purchase, our customers can choose to deploy the system for intrusionprevention (“IPS”) or intrusion detection (“IDS”), providing a superior levelof flexibility and simple migration from passive detection to active preventionwithout additional licensing cost.

 

Our NIP/DS product provides detection ofspecific exploit and misuse patterns in the traffic that the firewallallows.  NIP/DS product detects knownexploits and misuse patterns, suspicious activities and anomalous traffic orbehavior  within both inbound andoutbound traffic. This added visibility provides a checking mechanism for theefficacy of the firewall’s rule base.

 

Our NIP/DS product provides networkmonitoring and analysis functionality like IDS, with the added ability to blockmalicious network traffic. IPS actively regulates inbound and outbound trafficbased on specific user’s access while controlling what they can do with thataccess on a granular, per-conversation basis.

 

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

 

Our SecureNet Sensors have their own web browser interface forsimplified configuration.  SecureNetSensors also deliver complete, stand-alone NIP/DS products for the small andmedium sized business with the capacity for local management and monitoring.This configuration allows customers to use their standard web browser to accessa full power, full-featured NIP/DS product, without additional hardware orsoftware configuration time or expense.

 

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

 

# *Intrusion TraceCopProducts*

# * *

Our TraceCop product assists in 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 any ofthese third-party relationships to be material and we do not expect the salesfrom these relationships to be material because these product offerings areonly complementary to our existing product offerings.

 

**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.

 

7

----

Tableof Contents

 

**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 marketingTraceCop, Compliance Commander and SecureNet products to meet emerging marketrequirements and are continuously engaged in testing to ensure that our productsinteroperate with other manufacturers’ products, which comply with industrystandards.

 

During 2008 and 2007, our research anddevelopment expenditures were $1.1 million and $1.7 million, respectively. Allof our expenditures for research and development have been expensed asincurred.  At December 31, 2008, wehad 6 employees engaged in research and product development.

 

**Manufacturing and Supplies**

 

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

 

The hardware we sell are standardoff-the-shelf products, which we OEM or resell from our suppliers.

 

**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 orsuperior to 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**

 

***    Field Sales Force.***  Our direct sales organization focuses onmajor account sales, channel partners including distributors, Value AddedResellers (VARs) and integrators; promotes our products to current andpotential customers; and monitors evolving customer requirements. The fieldsales and technical support force provides training and technical support toour resellers and end users and assists our customers in designing secure datanetworking solutions.  We currentlyconduct sales and marketing efforts from our principal office in Richardson(Dallas), Texas.  In addition, we havesales personnel, sales engineers or sales representatives located inCalifornia, Europe and Asia.

 

***    Distributors.***  We have signed distribution agreements withdistributors in the United States, Europe and Asia. In general, theserelationships are non-exclusive.

 

***    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 andtechnical support organization provide support to these resellers. Ouragreements with resellers are non-exclusive, and our resellers generally sellother products that may compete with our products. Resellers may place higherpriority on products of other suppliers who are larger than and have more namerecognition than us, and there can be no assurance that resellers will continueto sell and support our products.

 

8

----

Tableof Contents

 

***    Foreign Sales.***  We believe that rapidly evolvinginternational markets are important sources of future net sales. Our exportsales are currently being made through an indirect sales force comprised ofinternational resellers in Europe and Asia. Export sales accounted for approximately 4.7% and 9.2% of total revenuein 2008 and 2007, respectively.  See “Management’sDiscussion and Analysis of Financial Conditions and Results of Operations”included in this report for a geographic breakdown of our revenue in 2008 and2007. Sales to foreign customers and resellers generally have been made inUnited 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 banks, creditunions, other financial institutions, U.S. federal government entities, foreigngovernment entities, hospitals and other healthcare providers.  Essentially, our customers include any entityrequiring network security solutions for protecting their mission criticaldata.  Sales to certain customers andgroups of customers can be impacted by seasonal capital expenditure approvalcycles, and sales to customers within certain geographic regions can be subjectto 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 2008, 86.2%of our revenue was derived from a variety of U.S. government entities throughdirect sales and indirectly through system integrators and resellers.  In 2008, 73.1% of our total revenues areattributable to two U.S. Government customers. Comparatively, sales to the U.S. Government through direct and indirectchannels totaled 73.2% of total revenues for 2007 and 66.5% of our totalrevenues in 2007 were attributable to two customers, one of which exceeded 10%of our total revenues individually.  Areduction in our sales to U.S. government entities could have a materialadverse effect on our business and operating results 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 or contract inventory basedupon our forecast of customer demand and maintain inventories in advance ofreceiving firm orders from customers. Commercial orders are generally fulfilledwithin two days to two weeks following receipt of an order. Certain governmentorders may be scheduled over several months, generally not exceeding one year.

 

***    Customer Support, 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.

 

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 performance characteristics.Industry suppliers compete in areas such as conformity to existing and emergingindustry standards, interoperability with networking and other securityproducts, management and security capabilities, performance, price, ease ofuse, scalability, reliability, flexibility, product features and technicalsupport.

 

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.(IBM), Cisco Systems, Inc., Symantec, Inc.,Netscreen  (Juniper Networks, Inc.),McAfee Inc., Tipping Point Technologies, a division of 3Com Corporation, andNFR Security (Checkpoint).  Ourcompetitors in the regulated information compliance market include Vontu(Symantec), Port Authority (Websense), Vericept, Reconnex (McAfee Inc.), Tablus(RSA Security) and a small number of start-up companies that entered the spacewithin the last two years.

 

9

----

Tableof Contents

 

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, 2008, we employed atotal of 26 persons, including 8 in sales, marketing and technical support, 14in research product development and engineering, and 4 in administration andfinance.

 

None ofour employees are represented by a labor organization, and we are not a partyto any collective bargaining agreement. We have not experienced any work stoppages andconsider 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.

 

10

----

Tableof Contents

 

**Item 1A. Risk Factors**

 

In addition to the other information in this Form 10-K,the following factors should be considered in evaluating Intrusion Inc.and our business.

 

***Our cash, cashequivalents, and investments increased from $0.4 million at December 31,2007 to $0.6 million at December 31, 2008. We may not have sufficient cash to operate our business and may not beable to maintain certain liquidity requirements under our existing debtinstruments.  Additional debt and equityofferings to fund future operations may not be available and, if available, maysignificantly dilute the value of our currently outstanding common stock.***

 

As of December 31, 2008, we had cash and cash equivalents ofapproximately $554,000, up from approximately $362,000 as of December 31,2007.  Although we generated net incomeof $67,000 in the last three quarters of 2008, we had a net loss for the yearended December 31, 2008 of $808,000. We used $112,000 of cash in operations in 2008 and operating cashoutflows may continue in 2009.  We areobligated to make payments of accrued dividends on all our outstanding sharesof preferred stock that will reduce our available cash resources.   As of December 31, 2008, we had cashand cash equivalents of $554,000, $48,000 in funding available under our lineof credit at Silicon Valley Bank and $1.5 million funding available from awritten commitment to invest up to $1.5 million from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Based on projections for continuedgrowth in revenue and net income in the coming quarters, a commitment from theCompany’s CEO to advance the Company up to an additional $1.5 million in fundingshould it be necessary and $2.5 million line of credit with borrowingsavailable of $48,000 at December 31, 2008, we believe that our availablecredit line and available cash resources will provide sufficient cash resourcesto finance our operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we are ableto obtain, will have the effect of diluting our existing common stockholders,perhaps significantly.  Any equity ordebt financings, if available at all, may be on terms which are not favorableto us and, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in theupcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

***We had a net loss of $0.8million for the year ended December 31, 2008 and have an accumulateddeficit of $58.3 million as of December 31, 2008.  To achieve profitability, we must continue togenerate greater revenue levels.***

 

Weincurred operating losses for the fiscal year ended December 31, 2008 andhave incurred even greater operating losses in previous years.  For the year ended December 31, 2008, weincurred a net loss of $0.8 million and had an accumulated deficit ofapproximately $58.3 million as of December 31, 2008, compared to a netloss of $2.4 million and an accumulated deficit of approximately $57.5 millionas of December 31, 2007. ** **We need to generate and sustainsubstantially greater revenues from the sales of our products if we are toachieve profitability.  If we are unableto achieve these greater revenues, our losses will continue for the near termand possibly longer, and we may never achieve or sustain profitability orgenerate positive cash flow from operations.

 

***If our newer products donot achieve market acceptance, our revenue growth may suffer.***

 

Our newnetwork security products, entity identification products and regulatedinformation compliance systems have only been in the market place for a limitedperiod of time and may have longer sales cycles than our previousproducts.  Accordingly, we may notachieve the meaningful revenue growth needed to sustain operations.  We can provide no assurances that sales ofour newer products will continue to grow or generate sufficient revenues tosustain our business.  If we are unableto recognize revenues due to longer sales cycles or other problems, our resultsof operations will be adversely affected, perhaps materially.

 

We havenot yet received broad market acceptance for our newer products.  We cannot assure you that our present orfuture products will achieve market acceptance on a sustained basis.  In order to achieve market acceptance andachieve future revenue growth, we must introduce complementary securityproducts, incorporate new technologies into our existing product lines anddesign, develop and successfully commercialize higher performance products in atimely manner.  We cannot assure you thatwe will be able to offer new or complementary products that gain marketacceptance quickly enough to avoid decreased revenues during current or futureproduct introductions or transitions.

 

11

----

Tableof Contents

 

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

 

A large percentage of our revenuesresult from sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the years ended December 31,2006, 2007****and 2008, sales to U.S.government entities collectively accounted for 73.6%, 73.2% and 86.2% of ourtotal net revenues, respectively. The loss of any of these key relationshipsmay send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering.  We cannot assure you that U.S. governmententitieswill be customers of ours in future periods or that we will be able todiversify our customer portfolio to adequately mitigate the risk of loss of anyof these customers.

 

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

 

We expectto continue to derive a substantial portion of our revenues from 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 regulationswith which we must comply and which can vary significantly amongdepartments.  As a result, cutbacks orre-allocations in the federal budget or losses of government sales due to otherfactors could have a material adverse effect on our revenues and operatingresults.

 

***We are highly dependent onsales made through indirect channels, the loss of which would materiallyadversely affect our operations.***

 

For theyears ended December 31, 2006, 2007 and 2008, we derived 17.3%, 19.2% and33.9% of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We must expand our sales through these indirect channels in order toincrease our revenues.  We cannot assureyou that our products will gain market acceptance in these indirect saleschannels or that sales through these indirect sales channels will increase ourrevenues.  Further, many of ourcompetitors are also trying to sell their products through these indirect saleschannels, which could result in lower prices and reduced profit margins forsales of our products.

 

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

 

Revenuesfrom foreign customers for the fiscal years ended December 31, 2006, 2007and 2008 accounted for approximately 9.4%, 9.2% and 4.7%, respectively, of ourrevenues.  We expect sales to foreigncustomers to continue to represent a significant portion of our revenues in thefuture.  Our international operations aresubject to many inherent risks that may adversely affect our business,financial condition and operating results, including:

 

·              political,social and economic instability;

 

·              traderestrictions;

 

·              increasesin duty rates and other potentially adverse tax consequences;

 

·              exposureto different legal standards, particularly with respect to the protection ofintellectual property;

 

·              burdensof complying with a variety of foreign laws;

 

·              unexpectedchanges in regulatory requirements;

 

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

 

·              fluctuationsin currency exchange rates; and

 

12

----

Table of Contents

 

·              changesin local purchasing practices, including seasonal fluctuations in demand.

 

Any interruptions or declines inour international sales would result in a significant adverse impact on ourresults of operations and business.

 

***The payment of accrued dividends on ourpreferred stock may strain our cash resources.***

 

On March 25, 2004, we completed a $5,000,000private placement pursuant to which we issued 1,000,000 shares of our 5%Convertible Preferred Stock (the “Series 1 Preferred Stock”) and warrantsto acquire 556,619 shares of our common stock. The conversion price for the Series 1 Preferred Stock and theexercise price of the warrants is $3.144 per share.  As of February 28, 2009, there were259,696 shares of the Series 1 Preferred Stock outstanding, representingapproximately 413,003 shares of common stock upon conversion.

 

On March 28, 2005, we completed a $2,663,000private placement pursuant to which we issued 1,065,200 shares of our Series 25% Convertible Preferred Stock (the “Series 2 Preferred Stock”) andwarrants to acquire 532,600 shares of our common stock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of February 28,2009, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

On December 2, 2005, we completed a$1,230,843 private placement pursuant to which we issued 564,607 shares of our Series 35% preferred stock  (the “Series 3Preferred Stock”) and warrants to acquire 282,306 shares of our commonstock.  The preferred shares may beconverted into 564,607 shares of common stock at an initial conversion price of$2.18 per share, and the warrants may be exercised at a price of $0.40 pershare during the five-year period commencing on June 2, 2006.  As of February 28, 2009, there were354,056 shares of Series 3 Preferred Stock outstanding, representing354,056 shares of common stock upon conversion.

 

***We have been unable to pay scheduled dividends on shares of ourpreferred stock, and the continued failure to make such payments has resultedin late penalty payments and could potentially result in additionalconsequences, some of them material.***

 

During the fiscal year ended December 31, 2008,we accrued $64,000 in dividends to the holders of our 5% Preferred Stock,$57,000 in dividends to the holders of our Series 2 5% Preferred Stock and$40,000 in dividends to the holders of our Series 3 5% PreferredStock.  At December 31, 2008, wehave dividends accrued of $82,000 related to our 5% Preferred Stock, $63,000related to our Series 2 5% Preferred Stock and $43,000 related to our Series 35% Preferred Stock.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and as of theyear ended December 31, 2008, did not have sufficient capital surplus,defined as the amount by which our net assets exceed our stated capital, basedon par value of our outstanding shares as provided by Delaware law.  We cannot assure you that our net assets willexceed our stated capital or that we will have net profits in order to paythese dividends in the future.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  Our CEO and outsideboard member that are invested in Series 2 and Series 3 PreferredStock have waived the late fee penalty. In addition to this late penalty, the holders of our Series 2Preferred Stock and Series 3 Preferred Stock could elect to present uswith written notice of our failure to pay dividends as scheduled, in which casewe would have 45 days to cure such a breach. In the event that we failed to cure the breach, the holders of theseshares of preferred stock would then have the right to require us to redeemtheir shares of preferred stock for a cash amount calculated in accordance withtheir respective certificates of designation. If we were required to redeem all shares of Series 2 PreferredStock and Series 3 Preferred Stock as of February 28, 2009, theaggregate redemption price we would owe would be $2.0 million.

