**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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

##### ** **

| **(Mark One)**                                                                 | ** ** | ** **                                                                                          |
|--------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|
| **ý**                                                                     | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**     |
|                                                                           | ** ** | ** **                                                                                          |
| **FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004**                           |
| ** **                                                                     | ** ** | ** **                                                                                          |
| **OR**                                                                         |
| ** **                                                                     | ** ** | ** **                                                                                          |
| **o**                                                                          | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                           | ** ** | ** **                                                                                          |
| **For the transition period from       to** |

 

**COMMISSIONFILE NUMBER 0-20191**

 

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**Intrusion Inc.**

(Exact name of registrant asspecified in its charter)

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

 

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

 

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

**None**

 

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

**CommonStock, $0.01 par value**

(Title of class)

 

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

 

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

 

State the issuer’s revenues for its mostrecent fiscal year:  $6,019,000

 

State the aggregate market value of thevoting and non-voting equity held by non-affiliates of the Registrant computedby reference to the price at which the common equity was last sold, or theaverage bid and asked price of such common equity, as of March 24, 2005: $12,733,360.  As of March 28, 2005, 6,058,030 sharesof the Registrant’s Common Stock were issued and outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the Registrant’s definitive ProxyStatement filed in connection with the Registrant’s 2004 Annual Meeting ofStockholders are incorporated by reference into Part III of thisForm 10-KSB.

 

 

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**INTRUSION INC.**

**INDEX**

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

 

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**PART I**

 

**Item 1**.           Description of Business.

** **

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

 

**General**

 

We develop, market and support a family ofnetwork intrusion prevention, intrusion detection, regulated informationcompliance and data privacy protection products.  Our product families include the ComplianceCommanderÔ for regulated informationand data privacy protection, Intrusion SpySnareÔfor real-time inline blocking of spyware and unwanted peer-to-peer (P2P)applications, and Intrusion SecureNetÔ for networkintrusion prevention and detection. Intrusion’s products help protect critical information assets by quicklydetecting, protecting, analyzing and reporting attacks or misuse of classified,private and regulated information for government and enterprise networks.

 

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

 

We were organized in Texas 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 NASDAQ ticker symbol from ODSI to INTZ toreflect our 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.

 

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

 

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

 

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numbers and related common stock numbers, such as earnings per shareand outstanding options, included in this report are set forth on a post-splitbasis.

 

On March 28, 2005, we completed a privateplacement of 1,065,200 shares of our Series 2 5% Convertible Preferred Stockand warrants to purchase 532,600 shares of our common stock for gross proceeds of$2,663,000.  The preferred shares may beconverted into 1,065,200 shares of common stock at an initial conversion priceof $2.50 per share, and the warrants may be exercised at a price of $2.77 pershare during the five-year period commencing on September 28, 2005.

 

**Product Transition**

 

Over the last four years, we havetransitioned our business from sales of our hardware-based PDS and SecureComnetwork security products to our higher margin software-based SecureNet,Compliance Commander and SpySnare products. Our product families includeintrusion prevention and detection, spyware and regulated informationcompliance products.

 

During this transition, our sales havedeclined from $7.8 million in 2002 to $6.5 million in 2003 and $6.0 million in2004 as sales of our new software products have not been sufficient to offsetreduced sales of our hardware products. Accordingly, we restructured our business to reflect our focus on oursales and to reduce our expenses.  Theseefforts resulted in a reduction in our operating loss from ($22.8) million in2002 to ($9.8) million in 2003 and ($4.5) million in 2004.

 

We plan to continue to focus our businessstrategy on sales of our higher margin software products, which includeSecureNet, Compliance Commander and SpySnare. We believe that changing regulatory requirements for obtaining andretaining information along with an increased need for data protection andnetwork security will increase market demand for and market acceptance of ourproducts, thus increasing our revenues and operating margins.