 

***You will experiencesubstantial dilution upon the conversion or redemption of the shares ofpreferred stock and the exercise of warrants that we issued in our recentprivate placements or in the event we raise additional funds through theissuance of new shares of our common stock or securities convertible orexercisable into shares of common stock.***

 

On March 13, 2009, we had 11,638,405 shares ofcommon stock outstanding.  Uponconversion of all outstanding shares of our preferred stock and exercise of thewarrants, we will have 14,389,318 shares of common stock outstanding,approximately a 25.0% increase in the number of shares of our common stockoutstanding.

 

13

----

Tableof Contents

 

Further, the occurrence of certain events could entitleholders of our Series 2 Preferred Stock and Series 3 Preferred Stockto require us to redeem their shares for a certain number of shares of ourcommon stock.  Assuming (i) we havepaid all liquidated damages and other amounts to the holders, (ii) incurredaccrued but unpaid dividends on February 28, 2009 of $120,600, (iii) avolume weighted average price of $0.30, which was the ten-day volume weightedaverage closing price of our common stock on February 28, 2009, and (iv) our11,638,405shares of common stock outstanding on February 28,2009, upon exercise of their redemption right by the holders of the Series 3Preferred Stock and the Series 2 Preferred Stock, we would be obligated toissue approximately 11,639,990 shares of our common stock.  This would represent an increase of approximately100.0% in the number of shares of our common stock as of February 28,2009.

 

In addition, management may issue additional shares ofcommon stock or securities exercisable or convertible into shares of commonstock in order to finance our continuing operations.  Any future issuances of such securities wouldhave additional dilutive effects on the existing holders of our Common Stock.

 

***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 andwarrants we issued in connection with the sale of our 5% Preferred Stock mayfreely convert their shares of preferred stock and exercise their warrants andsell the underlying shares of common stock pursuant to Rule 144 of theSecurities and Exchange Commission.  Asof February 28, 2009, 740,304 shares of our 5% Preferred Stock had converted into 1,177,327 shares of common stock.

 

Theholders of the shares of Series 2 5% Preferred Stock and warrants we issued in connection with the sale of our Series 2Preferred Stock may freely convert their shares of preferred stock and exercisetheir warrants and sell the underlying shares of common stock pursuant to Rule 144of the Securities and Exchange Commission. As of February 28, 2009, 605,200 shares of Series 2 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 in connection with the sale of our Series 3Preferred Stock, may freely convert their shares of Series 3 Preferred Stock and exercise their warrants and sell the underlying shares of commonstock pursuant to Rule 144 of the Securities and Exchange Commission.  As of February 28, 2009, 210,551 sharesof Series 3 Preferred Stock hadconverted into 210,551 shares of common stock.

 

For thefour weeks ended on February 28, 2009, the average daily trading volume ofour common stock on The OTCBB was 217 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity could cause a decline in the market price of our commonstock.  Furthermore, these sales, or thepotential for these sales, could encourage short sales, causing additionaldownward pressure on the market price of our common stock.

 

***Certain rights of the holders of our preferred stock and the terms ofour secured credit line may hinder our ability to raise additional financing.***

 

Under the terms of our preferred stock instruments,we cannot issue shares of capital stock with rights senior to those of ourexisting 5% Preferred Stock, Series 2 5% Preferred Stock or Series 35% Preferred Stock without the approval of at least a majority of the holdersof our 5% Preferred Stock, all of the holders of our Series 2 5% PreferredStock, and holders of at least 75% of our Series 3 5% Preferred Stock votingor acting as separate classes.  We alsocannot incur certain indebtedness without the approval of at least a majorityof the holders of each class of our Preferred Stock.  Furthermore, the terms of our secured creditline with Silicon Valley Bank include covenants which restrict our ability toincur additional debt and pay certain dividends.  The combination of these provisions couldhinder or delay our ability to raise additional debt or equity financing.

 

***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. We have alsoimplemented other strategic initiatives, such as reductions in our work forceand 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.

 

14

----

Tableof Contents

 

***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, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenuesgenerated from the sale of our network security products, which have receivedlimited market acceptance.  We haverecently introduced our regulated information compliance systems and entityidentification products, and the market for these products has only begun toemerge.  We can provide no assurancesthat our newly introduced products will ever achieve widespread marketacceptance or that an adequate market for these products will ever emerge.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

 

·                                          the need for our network securityproducts, regulated information compliance systems and entity identificationproducts to achieve market acceptance and produce a sustainable revenue stream;

 

·              ourability to manage costs and expenses;

 

·              ourdependence on key personnel;

 

·              ourability to obtain financing on acceptable terms; and

 

·              ourability to offer greater value than our competitors.

 

Our business strategy may notsuccessfully address these risks.  If wefail to recognize significant revenues from the sales of our network securityproducts, regulated information compliance systems and entity identificationproducts, our business, financial condition and operating results would bematerially adversely affected.

 

***Our management and larger stockholders exercisesignificant control over our company and have the ability to approve or takeactions that may be adverse to your interests.***

 

As of March 20,2009, our executive officers, directors and preferred stockholders beneficiallyown approximately 30.0% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we contemplate the possible issuanceof shares of our Common Stock or of securities exercisable or convertible intoshares of our Common Stock in the future by our Chief Executive Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management group beneficiallyholds.

 

***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 Security Systems, Inc.(IBM), Cisco Systems, Inc., Symantec, Inc., Juniper Networks, Inc.,McAfee Inc., Tipping Point Technologies, a division of 3Com Corporation, andNFR Security, Inc.  Our competitorsin the regulated information compliance market include Vontu (Symantec), PortAuthority (Websense), Vericept, Reconnex (McAfee Inc.), Tablus (RSA Security)and a small number of start-up companies that entered the space within the lasttwo years. Our current and potential competitors may have one or more of thefollowing significant advantages over us:

 

·              greaterfinancial, technical and marketing resources;

 

·              bettername recognition;

 

·              morecomprehensive security solutions;

 

15

----

Table of Contents

 

·              betteror more extensive cooperative relationships; and

 

·              largercustomer base.

 

We cannotassure you that we will be able to compete successfully with our existing ornew competitors.  Some of our competitorsmay have, in relation to us, one or more of the following: longer operatinghistories, longer-standing relationships with OEM and end-user customers andgreater customer service, public relations and other resources. As a result,these competitors may be able to more quickly develop or adapt to new oremerging technologies and changes in customer requirements, or devote greaterresources to the development, promotion and sale of their products.Additionally, it is likely that new competitors or alliances among existingcompetitors could emerge and rapidly acquire significant market share.

 

***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 products are highlytechnical and if they contain undetected errors, our business could beadversely affected and we might have to defend lawsuits or pay damages inconnection with any alleged or actual failure of our products and services.***

 

Our products are highly technical and complex, are critical to theoperation of many networks and, in the case of our security products, provideand monitor network security and may protect valuable information. Our productshave contained and may contain one or more undetected errors, defects orsecurity vulnerabilities. Some errors in our products may only be discoveredafter a product has been installed and used by end customers. Any errors orsecurity vulnerabilities discovered in our products after commercial releasecould result in loss of revenues or delay in revenue recognition, loss ofcustomers and increased service and warranty cost, any of which could adverselyaffect our business and results of operations. In addition, we could faceclaims for product liability, tort or breach of warranty. Defending a lawsuit,regardless of its merit, is costly and may divert management’s attention. Inaddition, if our business liability insurance coverage is inadequate or futurecoverage is unavailable on acceptable terms or at all, our financial conditioncould be harmed.

 

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

 

If an actual or perceived breach of network security occurs in the networkof a customer of our security products, regardless of whether the breach isattributable to our products, the market perception of the effectiveness of ourproducts could be harmed. This could cause us to lose current and potential endcustomers or cause us to lose current and potential value-added resellers anddistributors. Because the techniques used by computer hackers to access orsabotage networks change frequently and generally are not recognized untillaunched against a target, we may be unable to anticipate these techniques.

 

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

 

Our products are designed to interface with our customers’ existingnetworks, each of which have different specifications and utilize multipleprotocol standards and products from other vendors. Many of our customers’networks contain multiple generations of products that have been added overtime as these networks have grown and evolved. Our products will be required tointeroperate with many or all of the products within these networks as well asfuture products in 

 

16

----

Tableof Contents

 

order to meet our customers’ requirements. If we find errors in theexisting software or defects in the hardware used in our customers’ networks,we may have to modify our software or hardware to fix or overcome these errorsso that our products will interoperate and scale with the existing software andhardware, which could be costly and negatively impact our operating results. Inaddition, if our products do not interoperate with those of our customers’networks, demand for our products could be adversely affected, orders for ourproducts could be cancelled or our products could be returned. This could hurtour operating results, damage our reputation and seriously harm our businessand prospects.

 

***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 expendsignificant time and resources before we receive any revenues from a customeror potential customer.  Our quarterly andannual operating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

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

 

Severalof our competitors have acquired security companies with complementarytechnologies in the past.  We expect consolidationin 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.

 

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

 

We relyprimarily on a combination of 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.  Thirdparties may claim that our products infringe on their intellectual propertyrights.  Any claim, with or withoutmerit, could consume our management’s time, result in costly litigation, causedelays in sales or implementations of our products or require us to enter intoroyalty or licensing agreements. Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

 

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

 

Our operating results have variedsignificantly from quarter to quarter in the past, and we expect our operatingresults to vary from quarter to quarter in the future due to a variety offactors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond tounexpected decreases in revenues. Therefore, if revenues are below our expectations, this shortfall islikely to adversely and 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.

 

17

----

Tableof Contents

 

***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 2008, the market price of our common stockon The OTCBB Market fluctuated between $0.13 and $0.41 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:

 

·      variationsin our quarterly operating results;

 

·      changes inestimates of our financial performance by securities analysts;

 

·      changes inmarket valuations of our competitors;

 

·                  announcements by us or our competitors of newproducts, significant contracts, acquisitions, strategic relationships, jointventures or capital commitments;

 

·      product ordesign flaws, product recalls or similar occurrences;

 

·      additionsor departures of key personnel;

 

·      sales ofcommon stock in the future; and

 

·                  fluctuations in stock market prices and volume, whichcan be particularly common among network security and other high technologycompanies.

 

***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.

 

***Our acquisition of complementary products or businesses may adverselyaffect our financial condition.***

 

We have made acquisitions in thepast and, in the future we may acquire or invest in additional companies,business units, product lines or technologies to accelerate the development ofproducts and sales channels complementary to our existing products and saleschannels.  Negotiation of potentialacquisitions and integration of acquired products, technologies or businessescould divert our management’s time and resources.  Future acquisitions could cause us to issueequity securities that would dilute your ownership of us, incur debt orcontingent liabilities, amortize intangible assets or write off in-processresearch and development, goodwill and other acquisition-related expenses thatcould seriously harm our financial condition and operating results.  Further, if we are not able to properly integrateacquired products, technologies or businesses with our existing products andoperations, train, retain and motivate personnel from the acquired business orcombine potentially different corporate cultures, we may not receive theintended benefits of our acquisitions, which could adversely affect ourbusiness, operating results and financial 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

----

Tableof Contents

 

**Item 2.          Properties.**

** **

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 facility extends through February 2010.

 

Approximately thirty percent of our security software research anddevelopment staff is located in two separate small facilities in San Diego,California.  These leases are currentlyset to expire in March 2010. Research and development personnel occupy these facilities.

 

We believe that the existing facilities at December 31,2008 will be adequate to meet our requirements through 2010.  We believe that all facilities are adequatelycovered by appropriate property insurance. See Note 4 of Notes to Consolidated Financial Statements foradditional information regarding our obligations under leases.

 

**Item 3.          Legal Proceedings.**

** **

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

 

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

** **

There were no matters submitted to a vote ofour security holders during the fourth quarter of 2008.

 

19

----

Table of Contents

 

**PART II**

 

**Item 5.          Market for Common Equity and RelatedStockholder Matters and Business Issuer Purchases of Equity Securities.**

** **

Our common stock trades on The OTCBB, whereit is currently listed under the symbol “INTZ.” As of February 28, 2009, there were approximately 125 registeredholders of record of the common stock. The following table sets forth, for theperiods indicated, the high and low per share bid information for the commonstock, as reported by The OTCBB.  Thesequotations reflect inter-dealer prices, without retail mark-up, mark-down orcommission and may not represent actual transactions.

 
| ** **     | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|           |       |     |       |     |       |   |   |   |   |
| First Quarter  |       | $        | .22        |     | $          | .13 |   | $ | .75 |   | $ | .43 |   |
| Second Quarter |       | .24      |       | .14      |       | 52 |   | .37 |   |
| Third Quarter  |       | .41      |       | .17      |       | .43 |   | .35 |   |
| Fourth Quarter |       | .39      |       | .20      |       | .42 |   | .17 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

We have not declared or paid cash dividends on ourcommon stock in our two most recent fiscal years.  We intend to retain any earnings for use inour business and do not anticipate paying any cash dividends on our commonstock in the foreseeable future.  Futuredividends on common stock, if any, will be determined by our Board ofDirectors.  However, shares of our 5%convertible preferred stock accrue cash dividends equal to $0.25 per share perannum, payable in arrears on March 31 and September 30 of each year,and shares of our Series 2 5% and Series 3 5% convertible preferredstock accrue cash dividends equal to $0.125 per share per annum payable inarrears on the first business day of March, June, September and December ofeach year.  During the fiscal year ended December 31,2008, we accrued $64,000 in dividends to the holders of our 5% Preferred Stock,$57,000 in dividends to the holders of our Series 2 5% Preferred Stock and$40,000 in dividends to the holders of our Series 3 5% PreferredStock.  At December 31, 2008, wehave dividends accrued of $82,000 related to our 5% Preferred Stock, $63,000related to our Series 2 5% Preferred Stock and $43,000 related to our Series 35% Preferred Stock.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and as of theyear ended December 31, 2008, did not have sufficient capital surplus,defined as the amount by which our net assets exceed our stated capital, basedon par value of our outstanding shares as provided by Delaware law.  We cannot assure you that our net assets willexceed our stated capital or that we will have net profits in order to paythese dividends in the future.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends onour preferred stock, we began accruing an additional late fee penalty of 18%per annum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  In addition to thislate penalty, the holders of our Series 2 Preferred Stock and Series 3Preferred Stock could elect to present us with written notice of our failure topay dividends as scheduled, in which case we would have 45 days to cure such abreach.  In the event that we failed tocure the breach, the holders of these shares of preferred stock would then havethe right to require us to redeem their shares of preferred stock for a cashamount calculated in accordance with their respective certificates ofdesignation.  If we were required toredeem all shares of Series 2 Preferred Stock and Series 3 PreferredStock as of February 28, 2009, the aggregate redemption price we would owewould be $2.0 million.  The accrual ofthese dividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business. Furthermore, our inability to pay dividends could adversely affect ourability to raise equity financing in the future, if required.  The terms of our credit line with SiliconValley Bank also prohibit us from paying any dividends on our common stock.

 

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 of December 31,2008 for all of our equity compensation plans (in thousands, except per sharedata). See Note 9 to our consolidated financial statements for additionaldiscussion.

 

20

----

Table of Contents

 
| ** **                                                  | ** ** | **Number of shares of  common stock to be  issued upon exercise  of outstanding  options** | ** ** | **Weighted average  exercise price of  outstanding options.** | ** ** | **No. of shares of  common stock  remaining available  for future issuance  under equity  compensation plans.** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                        |       |                                                                                                                                    |       |                                                                              |       |                                                                                                                                                         |       |
| Equity compensation plans approved by  security holders     |       | 1,468                                                                                                                                   | (1)        | $                                                                                 | 1.66       |                                                                                                                                                         | 795.5      |   |
| Equity compensation plans not approved by  security holders |       | —                                                                                                                                  |       | —                                                                            |       | —                                                                                                                                                       |       |
| Total                                                       |       | 1,468                                                                                                                                   |       | $                                                                                 | 1.66       |                                                                                                                                                         | 795.5      |   |

 

----

(1)                                  Included in theoutstanding options are 1,204,500 from the 2005 Plan, 231,225 from the 1995Plan and 32,500 from the 1995 Non-Employee Director Plan.

 

**Item7.          Management’s Discussion andAnalysis of Financial Condition and Results of Operations.**

 

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

 

This Annual Report,including the sections entitled “Risk Factors,” “Management’s Discussion andAnalysis of Financial Condition and Results of Operations,” and “Description ofBusiness,” contains forward-looking statements. These statements relate to future events or to our future financialperformance, and involve known and unknown risks, uncertainties and otherfactors that may cause our actual results, levels of activity, performance, orachievements to be materially different from any future results, levels ofactivity, performance or achievements expressed or implied by theseforward-looking statements. In some cases, you can identify forward-lookingstatements by the use of words such as “may,” “could,” “expect,” “intend,” “plan,”“seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “continue,”or the negative of these terms or other comparable terminology.  You should not place undue reliance onforward-looking statements since they involve known and unknown risks,uncertainties and other factors which are, in some cases, beyond our controland which could materially affect actual results, levels of activity,performance or achievements.  Factorsthat may cause actual results to differ materially from current expectations,which we describe in more detail elsewhere in this prospectus under the heading“Risk Factors,” include, but are not limited to:

 

·                  failureto respond to rapid technological changes in the network security industry;

 

·                  failureof our network intrusion detection, regulated information compliance, andentity identification products to achieve market acceptance;

 

·                  ourstatus as a developmental stage company;

 

·                  our needto generate substantially greater revenues from sales in order to achieveprofitability;

 

·                  intensecompetition from both start-up and established companies that may havesignificant advantages over us and our products;

 

·                  disruptionto our business due to military actions;

 

·                  longsales and implementation cycles of our products;

 

·                  insufficientcash to operate our business;

 

·                  failureto realize the expected benefits of our recent restructuring efforts;

 

·                  theeffect of consolidation in the network security industry;

 

·                  risksinvolved with Government and international customers;

 

·                  ourinability to expand our sales;

 

21

----

Table of Contents

 

·                  failureto adequately protect our intellectual property; or

 

·                  therights of the holders of our preferred stock and the terms of our securedcredit line.

 

If one or more of these orother risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary significantly from what weprojected. Any forward-looking statement you read in this filing reflects ourcurrent views with respect to future events and is subject to these and otherrisks, uncertainties and assumptions relating to our operations, results ofoperations, growth strategy and liquidity. We assume no obligation to publiclyupdate or revise these forward-looking statements for any reason, or to updatethe reasons actual results could differ materially from those anticipated inthese forward-looking statements, even if new information becomes available inthe future. The Private Securities Litigation Reform Act of 1995 and Section 27Aof the Securities Act, each of which provide protection in connection withcertain forward-looking statements, do not directly protect any statements wemake in connection with this Annual Report.

 

**Overview**

 

We develop, market and support a family ofentity identification products, regulated information compliance and dataprivacy protection, and network intrusion prevention/detection products.  Our product families include:

 

·                                         TraceCop for identity identification;

·                                         Compliance Commander for regulatedinformation compliance and data privacy protection; and

·                                         Intrusion SecureNet for network intrusionprevention and detection.

 

Intrusion’s products help protect critical information assets byquickly detecting, protecting, analyzing and reporting attacks or misuse ofclassified, private and regulated information for government and enterprisenetworks.

 

Our revenues have decreased over the past fewyears due primarily to the change in our product focus from networking hardwareto network security software products with a corresponding decrease in oursales volume related to this change in our product mix.  To date, we have not encountered significantcompetition in the market that has caused us to decrease our sales prices whencompared to sales prices in previous years. To help counteract our declining revenues and bring our operations inline with our new strategic focus, we held our employee headcount approximatelyconstant in 2008.  At December 31,2007 we employed 27 employees and at December 31, 2008 we employed 26employees.  As a result of our migrationto software-based solutions, our margins have increased from 60.8% in 2007, to66.8% in 2008.  We have also restructuredour personnel and operations around the development and sale of our coresoftware products.  As a result of theseefforts, we believe we have reduced operating expenses to a level that willremain consistent going forward.

 

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 SecureNet products by generating additionalrevenues from sales of our entity identification software and regulatedinformation compliance products.  Inorder to obtain these sales, our products must gain acceptance in intenselycompetitive and emerging markets.  Webelieve our ability to introduce our TraceCop and Compliance Commander productsinto the marketplace in a timely manner and our efforts to maintain our reducedspending levels 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 the following critical accounting policies affect our moresignificant judgments and estimates used in the preparation of our consolidatedfinancial statements.

 

22

----

Table of Contents

 

*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 theextent that they do decline, our warranty reserve from current sales willdecrease.  To the extent that ourwarranty costs exceed our expectations, we will increase our warranty reserveto compensate for the additional expense expected to be incurred.  We review these estimates periodically anddetermine the appropriate reserve percentage. However, to date, warranty costs and sales returns have not beenmaterial.  Historically, our estimatesfor these items have not differed materially from actual results.  Significant or subjective estimatesassociated with our revenue recognition policy include our estimate of warrantycost and sales returns.

 

We recognize software revenue from 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 revenuefrom the licensing of our products is not recognized until all four of thefollowing criteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectability 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 thecontract period, which is generally one year.

 

We have signed distribution agreements withdistributors in the United States, Europe and Asia. In general, theserelationships are non-exclusive.

 

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.  To date,training and installation revenue has 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 the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances may be required.  Historically, our estimates for sales returnsand doubtful accounts have not differed materially from actual results.

 

*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.

 

23

----

Table of Contents

 

**Results of Operations**

 

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

 
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                        | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
|                                              |       |                                       |       |   |   |
| Net product revenue                               |       | 86.1                                       | %          | 80.2 | % |
| Net customer support and maintenance  revenue     |       | 13.9                                       |       | 19.8 |   |
| Total revenue                                     |       | 100.0                                      |       | 100.0 |   |
| Cost of product revenue                           |       | 32.6                                       |       | 37.2 |   |
| Cost of customer support and maintenance  revenue |       | 0.6                                        |       | 2.0 |   |
| Total cost of revenue                             |       | 33.2                                       |       | 39.2 |   |
| Gross profit                                      |       | 66.8                                       |       | 60.8 |   |
| Operating expenses:                               |       |                                       |       |   |   |
| Sales and marketing                               |       | 34.0                                       |       | 55.0 |   |
| Research and development                          |       | 27.4                                       |       | 47.2 |   |
| General and administrative                        |       | 23.4                                       |       | 26.4 |   |
| Operating loss                                    |       | (18.0                                      | )          | (68.4 | ) |
| Interest income (expense), net                    |       | (1.5                                       | )          | 0.2 |   |
| Loss from operations before income taxes          |       | (19.5                                      | )          | (68.2 | ) |
| Income tax provision                              |       | —                                     |       | — |   |
| Net loss                                          |       | (19.5                                      | )          | (68.2 | ) |
| Preferred stock dividends accrued                 |       | (3.9                                       | )          | (4.9 | ) |
| Net loss attributable to common  stockholders     |       | (23.4                                      | )%         | (73.1 | )% |

 
| ** **         | ** ** | **2008** | ** ** | **2007** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
|               |       |     |       |     |       |
| Domestic revenue   |       | 95.3     | %          | 90.8     | %          |
| Export revenue to: |       |     |       |     |       |
| Europe             |       | 4.2      |       | 8.2      |       |
| Asia               |       | 0.3      |       | 0.8      |       |
| Latin America      |       | 0.2      |       | 0.1      |       |
| Canada             |       | —   |       | 0.1      |       |
| Net revenue        |       | 100.0    | %          | 100.0    | %          |

 

**2008 compared with 2007**

 

***Net Revenue***

 

Total revenue increased to $4.1 millionin 2008 from $3.5 million in 2007.  Theincrease in revenue is related to increased sales from our TraceCop productlines.  Our customer support andmaintenance revenue decreased 14.3% from $0.7 million in 2007 to $0.6 millionin 2008.  This decline is mainly due tothe expiration of maintenance contracts related to our SecureNet productline.  In 2008, total revenues related toour SecureNet product line decreased 30.0% or $0.3 million from $1.0 million in2007 to $0.7 million in 2008, and our non-core product lines, including our PDSand SecureCom hardware products decreased 44.4% or $36 thousand from $81thousand in 2007 to $45 thousand in 2008. Our product revenues increased 28.6% from $2.8 million in 2007 to $3.6million in 2008.   We expect our productrevenues to increase in the future as the market acceptance of our ComplianceCommander and TraceCop product lines increase.

 

Export sales in 2008 decreased to$0.2 million, or 4.7% of net revenue, compared to $0.3 million, or9.2% of net revenue in 2007 primarily due our focus on domestic revenuesales.  As part of our headcountreductions, we have focused most of our sales personnel on the domesticmarket.  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.

 

24

----

Table of Contents

 

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 33% to $2.8 million in2008 from $2.1 million in 2007. As a percentage of net revenue, grossprofit increased from 60.8% in 2007 to 66.8% in 2008.  Gross profit on products increased from 53.7%in 2007 to 62.1% in 2008 due to the shift in a more profitable product mix,namely our software-based products.  Theincrease in gross profit during 2008 was due to revenue growth and product mixthat includes and increase in TraceCop sales with a decrease in SecureNetsales.  Gross profit on customer supportand maintenance increased from 89.6% in 2007 to 96.0% in 2008.  The increase in gross profit on customersupport and maintenance was reflected by eliminating our Supply Chaindepartment, one driver of that cost.   As we go forward, we expect our gross profit as a percentage of revenueto remain about the same as 2008 levels.

 

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 26.3%to $1.4 million in 2008 from $1.9 million in 2007, as we continued toreduce expenses to respond to current efforts to become profitable.  As a percentage of net revenue, sales andmarketing expenses decreased from 55.0% in 2007 to 34.0% in 2008. We expectsales and marketing expenses to decrease as a percentage of net revenues in2009 compared to 2008 as revenue increases.

 

***Research and Development***

 

Research and development expenses decreasedto $1.1 million, or 27.4% of net revenue, in 2008 compared to$1.7 million, or 47.2% of net revenue, in 2007.  Our research and development costs are expensedin the period in which they are incurred. We expect research and developmentexpenses to increase in 2009 compared to 2008. We expect research and development, as a percentage of net revenue todecrease in 2009 as revenue increases.

 

***General and Administrative***

 

General and administrative expenses remainedrelatively flat at $0.9 million, or 23.4% of net revenue in 2008 compared to$0.9 million or 26.4 % of net revenue in 2007 as a result of continuing to keepspending under control.  We expectgeneral and administration expenses to decrease as a percentage of net revenuein 2009 as revenue increases.

 

***Interest Income, Net***

 

Net interest income reflects a shift from $5thousand net income in 2007 to $62 thousand net expense in 2008. This isprimarily because of interest on the line of credit and officer loan debt and adecrease in average cash and interest-bearing investment balances. We expectnet interest income and expense to remain constant in 2009 compared to2008.  Net interest income will vary inthe future based on our cash flow and rate of return on investments.

 

***Income Taxes***

 

Our effective income tax rate was 0% in 2008and 2007 as valuation allowances have been recorded for the entire amount ofthe net deferred tax assets due to uncertainty of realization.