 

**Government Sales**

 

In December 2002, our SecureNet networksecurity products became the first product of their kind to receive CommonCriteria Certification under the National Information Assurance Partnership(NIAP) Common Criteria Evaluation and Validation Scheme, which is designed tofurther the goals of the government and commercial sectors to improve securityin commercial products.  This governmentinitiated partnership of the National Institute of Standards and Technology andthe National Security Agency establishes and verifies information technologystandards and certifies products that meet their standards, in an effort topromote the development and use of evaluated information technology productsand systems.  This organization also developsnational and international standards for information technology security, in aneffort to increase the level of trust government and commercial consumers havein information systems and related networking products.  In connection with this certification, weincreased our efforts to sell our products to government entities in both theUnited States and abroad.  We believethat common criteria certification will increase our ability to sell ourproducts to these government entities and, eventually, will drive increasedacceptance of our products across a broad range of industries.  Accordingly, on January 17, 2005, weentered into an agreement with the Common Criteria Testing Laboratory at COACTInc. to register and have our security products certified under NIAP higherevaluated assurance levels.  We believereceiving this certification will provide continued evidence that our productsmeet the highest standards of quality of government and commercial sectorsecurity products.

 

Sales to U.S. government customers accountedfor 53.6% of our revenues for the year ended December 31, 2004, comparedto 17.0% of our revenue in 2003.  Weexpect to continue to derive a substantial portion of our revenues from salesto governmental entities in the future as we continue to market our CommonCriteria Certified network security products as well as government use of ourregulated information compliance system products.  Sales to the government present risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including potential disruption due toappropriation and spending patterns and the government’s reservation of theright to cancel contracts and purchase orders for its convenience.

 

Generally, we make our sales under purchaseorders rather than long-term contracts. Our customers, including government customers may cancel their orderswith little or no prior notice without penalty. Although we transact business

 

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with various government entities, we do not believe that thecancellation of any particular order would have a material effect on ourfinancial results.  In addition, we donot believe that any of our revenues with government customers are subject torenegotiation of profits.  However,because we derive and expect to continue to derive a substantial portion of ourrevenue from sales to government entities, a large number of cancelled orrenegotiated government orders could possibly have a material adverse effect onour financial results.  Currently, we arenot aware of any proposed cancellation or renegotiation of any of our existingarrangements with government entities, and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

 

**Recent Developments**

 

On March 28, 2005, we completed a $2,663,000private placement of Series 2 5% Convertible Preferred Stock and warrants. Inthe private placement, we sold 1,065,200 shares of preferred stock at a priceof $2.50 per share, which convert into 1,065,200 shares of common stock at an initialconversion price of $2.50 per share, and warrants to purchase 532,600 shares ofcommon stock at an exercise price of $2.77 per share. 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.

 

**Industry Background**

 

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

 

As a result, enterprises are adopting avariety of security solutions to meet the challenge posed by external andinternal threats. To be effective, organizations require enterprise-wideinformation risk management solutions that are broadly deployed and centrallymanaged. Organizations seek systems with the optimum combination ofbest-of-breed capabilities and total cost of ownership. It is our belief thatsecuring the enterprise network requires two key elements:

 

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

 

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

 

We focus on providing these two primaryingredients of network security within a single device for overall networksecurity and for the protection of specific classified, confidential orcustomer information assets.

 

**Our SecureNet Network Systems**

 

The Intrusion SecureNet System, ComplianceCommander, and SpySnare System can operate standalone or with two primarycomponents, Sensors and the Management System.

 

Sensors are appliances or software componentsthat are connected to the network and monitor the traffic searching for matchesto signatures or database information as evidence of an external or internalnetwork attack or malicious use that could threaten information assets.Signatures are patterns, anomalies and traffic flows that match known attacksor indicate suspicious activities. When the Sensor matches traffic to asignature or customer defined database record it will detect,

 

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protect, block (if desired) and report to the Management System.

 

The Management System controls the Sensorsand displays events produced by the Sensors. Management is used for both configuration of the system and providinghighly productive monitoring of the events produced by the system. Managementis typically three-tier, where Sensors report to a centralized managementsystem that has multiple analysts viewing the data. Management can also be astandalone system for small- and medium-sized businesses where configurationand monitoring are all done directly from the Sensor.

 

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 SecureNet system provides more customization andevent flow options for high-end deployments.

 

Our SecureNet system is “plug-and-protect”and can be connected to any network without interfering with the networkoperations by using the Intrusion SecureNet passive and inline taps.

 

# *Intrusion Compliance CommanderRICS Products*

# * *

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

 

The Intrusion Compliance Commander RICSproducts leverage the same Management and Sensor components of the SecureNetNIP&DS products. Our Compliance Commander solutions are currently designedto address the security and confidentiality issues in the following industriesand customers:

 

•                                          Departmentof Defense to help prevent the leakage of classified information,

 

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

 

•                                          AnyFinancial institutions and e-commerce enterprises working to comply with thecustomer confidentiality provisions of GLBA and CA SB 1386.