 

25

----

Table of Contents

 

**Liquidity and Capital Resources**

 

Our principal sources of liquidity at December 31,2008 were $0.6 million of cash and cash equivalents. As of December 31,2008, we do not hold investments with a stated maturity beyond one year.Working capital deficiency at December 31, 2008 was $(1.3) millioncompared to $(0.4) million at December 31, 2007.

 

Net cash used in operations in 2008 was $112thousand, primarily due to a net loss of $808 thousand for the year and thefollowing use of cash: a $191 thousand increase in accounts receivable, a $40thousand decrease in the provision for doubtful accounts, and a decrease inaccounts payable, accrued expenses and other current liabilities totaling $122thousand.  This was partially offset bythe following sources of cash and non-cash items: a $778 thousand increase indeferred revenue, a $127 thousand decrease in inventories, a $19 thousanddecrease in prepaid expenses and other assets, $75 thousand in stock-basedcompensation, and $50 thousand in depreciation expense.  Net cash used in operations in 2007 was$1.8 million, primarily due to a net loss of $2.4 million for the year andthe following uses of cash: a $410 thousand decrease in accounts payable andaccrued expenses, a $55 thousand reduction in deferred revenue and a $50thousand reduction in the allowance for doubtful accounts.   This was partially offset by the followingsources of cash and non-cash items: a $784 thousand decrease in accountsreceivable, a $63 thousand decrease in inventories, a $125 thousand decrease inprepaid expenses and other assets, $123 thousand in stock-based compensationand $56 thousand in depreciation expense. 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 2008was $76 thousand for net purchases of property and equipment. Net cash used ininvesting activities in 2007 was $39 thousand for net purchases of property andequipment.

 

Cash provided by financing activities in 2008 was$380 thousand, primarily consisting of net financing proceeds from a loan by anofficer of $480 thousand and a net reduction in the line of credit of $100thousand; compared to cash provided by financing activities in 2007 was $1.2million, primarily consisting of net financing proceeds from private placementsconsisting of the proceeds of $1.5 million, partially offset by payment ofdividends on preferred stock of $173 thousand, and a net reduction in the lineof credit of $100 thousand.

 

At December 31, 2008, we did not haveany material commitments for capital expenditures. Operating lease commitmentsof $0.5 million are detailed below. During 2008, we funded our operationsthrough the use of available cash, cash equivalents and investments, our lineof credit and loans from our Company’s CEO.

 

As of December 31, 2008, we had cash, cash equivalents andinvestments in the amount of approximately $0.6 million, up fromapproximately $0.4 million as of December 31, 2007.  Throughout 2008, we continued to reduceexpenses and realize the benefit of cost-cutting actions taken in previousyears.

 

On January 30, 2008, the Company entered into arevolving promissory note to borrow up to $700,000 from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.

 

On March 29, 2006, we entered into a Loan andSecurity Agreement (the “Loan Agreement”) with Silicon Valley Bank (“SVB”) toestablish a $1.0 million line of credit with SVB (the “2006 Credit Line”).  On June 30, 2008, we entered into anAmended and Restated Loan and Security Agreement (the “Amended and RestatedLoan Agreement”) with SVB to, among other things, replace the 2006 Credit Linewith a new $2.5 million line of credit (the “Current Line of Credit”).  Our obligations under the Amended andRestated Loan Agreement are secured by substantially all of our assets,including all of our intellectual property. Borrowings under the Current Line of Credit are based on advances (each,an “Advance”) against certain of our accounts receivable that are approved bySVB (each an “Eligible Account”).  SVBmay make an Advance of up to eighty percent (80%) of each Eligible Account, orsuch other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance chargecalculated as a daily rate that is based on a 360-day annual rate of (a) thegreater of the prime rate or 5.25%, plus (b) 1.5% or 2.0%, depending oncertain qualifying financial factors specified in the Amended and Restated LoanAgreement.  Finance charges are payableat the same time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.25% or 0.5% of all outstanding Advances, depending on certain qualifyingfinancial factors specified in the Amended and Restated Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Amended and Restated LoanAgreement, or (c) the date on which any “Adjustment” (as defined in theAmended and Restated Loan Agreement) is asserted to the Eligible Account.  On June 29, 2009, the Amended andRestated Loan Agreement terminates and all outstanding advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Amended and Restated Loan Agreement and 

 

26

----

Table of Contents

 

related documents.  We have noborrowings outstanding under the current Line of Credit as of December 31,2008 and had borrowings available of $48,000.

 

As of December 31, 2008, we had cash, cash equivalents andinvestments of approximately $554,000, up from approximately $362,000 as of December 31,2007.  Although we generated net incomeof $67,000 in the last three quarters of 2008, we had a net loss for the yearended December 31, 2008 of $808,000. We used $112,000 of cash in operations in 2008 and operating cashoutflows may continue in 2009.  We areobligated to make payments of accrued dividends on all our outstanding sharesof preferred stock that will reduce our available cash resources.   As of December 31, 2008, we had cashand cash equivalents of $554,000, $48,000 in funding available under our lineof credit at Silicon Valley Bank and $1.5 million funding available from awritten commitment to invest up to $1.5 million from G. Ward Paxton, theCompany’s Chairman, President and Chief Executive Officer.  Based on projections for continuedgrowth in revenue and net income in the coming quarters, a commitment from theCompany’s CEO to advance the Company up to an additional $1.5 million infunding should it be necessary and $2.5 million line of credit with borrowingsavailable of $48,000 at December 31, 2008, we believe that our availablecredit line and available cash resources will provide sufficient cash resourcesto finance our operations and expected capital expenditures for the next twelvemonths.  We expect to fund our operations throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders. If our operations do not generate positive cash flow inthe upcoming year, or if we are not able to obtain additional debt or equityfinancing on terms and conditions acceptable to us, if at all, we may be unableto implement our business plan, fund our liquidity needs or even continue ouroperations.

 

We intend to explore the 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, ifavailable at all, may be on terms which are not favorable to us and, in thecase of equity 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 31,2008.  We have no other significantcontractual obligations at December 31, 2008.

 

**Future minimum lease payments consisted ofthe following on December 31, 2008 (in thousands):**

 
| 2009   |   | 418    |   |
|--------|--------|--------|--------|
| 2010   |   | 68     |   |
|   |   |   |   |
|   |   | $      | 486    |   |
|        |        |        |        |  |

 

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

### ** **

As of December 31, 2008, we did not have any significantoff-balance sheet arrangements, as defined in Item 303(a)(4)(ii) ofRegulation S-K.

 

**Item 8.          Financial Statements and SupplementaryData.**

 

Note that Supplementary Data is not includedbecause it is not required for smaller reporting companies.

 

**Item 9.          Changes In and Disagreements withAccountants on Accounting and Financial Disclosure.**

 

None.

 

27

----

Table of Contents

 

**Item9A(T).       Controls and Procedures**

### ** **

Ourmanagement is responsible for establishing and maintaining adequate internalcontrol over financial reporting as defined in Rule 13a-15(f) of theSecurities Exchange Act of 1934.  Our internal control system wasdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial reporting and the preparation offinancial statements for external purposes, in accordance with generallyaccepted accounting principles.  Because of its inherent limitations,internal control over financial reporting may not prevent or detectmisstatements.  Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Ourmanagement, including our President, who serves as our principal executiveofficer, and our Chief Financial Officer, who serves as our principal financialofficer, conducted an evaluation of the effectiveness of internal control overfinancial reporting using the criteria set forth by the Committee of SponsoringOrganizations of the Treadway Commission in Internal Control — IntegratedFramework.  Based on its evaluation, our management concluded thatour internal control over financial reporting was effective as of December 31,2008.

 

ThisAnnual Report does not include an attestation report of our independentregistered public accounting firm regarding internal control over financialreporting.  Management’s report was not subject to attestation by ourindependent registered public accounting firm pursuant to temporary rules ofthe Securities and Exchange Commission that permit us to provide onlymanagement’s report in this Annual Report.

 

Therehave not been any changes in our internal control over financial reporting (asdefined in Rules 13a-15(f) and 15d-15(f) under the SecuritiesExchange Act ) that occurred during the fiscal quarter ended December 31,2008 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

Thisreport shall not be deemed to be filed for purposes of Section 18 of theSecurities Exchange Act of 1934, or otherwise subject to the liabilities ofthat section, and is not incorporated by reference into any filing of theCompany, whether made before or after the date hereof, regardless of anygeneral incorporation language in such filing.

 

**Item 9B.       Other Information**

 

Not applicable.

 

**PART III**

 

Certain information required by Part III is omitted from this Form 10-Kbecause we will file a definitive Proxy Statement for our 2009 annualmeeting of stockholders pursuant to Regulation 14A (the “Proxy Statement”)no later than 120 days after the end of the fiscal year covered by this Form 10-K,and certain information to be included therein is incorporated herein by reference.

 

**Item 10.        Directors, Executive Officers andCorporate Governance.**

 

The information called for by this item is incorporated herein byreference to the Proxy Statement.

 

**Item 11.        Executive Compensation.**

 

The information called for by this item is incorporated herein byreference to the Proxy Statement.

 

**Item 12.        Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters.**

 

Theinformation called for by this item is incorporated herein by reference to theProxy Statement.

 

**Item 13.        Certain Relationships and RelatedTransactions, and Director Independence.**

 

The information called for by this item is incorporated herein byreference to the Proxy Statement.

 

28

----

Tableof Contents

 

**Item 14.        Principal Accountant Fees and Services.**

 

Theinformation called for by this item is incorporated herein by reference to theProxy Statement.

 

**Item 15.        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, 2008 and 2007                                                        | F-2 |
| Consolidated  Statements of Operations for the years ended December 31, 2008 and 2007                             | F-3 |
| Consolidated  Statements of Changes in Stockholders’ Deficit for the years ended  December 31, 2008 and 2007 | F-4 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2008 and 2007                             | F-5 |
| Notes to  Consolidated Financial Statements                                                                            | F-6 |

 

(b)**                                 Exhibits**

 

The following Exhibits are filed herewith pursuant to Item 601 ofRegulation S-K or incorporated herein by reference to previous filings asnoted:

 
| **Exhibit Number** | ** ** | **Description of Exhibit**                                                                                                                                                        |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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 Designations 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 Designations 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                                                                     |
| 4.9(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    |
| 4.15(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 |
| 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                                                                                                                   |
| 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                                                                                                        |

 

29

----

Table of Contents

 
| 10.10(12) |   | 2005 Stock  Incentive Plan of the Registrant (amended and restated as of  May 30, 2007)                                                                                                                   |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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(10) |   | Securities Purchase Agreement dated as of March 28, 2005, by and  among the Registrant and the investors listed on Exhibit A thereto                                                                 |
| 10.18(11) |   | Securities Purchase Agreement dated as of December 2, 2005, by  and among the Registrant and the investors listed on Exhibit A thereto                                                               |
| 10.19(14) |   | Loan and Security  Agreement dated as of March 29, 2006, by and between the Registrant and  Silicon Valley Bank (extended on March 28, 2008)                                                         |
| 10.20(14) |   | Intellectual  Property Security Agreement dated as of March 29, 2006, by and between  the Registrant and Silicon Valley Bank                                                                              |
| 10.21(15) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and G. Ward  Paxton, dated December 28, 2006.                                                                         |
| 10.21(15) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and Michael  L. Paxton, dated December 28, 2006.                                                                      |
| 10.21(16) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and G. Ward  Paxton, dated March 15, 2007.                                                                            |
| 10.21(16) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and Michael  L. Paxton, dated March 15, 2007.                                                                         |
| 10.21(17) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and G. Ward  Paxton, dated June 27, 2007.                                                                             |
| 10.21(17) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and Michael  L. Paxton, dated June 27, 2007.                                                                          |
| 10.21(18) |   | Subscription and  Investment Representation Agreement by and between Intrusion Inc. and G. Ward  Paxton, dated September 26, 2007.                                                                        |
| 10.21(19) |   | Promissory Note  dated as of January 30, 2008, by and between the Registrant and G. Ward  Paxton                                                                                                          |
| 10.22(20) |   | Amended and  Restated Loan and Security Agreement dated as of June 30, 2008, by and  between the Registrant and Silicon Valley Bank                                                                       |
| 10.23(21) |   | Intellectual  Property Security Agreement dated as of June 30, 2008, by and between  the Registrant and Silicon Valley Bank                                                                               |
| 21(5)     |   | List of Subsidiaries of Registrant                                                                                                                                                                             |
| 23.1(22)  |   | Consent of KBA Group LLP, Independent Registered Public Accounting  Firm                                                                                                                                       |
| 31.1(22)  |   | Certification of Chief Executive Officer Pursuant to  Rule 13a-14(a) of the Exchange Act                                                                                                             |
| 31.2(22)  |   | Certification of Chief Financial Officer Pursuant to  Rule 13a-14(a) of the Exchange Act                                                                                                             |
| 32.1(22)  |   | 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(22)  |   | 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)    |   | Filed as 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, by the Securities and Exchange Commission,  which Exhibit is incorporated herein by reference. |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                    |
| (2)    |   | Filed as an Exhibit to the Registrant’s Definitive Proxy  Statement on Schedule 14A in connection with the solicitation of proxies  for its 2002 Annual Meeting of Stockholders, which Exhibit is  incorporated herein by reference.                                |
|   |   |                                                                                                                                                                                                                                                                                    |
| (3)    |   | Filed as an Exhibit to the  Registrant’s Definitive Proxy Statement on Schedule 14A in connection  with the solicitation of proxies for its 2002 Annual Meeting of Stockholders,  which Exhibit is incorporated herein by reference.                                |
|   |   |                                                                                                                                                                                                                                                                                    |
| (4)    |   | Filed as an Exhibit to the Registrants’ Annual Report on  Form 10-K, for the fiscal year ended December 31, 2000.                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                    |
| (5)    |   | Filed as an Exhibit to the  Registrant’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2001, which Exhibit is incorporated herein by  reference.                                                                                          |

 

30

----

Tableof Contents

 
| (6)    |   | Filed as an Exhibit to the Registrant’s Quarterly Report on  Form 10-Q for the quarter ended March 31, 2002, which  Exhibit is incorporated herein by reference.                                                                                     |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                          |
| (7)    |   | Filed as an Exhibit to the Registrant’s Definitive Proxy  Statement on Schedule 14A in connection with the solicitation of proxies  for its Special Meeting of Stockholders held March 18, 2004, which  Exhibit is incorporated herein by reference. |
|   |   |                                                                                                                                                                                                                                                                          |
| (8)    |   | Filed as an Exhibit to the Registrant’s Current Report on  Form 8-K dated March 26, 2004 (as amended), which Exhibit is  incorporated by reference.                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                          |
| (9)    |   | Filed as an Exhibit to the Registrant’s Annual Report on  Form 10-K for the fiscal year ended December 31, 2003 (as amended),  which Exhibit is incorporated herein by reference.                                                                    |
|   |   |                                                                                                                                                                                                                                                                          |
| (10)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated March 29, 2005, which  Exhibit is incorporated herein by reference                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                          |
| (11)   |   | Filed as an  Exhibit to the Registrant’s Current Report on Form 8-K dated  December 6, 2005, which Exhibit is incorporated herein by  reference.                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                          |
| (12)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated June 15, 2005, which  Exhibit is incorporated herein by reference.                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                          |
| (13)   |   | Filed as an Exhibit to the  Registrant’s Quarterly Report on Form 10-Q for the quarter ended  September 30, 2004, which Exhibit is incorporated herein by  reference.                                                                                |
|   |   |                                                                                                                                                                                                                                                                          |
| (14)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated March 29, 2006, which  Exhibit is incorporated herein by reference.                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                          |
| (15)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated January 4, 2007,  which Exhibit is incorporated herein by reference.                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                          |
| (16)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated March 16, 2007, which  Exhibit is incorporated herein by reference.                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                          |
| (17)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated June 28, 2007, which  Exhibit is incorporated herein by reference.                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                          |
| (18)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated September 27, 2007,  which Exhibit is incorporated herein by reference.                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                          |
| (19)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated January 31, 2008,  which Exhibit is incorporated herein by reference.                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                          |
| (20)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated July 1, 2008, which  Exhibit is incorporated herein by reference.                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                          |
| (21)   |   | Filed as an Exhibit to the  Registrant’s Current Report on Form 8-K dated November 13, 2008,  which Exhibit is incorporated herein by reference.                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                          |
| (22)   |   | Filed herewith.                                                                                                                                                                                                                                                               |

 

31

----

Tableof Contents

 

**SIGNATURES**

 

In accordance with Section 13 or 15(d) of the Exchange Act,the registrant caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| Dated: March 27, 2009 | INTRUSION INC. |
|----------------------------|---------------------|
|                       | (Registrant)        |
|                       |                |   |
|                       | By:                 | /s/ G. WARD PAXTON |
|                       |                | G. Ward Paxton |
| * *                   | * *            | *Chairman, President, and Chief Executive  Officer* |
| * *                   | * *            | *(Principal Executive Officer)* |

 

In accordance with the Securities Exchange Act, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title**                                    | ** ** | **Date**            |
|------------------------|------------|----------------------------------------------|------------|---------------------|
|                   |       |                                         |       |                |
| /s/ G. WARD PAXTON     |       | Chairman, President,                         |       | March 27, 2009 |
| G. Ward Paxton         |       | Chief Executive Officer, and Director        |       |                |
|                   |       |                                         |       |                |
| /s/ T. JOE HEAD        |       | Vice Chairman, Vice President                |       | March 27, 2009 |
| T. Joe Head            |       | and Director                                 |       |                |
|                   |       |                                         |       |                |
| /s/ MICHAEL L. PAXTON  |       | Vice President, Chief Financial              |       | March 27, 2009 |
| Michael L. Paxton      |       | Officer, Treasurer and Secretary             |       |                |
|                   |       | (Principal Financial and Accounting Officer) |       |                |
|                   |       |                                         |       |                |
| /s/ JAMES F. GERO      |       | Director                                     |       | March 27, 2009 |
| James F. Gero          |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ J. FRED BUCY, JR.  |       | Director                                     |       | March 27, 2009 |
| J. Fred Bucy, Jr. |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ DONALD M. JOHNSTON |       | Director                                     |       | March 27, 2009 |
| Donald M. Johnston     |       |                                         |       |                |

 

32

----

Table of Contents

 

**ANNUAL REPORT ON FORM 10-K**

**ITEM 7**

**FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2008 and 2007**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

33

----

Tableof Contents

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING 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 31,2008 and 2007, and the related consolidated statements of operations, changesin stockholders’ deficit, and cash flows for the years then ended. These consolidatedfinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements 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, 2008 and 2007,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

March 27, 2009

 

F-1

----

Tableof Contents

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                        | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                        | ** ** | **2008**              | ** ** | **2007** | ** ** |
| **Assets**                                                                                                        |       |                  |       |   |   |
| Current Assets:                                                                                                   |       |                  |       |   |   |
| Cash and cash equivalents                                                                                         |       | $                     | 554        |   | $ | 362 |   |
| Accounts receivable, net of allowance for  doubtful accounts and returns of $0 in 2008 and $40 in 2007            |       | 341                   |       | 110 |   |
| Inventories, net                                                                                                  |       | 20                    |       | 146 |   |
| Prepaid expenses                                                                                                  |       | 56                    |       | 75 |   |
| Total current assets                                                                                              |       | 971                   |       | 693 |   |
| Property and Equipment:                                                                                           |       |                  |       |   |   |
| Equipment                                                                                                         |       | 509                   |       | 438 |   |
| Furniture and fixtures                                                                                            |       | 34                    |       | 30 |   |
| Leasehold improvements                                                                                            |       | 101                   |       | 101 |   |
|                                                                                                              |       | 644                   |       | 569 |   |
| Accumulated depreciation and amortization                                                                         |       | (475                  | )          | (425 | ) |
|                                                                                                              |       | 169                   |       | 144 |   |
| Other assets                                                                                                      |       | 39                    |       | 39 |   |
| **TOTAL ASSETS**                                                                                                  |       | $                     | 1,179      |   | $ | 876 |   |
|                                                                                                              |       |                  |       |   |   |
| **Liabilities and Stockholders’ Deficit**                                                                    |       |                  |       |   |   |
| Current Liabilities:                                                                                              |       |                  |       |   |   |
| Line of credit                                                                                                    |       | $                     | —     |   | $ | 100 |   |
| Loan payable to officer                                                                                           |       | 480                   |       | — |   |
| Accounts payable, trade                                                                                           |       | 204                   |       | 236 |   |
| Accrued expenses                                                                                                  |       | 334                   |       | 427 |   |
| Dividends payable                                                                                                 |       | 187                   |       | 25 |   |
| Deferred revenue                                                                                                  |       | 1,090                 |       | 312 |   |
| Total current liabilities                                                                                         |       | 2,295                 |       | 1,100 |   |
|                                                                                                              |       |                  |       |   |   |
| **Commitments and Contingencies**                                                                                 |       |                  |       |   |   |
|                                                                                                              |       |                  |       |   |   |
| Stockholders’ Deficit:                                                                                       |       |                  |       |   |   |
| Preferred stock, $0.01 par value:                                                                                 |       |                  |       |   |   |
| Authorized shares — 5,000                                                                                    |       |                  |       |   |   |
| Series 1 shares issued and outstanding  — 260 in 2008 and 2007 Liquidation preference of $1,380 in 2008 |       | 918                   |       | 918 |   |
| Series 2 shares issued and outstanding  — 460 in 2008 and 2007 Liquidation preference of $1,213 in 2008 |       | 724                   |       | 724 |   |
| Series 3 shares issued and outstanding  — 354 in 2008 and 2007 Liquidation preference of $814 in 2008   |       | 504                   |       | 504 |   |
| Common stock, $0.01 par value:                                                                                    |       |                  |       |   |   |
| Authorized shares — 80,000                                                                                   |       |                  |       |   |   |
| Issued shares — 11,648 in  2008 and 2007                                                                     |       |                  |       |   |   |
| Outstanding shares — 11,638 in 2008 and  2007                                                                |       | 116                   |       | 116 |   |
| Common stock held in treasury, at cost—10  shares                                                            |       | (362                  | )          | (362 | ) |
| Additional paid-in-capital                                                                                        |       | 55,443                |       | 55,527 |   |
| Accumulated deficit                                                                                               |       | (58,280               | )          | (57,472 | ) |
| Accumulated other comprehensive loss                                                                              |       | (179                  | )          | (179 | ) |
| Total stockholders’ deficit                                                                                  |       | (1,116                | )          | (224 | ) |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ DEFICIT**                                                              |       | $                     | 1,179      |   | $ | 876 |   |

 

See accompanying notes.

 

F-2

----

Tableof Contents

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                  | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
|                                                                        |       |                                       |       |   |   |
| Net product revenue                                                         |       | $                                          | 3,566      |   | $ | 2,815 |   |
| Net customer support and maintenance  revenue                               |       | 574                                        |       | 695 |   |
| Total revenue                                                               |       | 4,140                                      |       | 3,510 |   |
| Cost of product revenue                                                     |       | 1,352                                      |       | 1,304 |   |
| Cost of customer support and maintenance  revenue                           |       | 23                                         |       | 72 |   |
| Total cost of revenue                                                       |       | 1,375                                      |       | 1,376 |   |
| Gross profit                                                                |       | 2,765                                      |       | 2,134 |   |
| Operating expenses:                                                         |       |                                       |       |   |   |
| Sales and marketing                                                         |       | 1,407                                      |       | 1,933 |   |
| Research and development                                                    |       | 1,136                                      |       | 1,655 |   |
| General and administrative                                                  |       | 968                                        |       | 947 |   |
| Operating loss                                                              |       | (746                                       | )          | (2,401 | ) |
| Interest income (expense), net (including  $52 to related party in 2008)    |       | (62                                        | )          | 5 |   |
| Other income, net                                                           |       | —                                     |       | 1 |   |
| Loss from operations before income taxes                                    |       | (62                                        | )          | (2,395 | ) |
| Income tax provision                                                        |       | —                                     |       | — |   |
| Net loss                                                                    |       | (808                                       | )          | (2,395 | ) |
| Preferred stock dividends accrued                                           |       | (161                                       | )          | (173 | ) |
| Net loss attributable to common  stockholders                               |       | $                                          | (969       | ) | $ | (2,568 | ) |
|                                                                        |       |                                       |       |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |       | $                                          | (0.08      | ) | $ | (0.26 | ) |
| Weighted average common shares outstanding  (basic and diluted)             |       | 11,638                                     |       | 9,929 |   |

 

See accompanying notes.

 

F-3

----

Tableof Contents

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
| **NUMBER OF PREFERRED SHARES—ISSUED AND  OUTSTANDING**                  |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | 1,074                                      |       | 1,118 |   |
| Conversion of preferred shares to common  shares                             |       | —                                     |       | (114 | ) |
| Balance, end of year                                                         |       | 1,074                                      |       | 1,074 |   |
| **PREFERRED STOCK**                                                          |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | $                                          | 2,146      |   | $ | 2,309 |   |
| Conversion of preferred shares to common  shares                             |       | —                                     |       | (163 | ) |
| Balance, end of year                                                         |       | $                                          | 2,146      |   | $ | 2,146 |   |
| **NUMBER OF COMMON SHARES—ISSUED**                                      |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | 11,638                                     |       | 8,306 |   |
| Issuance of common shares under private  placements                          |       | —                                     |       | 3,228 |   |
| Conversion of preferred shares to common  shares                             |       | —                                     |       | 114 |   |
| Balance, end of year                                                         |       | 11,638                                     |       | 11,638 |   |
| **COMMON STOCK**                                                             |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | $                                          | 116        |   | $ | 83 |   |
| Issuance of common shares under private  placement                           |       | —                                     |       | 32 |   |
| Conversion of preferred shares to common  shares                             |       | —                                     |       | 1 |   |
| Balance, end of year                                                         |       | $                                          | 116        |   | $ | 116 |   |
| **TREASURY SHARES**                                                          |       |                                       |       |   |   |
| Balance, beginning of year and end of year                                   |       | $                                          | (362       | ) | $ | (362 | ) |
| **ADDITIONAL PAID-IN-CAPITAL**                                               |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | $                                          | 55,527     |   | $ | 53,947 |   |
| Stock-based compensation                                                     |       | 75                                         |       | 123 |   |
| Conversion of preferred shares to common  shares                             |       | —                                     |       | 162 |   |
| Issuance of common shares under private  placement                           |       | —                                     |       | 1,468 |   |
| Preferred stock dividends declared, net of  waived penalties by shareholders |       | (159                                       | )          | (173 | ) |
| Balance, end of year                                                         |       | $                                          | 55,443     |   | $ | 55,527 |   |
| **ACCUMULATED DEFICIT**                                                      |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | $                                          | (57,472    | ) | $ | (55,077 | ) |
| Net loss                                                                     |       | (808                                       | )          | (2,395 | ) |
| Balance, end of year                                                         |       | $                                          | (58,280    | ) | $ | (57,472 | ) |
| **ACCUMULATED OTHER COMPREHENSIVE LOSS**                                     |       |                                       |       |   |   |
| Balance, beginning of year                                                   |       | $                                          | (179       | ) | $ | (179 | ) |
| Balance, end of year                                                         |       | $                                          | (179       | ) | $ | (179 | ) |
| **TOTAL STOCKHOLDERS’ DEFICIT**                                         |       | $                                          | (1,116     | ) | $ | (224 | ) |

 

See accompanying notes.

 

F-4

----

Tableof Contents

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                   | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
| Operating Activities:                                                        |       |                                       |       |   |   |
| Net loss                                                                     |       | $                                          | (808       | ) | $ | (2,395 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities: |       |                                       |       |   |   |
| Depreciation and amortization                                                |       | 50                                         |       | 56 |   |
| Provision for doubtful accounts                                              |       | (40                                        | )          | (50 | ) |
| Stock based compensation                                                     |       | 75                                         |       | 123 |   |
| Changes in operating assets and  liabilities:                                |       |                                       |       |   |   |
| Accounts receivable                                                          |       | (191                                       | )          | 784 |   |
| Inventories                                                                  |       | 127                                        |       | 63 |   |
| Prepaid expenses and other assets                                            |       | 19                                         |       | 125 |   |
| Accounts payable, accrued expenses and  other current liabilities            |       | (122                                       | )          | (410 | ) |
| Deferred revenue                                                             |       | 778                                        |       | (55 | ) |
| Net cash used in operating activities                                        |       | (112                                       | )          | (1,759 | ) |
| Investing Activities:                                                        |       |                                       |       |   |   |
| Purchases of property and equipment                                          |       | (76                                        | )          | (39 | ) |
| Financing Activities:                                                        |       |                                       |       |   |   |
| Net payments on line of credit                                               |       | (100                                       | )          | (100 | ) |
| Borrowings from officer                                                      |       | 1,180                                      |       | — |   |
| Payments on loans from officer                                               |       | (700                                       | )          | — |   |
| Proceeds from issuance of common stock, net                                  |       | —                                     |       | 1,500 |   |
| Dividends paid on preferred stock                                            |       | —                                     |       | (173 | ) |
| Net cash provided by financing activities                                    |       | 380                                        |       | 1,227 |   |
| Net increase (decrease) in cash and cash  equivalents                        |       | 192                                        |       | (571 | ) |
| Cash and cash equivalents at beginning of  year                              |       | 362                                        |       | 933 |   |
| Cash and cash equivalents at end of year                                     |       | $                                          | 554        |   | $ | 362 |   |
|                                                                         |       |                                       |       |   |   |
| SUPPLEMENTAL CASH FLOW INFORMATION:                                          |       |                                       |       |   |   |
| Interest paid                                                                |       | $                                          | 62         |   | $ | 11 |   |
| Income taxes paid                                                            |       | $                                          | —     |   | $ | — |   |
|                                                                         |       |                                       |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                   |       |                                       |       |   |   |
| Preferred stock dividends accrued                                            |       | $                                          | 161        |   | $ | 173 |   |

 

See accompanying notes.

 

F-5

----

Table of Contents

 

**INTRUSION INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

We develop, market and support a family ofentity identification, regulated information compliance, data privacyprotection and network intrusion prevention/detection products.  Our product families include:  TraceCop for identity identification,Compliance Commander for regulated information and data privacy protection, andIntrusion SecureNet for network intrusion prevention and detection.  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 system integrators, managed serviceproviders and value-added resellers.  Ourend-user customers include banks, credit unions, other financial institutions,U.S. federal government entities, foreign government entities, hospitals andother healthcare providers. Essentially, our end-user can be defined as ‘anyend-user requiring network security solutions for protecting their missioncritical 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 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 from Intrusion.com, Inc.to Intrusion Inc.

 

Our principal executive offices are located at 1101 East Arapaho Road, Suite 200,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 andTraceCopTM are registered trademarks of Intrusion Inc.

 

As of December 31, 2008, we had cash,cash equivalents and investments of approximately $554,000, up fromapproximately $362,000 as of December 31, 2007.  Although we generated net income of $67,000in the last three quarters of 2008, we had a net loss for the year ended December 31,2008 of $808,000.  We used $112,000 ofcash in operations in 2008 and operating cash outflows may continue in2009.  We are obligated to make paymentsof accrued dividends on all our outstanding shares of preferred stock that willreduce our available cash resources.   Asof December 31, 2008, we had cash and cash equivalents of $554,000,$48,000 in funding available under our line of credit at Silicon Valley Bankand $1.5 million funding available from a written commitment to investup to $1.5 million from G. Ward Paxton, the Company’s Chairman, President andChief Executive Officer.  Based onprojections for continued growth in revenue and net income in the comingquarters, a commitment from the Company’s CEO to advance the Company up to anadditional $1.5 million in funding should it be necessary and $2.5 million lineof credit with borrowings available of $48,000 at December 31, 2008, webelieve that our available credit line and available cash resources willprovide sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  We expect to fund ouroperations through Company profits, our line of credit, borrowings from theCompany’s CEO, and possibly additional investments of private equity and debt,which, if we are able to obtain, will have the effect of diluting our existingcommon stockholders, perhaps significantly. Any equity or debt financings, if available at all, may be on termswhich are not favorable to us and, in the case of equity financings, may resultin dilution to our stockholders. If our operations do not generate positivecash flow in the upcoming year, or if we are not able to obtain additional debtor equity financing on terms and conditions acceptable to us, if at all, we maybe unable to implement our business plan, fund our liquidity needs or evencontinue our operations.

 

F-6

----

Table of Contents

 

**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.

 

***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.

 

***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. To minimize risk, we place our investments in U.S. governmentobligations, corporate securities and money market funds.  Substantially all of our cash, cash equivalentsand investments are maintained with two major U.S. financial institutions.  We do not believe that we are subject to anyunusual financial risk with our banking arrangements.  We have not experienced any significantlosses on our cash equivalents.

 

We sell our products to customers in diversified industries worldwideand periodically have receivables from customers, primarily in North America,Europe and Asia. Fluctuations in currency exchange rates and adverse economicdevelopments in foreign countries could adversely affect the Company’soperating results.  We perform ongoingcredit evaluations of our customers’ financial condition and generally requireno collateral.  We maintain reserves forpotential credit losses, and such losses, in the aggregate, have historicallybeen minimal and have not 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 may be 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 the collectabilityof specific customer accounts:  customercredit-worthiness, past transaction history with the customer, current economicindustry 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 an increase to a valuationallowance.  Balances that remainoutstanding after we have used reasonable collection efforts are written offthrough a charge to the valuation allowance.

 

***Inventories***

 

Inventories are stated at the lower of cost or market. We value ourinventories using average cost, which approximates actual cost on a first-in,first-out basis. Our management estimates the allowance required to stateinventory at the lower of cost or market. There is a risk that we will forecastdemand for our products and market conditions incorrectly and maintain excessinventories. Therefore, there can be no assurance that we will not maintainexcess inventory and incur inventory lower of cost or market charges in thefuture.

 

***Propertyand Equipment***

 

Equipment and furniture and fixtures are stated at cost lessaccumulated depreciation and depreciated on a straight-line basis over theestimated useful lives of the assets. Such lives vary from 1 to 5 years. Leasehold improvements are stated at cost less accumulated amortizationand are amortized on a straight-line basis over the shorter of estimated usefullives of the assets or the remaining terms of the leases.   Such lives vary from 2 to 5 years.  Expenditures for major renewals and 

 

F-7

----

Table of Contents

 

betterments that extend the useful lives of property and equipment arecapitalized.  Repair and maintenancecosts are expensed as incurred. Depreciation and amortization expense totaledapproximately $50,000 and $56,000 for the years ended December 31, 2008and 2007, respectively.

 

***Long-Lived Assets***

 

We review long-lived assets, including property and equipment forimpairment whenever events or changes in circumstances indicate that the carryingamount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparisonof the carrying amount of an asset to future undiscounted cash flows to begenerated by the asset.  If the carryingvalue exceeds the future undiscounted cash flows, the assets are written downto fair value.  During the years ended December 31,2008 and 2007, 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 themonth.  We recorded approximately $3,000as a reduction of operating expenses in 2008 and $6,000 in operating expensesin 2007, which represents the total accumulated foreign currency translationadjustments related to foreign offices.

 

***Accountingfor Stock Options***

 

We account for stock options using the guidance in SFAS 123 (revised2004), “Share-Based Payment” (SFAS 123(R)), which replaces SFAS 123 andsupersedes APB Opinion No. 25.  SFAS123(R) requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the financial statements based ontheir fair values.

 

Stock-basedcompensation expense recognized in the consolidated statement of operationsduring 2008 and 2007 included compensation expense for stock-based paymentawards granted prior to, but not yet vested, as of December 31, 2005 basedon the grant date fair value estimated in accordance with the pro formaprovisions of SFAS 148. Stock-based compensation expense recognized in thestatements of operations for the years ended 2008 and 2007 is based on awardsultimately expected to vest, reduced by estimated forfeitures.  SFAS 123(R) requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates.

 

**Valuation Assumptions**

 

The fair values of option awards were estimated at the date of grantusing a Black-Scholes option-pricing model with the following assumptions forfiscal years ending December 31, 2008 and 2007, respectively:

 
| ** **                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
|                                   |       |     |       |     |       |
| Weighted average grant date fair value |       | $        | 0.17       |     | $          | 0.32 |   |
| Weighted average assumptions used:     |       |     |       |     |       |
| Expected dividend yield                |       | 0.0      | %          | 0.0      | %          |
| Risk-free interest rate                |       | 2.64     | %          | 4.9      | %          |
| Expected volatility                    |       | 107.1    | %          | 105.1    | %          |
| Expected life (in years)               |       | 5.0      |       | 4.9      |       |
|                                        |            |          |            |          |            |  |  |

 

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

 

F-8

----

Table of Contents

 

***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 dilutive 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 at December 31,2008 and 2007 totaled 4,219,138, and 3,892,293, respectively.  Common stock equivalents are notincluded in the diluted loss per share for the years ended December 31,2008 and 2007, as they are anti-dilutive as a result of incurring net lossesduring these years.

 

***RevenueRecognition***

 

We generally recognize product revenue upon shipment.  These products include both hardware andperpetual software licenses, as we do not currently offer software on asubscription basis.  We accrue forestimated warranty costs and sales returns at the time of shipment based on ourexperience.  There is a risk thattechnical issues on new products could result in unexpected warranty costs andreturns.  However, as we migrate to moreof a software-based business model, the warranty costs should continue todecline.  To the extent that they dodecline, our warranty reserve will decrease. To the extent that our warranty costs exceed our expectations, we willincrease our warranty reserve to compensate for the additional expense expectedto be incurred.  We review theseestimates periodically and determine the appropriate reserve percentage.  However, to date, warranty costs and sales returnshave not been material.  The customer mayreturn a product only under very limited circumstances during the first thirtydays from delivery for a replacement if the product is damaged or for a fullrefund 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.

 

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) collectability 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 andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

Service revenue, primarily including maintenance, training andinstallation are recognized upon delivery of the service and typically areunrelated to product sales.  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 normal terms.  If certain customers do not meet our credit standards,we do require payment in advance to limit our credit exposure.

 

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

 

F-9

----

Table of Contents

 

***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 and 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 86, “Accounting for the Costs of ComputerSoftware to Be Sold, Leased, or Otherwise Marketed,” requires that softwaredevelopment costs incurred subsequent to reaching technological feasibility becapitalized, if material. If the process of developing a new product or majorenhancement does not include a detailed program design, technologicalfeasibility is determined only after completion of a working model. To date,the period between achieving technological feasibility and the generalavailability of such software has been short, and the software developmentcosts qualifying for capitalization have been insignificant.

 

***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 income taxes. Actual results could differ from theseestimates.

 

***IncomeTaxes***

 

We use the liability method to calculate deferred income taxes.Deferred tax assets and liabilities are recognized for the expected taxconsequences of temporary differences between the tax basis of assets andliabilities and their reported amounts. The realization of deferred tax assetsis based on historical tax positions and expectations about future taxableincome. The liability method also requires the recognition of future taxbenefits such as net operating loss carryforwards, to the extent thatrealization of such benefits is more likely than not.  Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be realized.

 

***Reclassifications***

 

Certain 2007 amounts have been reclassifiedto conform to 2008 presentation.

 

***Recent AccountingPronouncements***

 

In September 2006, the FASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”),which clarifies the definition of fair value whenever another standard requiresor permits assets or liabilities to be measured at fair value. Specifically,the standard clarifies that fair value should be based on the assumptionsmarket participants would use when pricing the asset or liability, andestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. SFAS 157 does not expand the use of fair valueto any new circumstances, and must be applied on a prospective basis except incertain cases. The standard also requires expanded financial statementdisclosures about fair value measurements, including disclosure of the methodsused and the effect on earnings.

 

In February 2008, FASB Staff Position (“FSP”) FAS No. 157-2, *Effective Date of FASB Statement No. 157*(“FSP 157-2”),was issued. FSP 157-2 defers the effective date of SFAS 157 to fiscalyears beginning after December 15, 2008, and interim periods within thosefiscal years, for all nonfinancial assets and liabilities, except those thatare recognized or disclosed at fair value in the financial statements on arecurring basis (at least annually). Examples of items within the scope ofFSP 157-2 are nonfinancial assets and nonfinancial liabilities initiallymeasured at fair value in a business combination (but not measured at fairvalue in subsequent periods), and long-lived assets, such as property, plantand equipment and intangible assets measured at fair value for an impairmentassessment under SFAS No. 144, *Accountingfor the Impairment or Disposal of Long-Lived Assets*.

 

The partial adoption of SFAS 157 on January 1, 2008 withrespect to financial assets and financial liabilities recognized or disclosedat fair value in the financial statements on a recurring basis did not have amaterial impact on our 

 

F-10

----

Table of Contents

 

consolidated financial statements. We are in the process of analyzingthe potential impact of SFAS 157 relating to our planned adoption of theremainder of the standard.

 

In December 2007, the FASB issued SFAS No. 160, *Non-Controlling Interests in Consolidated Financial Statements anamendment of ARB No. 51* (“SFAS 160”). SFAS 160 establishesnew standards for the accounting for and reporting of non-controlling interests(formerly minority interests) and for the loss of control of partially ownedand consolidated subsidiaries. SFAS 160 does not change the criteria forconsolidating a partially owned entity. SFAS 160 is effective for fiscalyears beginning after December 15, 2008. We do not expect the adoption ofSFAS 160 will have a material impact on our consolidated financialstatements.

 

In December 2007, the FASB issued SFAS No. 141(revised2007) (“SFAS 141R”), a revision of SFAS 141, *BusinessCombinations*.   SFAS 141Restablishes requirements for the recognition and measurement of acquiredassets, liabilities, goodwill, and non-controlling interests. SFAS 141Ralso provides disclosure requirements related to business combinations.SFAS 141R is effective for fiscal years beginning after December 15,2008. SFAS 141R will be applied prospectively to business combinationswith an acquisition date on or after the effective date.

 

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

 

**Inventories**

 
| ** **                     | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Finished products              |       | $                     | 67         |   | $ | 185 |   |
| Work in process                |       | —                |       | 8 |   |
| Demonstration systems          |       | 5                     |       | 15 |   |
| Reserve for obsolete inventory |       | (52                   | )          | (62 | ) |
|                           |       | $                     | 20         |   | $ | 146 |   |

 

**Accrued Expenses**

 
| ** **               | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2008**              | ** ** | **2007** | ** ** |
|                     |       |                  |       |   |   |
| Accrued payroll          |       | $                     | 111        |   | $ | 101 |   |
| Accrued vacation         |       | 172                   |       | 192 |   |
| Accrued property taxes   |       | 12                    |       | 30 |   |
| Accrued warranty expense |       | 3                     |       | 20 |   |
| Accrued sales taxes      |       | 1                     |       | 35 |   |
| Other                    |       | 35                    |       | 49 |   |
|                     |       | $                     | 334        |   | $ | 427 |   |

 

**4. Commitments and Contingencies**

 

***Leases***

 

We lease office space for our corporate headquarters in Richardson,Texas under an operating lease, the base term of which expires in February 2010.  We lease office space in San Diego,California for a portion of our security software research and developmentstaff under an operating lease that expires in March 2010.

 

The Company’s lease for the headquarters facility contains escalationprovisions.  The Company records rentexpense on facility leases on a straight-line basis.  Real estate taxes, insurance and maintenanceexpenses are the obligations of the Company. Rent expense totaled approximately $458,000 and $435,000 for the yearsended December 31, 2008 and 2007, respectively.

 

F-11

----

Table of Contents

 

Future minimum lease payments consisted of the following on December 31,2008 (in thousands):

 
| 2009   |   | 418    |   |
|--------|--------|--------|--------|
| 2010   |   | 68     |   |
|   |   |   |   |
|   |   | $      | 486    |   |
|        |        |        |        |  |

 

***LegalProceedings***

 

We are subject to legal proceedings and claims that arise in theordinary course of business. We do not believe that the outcome of thosematters will have a material adverse affect on our consolidated financialposition, operating results or cash flows. However, there can be no assurancesuch legal proceedings will not have a material impact.

 

We are not aware of any material claims outstanding or pending againstIntrusion Inc. at December 31, 2008.

 

**5. Employee Benefit Plans**

 

***EmployeeStock Purchase Plan***

 

On April 24, 1997, we adopted an Employee Stock Purchase Plan (the“Purchase Plan”) under which 125,000 shares of common stock were reserved forissuance. On April 24, 2007, the Purchase Plan was terminated pursuant toits 10 year term. A total of 45,702 shares were issued under the Purchase Planprior to its termination.

 

***Employee401(k) Plan***

 

We have a plan known as the Intrusion Inc. 401(k) SavingsPlan (the “Plan”) to provide retirement and incidental benefits for ouremployees.  The Plan covers substantiallyall employees who meet minimum age and service requirements.  As allowed under Section 401(k) ofthe Internal Revenue Code, the Plan provides tax deferred salary deductions foreligible employees.

 

Employees may contribute from 1% to 25% of their annual compensation tothe Plan, limited to a maximum amount as set by the Internal RevenueService.  Participants who are over theage of 50 may contribute an additional amount of their salary per year, asdefined annually by the Internal Revenue Service.  We match employee contributions at the rateof $0.25 per each $1.00 of contribution on the first 4% of compensation.  Matching contributions to the Plan wereapproximately $19,000 and $23,000 for the years ended December 31, 2008and 2007, respectively.

 

**6. Line of Credit**

 

On March 29, 2006, we entered into a Loan andSecurity Agreement (the “Loan Agreement”) with Silicon Valley Bank (“SVB”) toestablish a $1.0 million line of credit with SVB (the “2006 Credit Line”).  On June 30, 2008, we entered into an Amendedand Restated Loan and Security Agreement (the “Amended and Restated LoanAgreement”) with SVB to, among other things, replace the 2006 Credit Line witha new $2.5 million line of credit (the “Current Line of Credit”).  Our obligations under the Amended andRestated Loan Agreement are secured by substantially all of our assets,including all of our intellectual property. Borrowings under the Current Line of Credit are based on advances (each,an “Advance”) against certain of our accounts receivable that are approved bySVB (each an “Eligible Account”).  SVBmay make an Advance of up to eighty percent (80%) of each Eligible Account, orsuch other percentage SVB may determine in its sole discretion.  Each Advance is subject to a finance chargecalculated as a daily rate that is based on a 360-day annual rate of (a) thegreater of the prime rate or 5.25%, plus (b) 1.5% or 2.0%, depending oncertain qualifying financial factors specified in the Amended and Restated LoanAgreement.  Finance charges are payableat the same time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.25% or 0.5% of all outstanding Advances, depending on certain qualifyingfinancial factors specified in the Amended and Restated Loan Agreement.  The collateral handling fee is payable at thesame time its related Advance is due. Each Advance must be repaid at the earliest of (a) the date thatthe Eligible Account related to the Advance is paid, (b) the date theEligible Account is no longer eligible under the Amended and Restated LoanAgreement, or (c) the date on which any “Adjustment” (as defined in theAmended and Restated Loan Agreement) is asserted to the Eligible Account.  On June 29, 2009, the Amended andRestated Loan Agreement terminates and all outstanding advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Amended and Restated Loan Agreement and 

 

F-12

----

Table of Contents

 

related documents.  We have certainnon-financial and financial covenants, including a liquidity coverage ratio anda rolling EBITDA computation, as defined in the Loan Agreement.  We have no borrowings outstanding under theCurrent Line of Credit as of December 31, 2008 and had borrowingsavailable of $48,000.

 

**7. Borrowings from Officer**

 

On January 30, 2008, and extended on October 24,2008 and March 19, 2009, the Company entered into an unsecured revolvingpromissory note to borrow up to $700,000 from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.  Under the terms of the note, the Company mayborrow, repay and reborrow on the loan as needed up to an outstanding principalbalance due of $700,000 at any given time.

 

Amounts borrowed from this officer accrue interestat a floating rate per annum equal to SVB’s prime rate plus 1% (5% at December 31,2008).  All outstanding borrowings andaccrued but unpaid interest is due on December 31, 2009.  As of December 31, 2008 the borrowingsoutstanding totaled $480,000 and accrued interest totaled $1,000.  The Company paid approximately $52,000 ininterest to the officer during 2008.  Thisnote was replaced with a new note payable to this officer on March 19, 2009(See Note 13).

 

On March 20, 2008 and extended on November 7, 2008, wereceived a written commitment from our Chief Executive Officer to investup to an additional $1,500,000 in the Company until March 31, 2010, shouldsuch funding be required by the Company, on terms and conditions identical tothose described above on the $700,000 note.

 

**8. Income Taxes**

 

Deferred income taxes reflect the net tax effects of temporarydifferences between the carrying amounts of assets and liabilities forfinancial reporting purposes and the amounts used for income tax purposes.There are no deferred tax liabilities as of December 31, 2008 and2007.  Significant components of ourdeferred tax assets as of December 31, 2008 and 2007 are as follows (inthousands):

 
| ** **                                                | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **2008**             | ** ** | **2007** | ** ** |
| ** **                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net operating loss carryforwards                          |       | $                    | 29,510     |   | $ | 29,122 |   |
| Net operating loss carryforwards of foreign  subsidiaries |       | 374                  |       | 374 |   |
| Book over tax depreciation                                |       | 84                   |       | 88 |   |
| Intangible assets                                         |       | 579                  |       | 759 |   |
| Stock-based compensation expense                          |       | 234                  |       | 207 |   |
| Foreign tax credit                                        |       | —               |       | 1,083 |   |
| Other                                                     |       | 131                  |       | 169 |   |
| Deferred tax assets                                       |       | 30,912               |       | 31,802 |   |
| Valuation allowance for deferred tax assets               |       | (30,912              | )          | (31,802 | ) |
| Deferred tax assets, net of allowance                     |       | $                    | —     |   | $ | — |   |

 

Deferred tax assets are required to be reduced by a valuation allowanceif it is more likely than not that some portion or all of the deferred taxassets will not be realized.  Realizationof the 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 hasconsidered these factors in determining the valuation allowance for 2008 and2007.

 

F-13

----

Table of Contents

 

The differences between theprovision for income taxes and income taxes computed using the federalstatutory rate for the years ended December 31, 2008 and 2007 are asfollows (in thousands):

 
| ** **                                              | ** ** | **2008** | ** ** | **2007** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                    |       |     |       |     |       |
| Reconciliation of income tax benefit to statutory rate: |       |     |       |     |       |
| Income tax benefit at statutory rate                    |       | $        | (275       | )        | $          | (814 | ) |
| State income taxes, net of federal income tax benefit   |       | (21      | )          | (63      | )          |
| Expiration of foreign tax credits                       |       | 1,083    |       | —   |       |
| Changes in state net operating loss carryforwards       |       | 98       |       | 2,841    |       |
| Change in valuation allowance                           |       | (890     | )          | (1,971   | )          |
| Other                                                   |       | 5        |       | 7        |       |
|                                                    |       | $        | —     |     | $          | — |   |

 

At December 31, 2008,we had federal net operating loss carryforwards of approximately $87.2 millionfor income tax purposes that begin to expire in 2009 and are subject to theownership change limitations under Internal Revenue Code Section 382. Wealso had approximately $6 million of state net operating loss carryforwardsthat begin to expire in 2017.

 

**9. StockOptions**

 

At December 31, 2008,we had three stock-based compensation plans, which are described below. Theseplans were developed to retain and attract key employees and directors.

 

In 1995, we adopted our 1995Stock Option Plan (the “1995 Plan”), which provides for the issuance of up to400,000 shares of common stock upon exercise of options granted pursuant to the1995 Plan. On April 26, 2001, our stockholders increased the overallnumber of shares available for issuance pursuant to the plan to 825,000 sharesof common stock. The 1995 Plan provides for the issuance of both non-qualifiedand incentive stock options to our employees, officers, and employee-directors.The 1995 Plan expired by its terms on March 21, 2005 and no options wereavailable for future issuance after the expiration.  At December 31, 2008, 67,365 employeeoptions have been exercised and employee options to purchase a total of231,225 shares of common stock are outstanding.  A total of 2,290,295 options have beengranted pursuant to the 1995 Plan, of which, 1,991,705 have been cancelled.

 

In 1995, we adopted the 1995Non-Employee Director Stock Option Plan (the “1995 Non-Employee Director Plan”).  The 1995 Non-Employee Director Plan providedfor the issuance of non-qualified stock options to non-employee directors. The1995 Non-Employee Director Plan was amended in April 2002 to increase thenumber of shares available for issuance to 65,000 from 40,000 shares. The1995 Non-Employee Director Plan expired by its terms on March 21, 2005 andno options were available for future issuance after the expiration.  No options have been exercised under the 1995Non-Employee Director Plan.  Non-employeeoptions to purchase a total of 32,500 shares of common stock are outstandingat December 31, 2008. 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 for the 1995 Non-Employee DirectorPlan and the 1995 Option Plan which expired by their terms on March 21,2005.  The approval of the 2005 Plan hadno effect on the 1995 Plans or any options granted pursuant to eitherplan.  All options will continue withtheir existing terms and will be subject to the 1995 Non-Employee Director Planor the 1995 Plan, as applicable. Further, the Company will not be able to re-issue any option which iscancelled or terminated under the 1995 Non-Employee Director Plan or the 1995Option Plan.  The 2005 Plan provided forthe issuance of up to 750,000 shares of common stock upon exercise of optionsgranted pursuant to the 2005 Plan.  On May 30,2007, the Stockholders approved an Amendment to the 2005 Plan that increasedthis amount by 750,000 for a total of 1,500,000 shares of common stock that maybe issued upon the exercise of options granted pursuant to the 2005 Plan. On May 29,2008, the Stockholders approved an increase of 500,000 shares of common stockthat may be issued pursuant to the 2005 Plan for a total of 2,000,000 shares.

 

The 2005 Plan consists of three (3) separateequity incentive programs: the Discretionary Option Grant Program; the StockIssuance Program; and the Automatic Option Grant Program for non-employee Boardmembers.  Officers and employees,non-employee Board members and independent contractors are eligible to participatein the Discretionary Option Grant and Stock Issuance Programs.  Participation in the Automatic Option GrantProgram is limited to non-employee members of the

 

F-14

----

Table of Contents

 

Board.  Eachnon-employee Board member will receive an option grant for 10,000 shares ofcommon stock upon initial election or appointment to the Board, provided thatindividual has not previously been employed by the Company in the preceding six(6) months.  In addition, on thedate of each annual stockholders meeting, each Board member will automaticallybe granted an option to purchase 5,000 shares of common stock, provided he orshe has served as a non-employee Board member for at least six (6) months.  At December 31, 2008, no 2005 Planoptions have been exercised and employee and non-employee Board member optionsto purchase a total of 1,204,500 shares of common stock areoutstanding.  A total of 1,517,500options have been granted under the 2005 Plan, of which 313,000 have beencancelled and options for 795,500 shares remain available for futuregrant.  No shares have been issuedpursuant to the Stock Issuance Program.

 

Common shares reserved forfuture issuance, including conversions of preferred stock, warrants,outstanding options and options available for future grant under all of thestock option plans and employee stock purchase plans total5,014,638 million shares at December 31, 2008 as follows, inthousands:

 
| **(In thousands)**         | ** ** | **Common Shares  Reserved for Future  Issuance** | ** ** |
|---------------------------------|------------|-----------------------------------------------------------------|------------|
|                            |       |                                                            |       |
| Preferred Stock                 |       | 1,227                                                           |       |
| Warrants                        |       | 1,524                                                           |       |
| 1995 Plan                       |       | 231                                                             |       |
| 1995 Non-Employee Director Plan |       | 32                                                              |       |
| 2005 Plan                       |       | 2,000                                                           |       |
| Total                           |       | 5,014                                                           |       |

 

The Compensation Committeeof our Board of Directors determines for all employee options, the term of eachoption, option exercise price within limits set forth in the plans, number ofshares for which each option is granted and the rate at which each option isexercisable (generally ratably over one, three or five years from grant date).However, the exercise price of any incentive stock option may not be less thanthe fair market value of the shares on the date granted (or less than 110% ofthe fair market value in the case of optionees holding more than 10% of ourvoting stock of the Company), and the term cannot exceed ten years (five yearsfor incentive stock options granted to holders of more than 10% of our votingstock).

 

***Stock Incentive Plan Summary***

 

A summary of our stockoption activity and related information for the years ended December 31,2008 and 2007 is as follows:

 
| ** **                         | ** ** | **2008**                                         | ** ** | **2007**                               | ** ** |
|------------------------------------|------------|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                         | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                         | ** ** | ** **                                       | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at beginning of year   |       | 1,141                                            |       | $                                      | 2.30       |   | 1,086 |   | $ | 3.23 |   |
| Granted at price = market value    |       | 345                                              |       | .22                                    |       | 246 |   | .41 |   |
| Granted at price > market value |       | 100                                              |       | .24                                    |       | 100 |   | .44 |   |
| Exercised                          |       | —                                           |       | —                                 |       | — |   | — |   |
| Forfeited                          |       | (60                                              | )          | .69                                    |       | (137 | ) | .69 |   |
| Expired                            |       | (58                                              | )          | 4.15                                   |       | (153 | ) | 6.12 |   |
|                               |       |                                             |       |                                   |       |   |   |   |   |
| Outstanding at end of year         |       | 1,468                                            |       | $                                      | 1.66       |   | 1,142 |   | $ | 2.30 |   |
| Options exercisable at end of year |       | 749                                              |       | $                                      | 2.98       |   | 575 |   | $ | 3.99 |   |

 

F-15

----

Table of Contents

 

***Stock Options Outstanding andExercisable***

 

Information related to stock options outstanding at December 31,2008, is summarized below:

 
| ** **                                  | ** ** | **Options Outstanding**                           | ** ** | **Options Exercisable**                            | ** ** |
|---------------------------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Outstanding at  12/31/08 (in  thousands)** | ** ** | **Weighted  Average  Remaining  Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable at  12/31/08 (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                        |       |                                                   |       |                                                    |       |   |   |   |   |   |   |
| $ 0.20-$1.00                           |       | 1,019                                                  |       | 7.71  years                                             |       | $ | 0.31 |   | 304 |   | $ | .36 |   |
| $ 1.01-$5.00                           |       | 417                                                    |       | 5.89  years                                             |       | $ | 2.81 |   | 413 |   | $ | 2.82 |   |
| $ 5.01-$10.00                          |       | 13                                                     |       | 3.16  years                                             |       | $ | 5.29 |   | 13 |   | $ | 5.29 |   |
| $ 10.01-$20.00                         |       | 6                                                      |       | 1.79  years                                             |       | $ | 18.89 |   | 6 |   | $ | 18.89 |   |
| $ 20.01-$63.00                         |       | 13                                                     |       | 1.24  years                                             |       | $ | 58.77 |   | 13 |   | $ | 58.77 |   |
|                                        |       | 1,468                                                  |       | 7.07  years                                             |       | $ | 1.66 |   | 749 |   | $ | 2.98 |   |

 

Summarized information aboutoutstanding stock options as of December 31, 2008, that are fully vestedand those that are expected to vest in the future as well as stock options thatare fully vested and currently exercisable, are as follows:

 
| ** **                                  | ** ** | **Outstanding Stock  Options (Fully Vested  and Expected to Vest)*** | ** ** | **Options that are  Exercisable** | ** ** |
|---------------------------------------------|------------|----------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **As of December 31, 2008**            | ** ** | ** **                                                                                         | ** ** | ** **                                  | ** ** |
| Number of outstanding options               |       | 1,276                                                                                              |       | 749                                         |       |
| Weighted average remaining contractual life |       | 6.94                                                                                               |       | 6.07                                        |       |
| Weighted average exercise price per share   |       | $                                                                                                  | 1.87       |                                        | $          | 2.98 |   |
| Intrinsic value (in thousands)              |       | $                                                                                                  | 53         |                                        | $          | 9 |   |

 

----

* Includes effects of expected forfeitures

 

As of December 31,2008, the total unrecognized compensation cost related to non-vested optionsnot yet recognized in the statement of operations totaled approximately $46thousand (including expected forfeitures) and the weighted period over whichthese awards are expected to vest was 1.0 years.

 

**10.Preferred Stock**

 

***5% Preferred Stock***

 

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

 

The 5% dividends related tothe 5% preferred stock are paid semi-annually on the last business day in March andSeptember of each year, beginning with September 2004.  Preferred stockholders vote together withcommon stockholders on an as converted to common stock basis.  Based on the conversion rate of the preferredstock, holders of our 5% preferred stock will receive 1.5903 votes per sharerounded to the nearest whole number.  Theliquidation preference for the 5% preferred stock is an amount equal to $5.00per share plus any accrued and unpaid dividends.  Holders of our 5% preferred stock haveliquidation preference rights over common stockholders.

 

Included in this transactionwere warrants to purchase 556,619 shares of common stock at an exercise priceof $3.144 per share.  Warrant holdersinclude 80,000 held by our CEO and 30,000 held by a director of theCompany.  In connection with the closingof this 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. All of the warrants were immediately exercisable and expired on March 25,2009.

 

F-16

----

Table of Contents

 

We have the right to redeem any or all ofthe outstanding 5% preferred stock at a price of $5.00 per share plus accrueddividends at any time if certain conditions are met.

 

At December 31, 2008there are 259,696 shares of our 5% preferred stock outstanding.

 

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

 

OnMarch 28, 2005, we completed a $2.7 million private placement of Series 25% convertible preferred stock and warrants. In the private placement, we sold 1,065,200 shares of preferred stock ata price of $2.50 per share for gross proceeds of $2.7 million, less $173,000 ofissuance costs.  The shares of Series 25% preferred stock are convertible into 1,065,200 shares of common stock at aninitial conversion price of $2.50 per 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.

 

The5% dividends accruing on the Series 2 5% preferred stock are required tobe paid quarterly on the first business day in March, June, September and December ofeach year, beginning with June 2005. The liquidation preference for the preferred stock is an amount equal to$2.50 per share plus any accrued and unpaid dividends.  Holders of our Series 2 5% preferredstock have liquidation preference rights over our 5% preferred stock holders aswell as our common stockholders.  Theholders of the Series 2 5% preferred stock are not entitled to vote on anymatter, except as otherwise required by law or with respect to certain limitedmatters specified in the certificate of designations.

 

Includedin this transaction were warrants to purchase 532,600 shares of common stock atan exercise price of $2.77 per share. Warrant holders include 80,000 held by our CEO and 30,000 held by adirector of the Company.  In connectionwith the closing of this private placement, we issued warrants to purchase60,390 shares of our common stock at an exercise price of $2.77 per share totwo affiliates of our financial advisor for assistance with the privateplacement.

 

Holdersof Series 2 5% preferred stock have the right to require us to redeem anyor all 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****and the product of the volume weighted average price of our commonstock on the trading day immediately preceding the event multiplied by $2.50divided by the conversion price then in effect plus (2) any accrued butunpaid dividends on the Series 2 5% preferred stock plus (3) allliquidated damages or other amounts payable to the holders of Series 2 5%preferred stock.

 

At December 31, 2008there are 460,000 shares of Series 2 5% preferred stock outstanding.

 

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

 

OnDecember 2, 2005, we completed a $1.2 million private placement of Series 35% convertible preferred stock and warrants. In the private placement, we sold 564,607 shares of preferred stock at aprice of $2.18 per share for gross proceeds of $1.2 million, less $100,000 ofissuance costs.  The shares of Series 35% preferred stock are convertible into 564,607 shares of common stock at aninitial conversion price of $2.18 per share. 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.

 

The5% dividends accruing on the Series 3 5% preferred stock are required tobe paid quarterly on the first business day in March, June, September and December ofeach year, beginning with March 1, 2006. The liquidation preference for the preferred stock is an amount equal to$2.18 per share plus any accrued and unpaid dividends.  Holders of our Series 3 5% preferredstock have liquidation preference rights over holders of our 5% preferred, Series 25% preferred stock and common stock.  Theholders of the Series 3 5% preferred stock are not entitled to vote on anymatter, except as otherwise required by law or with respect to certain limitedmatters specified in the certificate of designations.

 

Includedin this transaction were warrants to purchase 282,306 shares of common stock atan exercise price of $0.40(repriced on December 28, 2006 from an initialexercise price of $2.58) per share. Warrant holders include 27,523 held by our CEO and 13,762 held by adirector of the Company.  In connectionwith the closing of this private placement, we issued warrants to purchase27,531 shares of our common stock at an exercise price of $2.58 per share to anaffiliate of our financial advisor for assistance with the private placement.

 

Holdersof Series 3 5% preferred stock have the right to require us to redeem anyor all of the their shares upon the occurrence of certain events within theCompany’s control that are defined in the certificate of designation at a priceequal

 

F-17

----

Table of Contents

 

the sum of (1) thegreater of $2.834****and the productof the volume weighted average price of our common stock on the trading dayimmediately preceding the event multiplied by $2.18 divided by the conversionprice then in effect plus (2) any accrued but unpaid dividends on the Series 35% preferred stock plus (3) all liquidated damages or other amountspayable to the holders of Series 3 5% preferred stock.

 

During 2007, 114,679 sharesof Series 3 5% preferred stock were converted into 114,679 shares of ourcommon stock.  There were no shares of Series 35% preferred stock converted to common stock during 2008.  At December 31, 2008 there are 354,056shares of Series 3 5% preferred stock outstanding.

 

***DividendsPayable***

 

During the fiscal year endedDecember 31, 2008, we accrued $64,000 in dividends to the holders of our5% Preferred Stock, $57,000 in dividends to the holders of our Series 2 5%Preferred Stock and $40,000 in dividends to the holders of our Series 3 5%Preferred Stock.  As of December 31,2008, we have $187,000 in accrued and unpaid dividends included in othercurrent liabilities.  Delaware lawprovides that we may only pay dividends out of our capital surplus or, if nosurplus is available, out of our net profits for the fiscal year the dividendis declared and/or the preceding fiscal year. We have not had net profits for the last two fiscal years and did nothave sufficient capital surplus, defined as the amount by which our net assetsexceed our stated capital, based on par value of our outstanding shares asprovided by Delaware law.  Thesedividends continue to accrue on all our outstanding shares of preferred stock,regardless of whether we are legally able to pay them.  Because we were unable to pay dividends on ourpreferred stock, we began accruing an additional late fee penalty of 18% perannum on the unpaid dividends for the Series 2 Preferred Stock and Series 3Preferred Stock.  Total penalties accruedduring 2008 were approximately $5,000. Our CEO and one member of our Board of Directors have waived the latefee penalty so we have recorded approximately $2,000 as contributed capitalduring 2008 related to these waivers.  Inaddition to this late penalty, the holders of our Series 2 Preferred Stockand Series 3 Preferred Stock could elect to present us with written noticeof our failure to pay dividends as scheduled, in which case we would have 45days to cure such a breach.  In the eventthat we failed to cure the breach, the holders of these shares of preferredstock would then have the right to require us to redeem their shares ofpreferred stock for a cash amount calculated in accordance with theirrespective certificates of designation. If we were required to redeem all shares of Series 2 PreferredStock and Series 3 Preferred Stock as of December 31, 2008, theaggregate redemption price we would owe would be $2.0 million.

 

**11. CommonStock Private Placement**

 

On March 15, 2007, wecompleted a private placement of 925,926 shares of our common stock for grossproceeds of $500,000.  G. Ward Paxton,our Chairman, President and Chief Executive Officer purchased 833,333 sharesfor a total of $450,000.  Michael L.Paxton, our Vice President and Chief Financial Officer purchased 92,593 sharesfor a total of $50,000.

 

On June 27, 2007, we completeda private placement of 1,111,111 shares of our common stock for gross proceedsof $500,000.  G. Ward Paxton, ourChairman, President and Chief Executive Officer purchased 1,000,000 shares fora total of $450,000.  Michael L. Paxton,our Vice President and Chief Financial Officer purchased 111,111 shares for atotal of $50,000.

 

# *On September 26, 2007,we completed a private placement of 1,190,476 shares of our common stock forgross proceeds of $500,000 with G. Ward Paxton, our Chairman, President andChief Executive Officer.*

# * *

**12.Concentrations**

 

Our operations areconcentrated in one area—security software/entity identification.  Sales to the U.S. Government through directand indirect channels totaled 86.2% of total revenues for 2008 and 73.2% oftotal revenues for 2007.  During 2008approximately 73.1% of total revenues are attributable to two governmentcustomers.  During 2007 approximately66.5% of total revenues are attributable to two government customers.  There were no individual commercial customersin 2008 or 2007 that exceeded 10% of total revenues for that year.  Our similar product and service offerings arenot viewed as individual segments, as our management analyzes the business as awhole and expenses are not allocated to each product offering.

 

**13.  Subsequent Event**

 

On March 19, 2009 the Company entered into an unsecured revolvingpromissory note to borrow up to $700,000 from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.  This replaces the note secured by the Companyon November 7, 2008 (NOTE 7).  Underthe terms of the note, the Company may borrow, repay and reborrow on the loanas needed up to an outstanding principal balance due of $700,000 at any giventime until March 31, 2010.

 

F-18

----