 

The Compliance Commander RICS solutionsprovides accuracy through our Dynamic Data Dictionary (D3) technology, whichsecurely connects directly to the customer’s database housing the confidential,classified, or regulated information. The RICS stays up to date with the databaseto match network traffic to the information that is resident in the database.This provides an automated accurate mechanism to identify leaks and misuse ofinformation assets.  By using thecustomer’s own data, the Compliance Commander virtually eliminates anypotential for false positives.  Users notonly benefit from the highly accurate data protection, but also quickly realizethe low-cost of ownership by the fully automated updating feature.

 

The Intrusion LPS leak prevention systemtargets public and private enterprises with confidential and classifiedinformation. The first release specifically targets the U.S. Department ofDefense with protection against “spillage”, when classified information leaksto unclassified networks.

 

*Intrusion SpySnare Product*

 

“Spyware”is software that gathers user information without their knowledge through theirInternet connection.  Most spywareprograms are independent executable files that take on the authorizationabilities of the victim.  They include

 

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auto-install andauto-update capabilities and can report on any attempts to remove or modifythem.  Spyware can install Dynamic LinkLibrary and other executable files. Spyware can also read, write and delete files and even reformat yourhard drive and do this while sending a steady stream of information back to theadvertising and marketing companies or hackers.

 

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

 

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

 

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

 

# *Intrusion SecureNetNIP&DS Products*

# * *

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

 

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

 

Network Intrusion Detection Systems IDSproduct (NIDS) provides detection of specific exploit and misuse patterns inthe traffic that the firewall allows. NIDS detects known exploits and misuse patterns, suspicious activitiesand anomalous traffic or behavior within both inbound and outbound traffic.This added visibility provides a checking mechanism for the efficacy of thefirewall’s rule base.

 

 OurSecureNet NIP&DS products provide user customizable, protocol decodedetection technology for up to Gigabit networks. While Intrusion SecureNetSensors are in the top-tier of the market for detection and throughputtechnology, we believe one of the primary benefits provided by our NIP&DSproducts is to reduce the total cost of ownership to our customers.

 

The SecureNet NIP&DS product familyprovides intuitive and powerful data mining and configuration. IntrusionSecureNet Provider is the three-tier enterprise management and monitoringsystem. SecureNet Provider is for enterprise deployments with no licenselimitations placed on architecture, freeing the enterprise to build themanagement system required. SecureNet Provider follows the workflow of thesecurity analyst with a highly productive environment for response, research,resolution and decision support. The SecureNet Provider suite includesapplications for event monitoring, policy creation and tuning and centralizedsoftware deployment — making up the complete suite of tools required to manageand monitor a SecureNet System from five sensors to more than 100.

 

Our SecureNet Sensors have their own webbrowser interface for effortless configuration. SecureNet Sensors also

 

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deliver complete, stand-alone NIP&DS for the small and mediumbusiness with local management and monitoring. This allows customers to usetheir standard web browser to access a full power; full-featured NIP&DS,without additional hardware or software.

 

Our SecureNet NIP&DS Sensors areavailable as Software Sensors and Hardware Sensors with performance and pricingappropriate for networks ranging from 10Mb/s to Gigabit with a Common CriteriaEAL2 certified Gigabit appliance. The following is a list of our NIPS and NIDSproducts:

 

•                                          IntrusionSecureNet 7000 Software Sensor products for networks up to 1000Mb/s.  Seamlessly turns leading servers andworkstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet CC 7345 rack-mount Hardware Sensor, highly redundant, gigabit Sensorwith Common Criteria EAL2 certification—specifically for governmentdeployments.

 

•                                          IntrusionSecureNet 7145 rack-mount, gigabit Hardware Sensor available with either acopper- or a fiber-monitoring interface.

 

•                                          IntrusionSecureNet 5500 Software Sensor for networks up to 250Mb/s.  Seamlessly turns leading servers andworkstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet 5545 rack mount 250Mb/s Hardware Sensor for server rooms anddatacenters.

 

•                                          IntrusionSecureNet 5000 Software Sensor for networks up to 100Mb/s.  Seamlessly turns leading servers andworkstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet 5445 rack-mount and 2445 desktop 100Mb/s Hardware Sensors for networkdeployments and remote and branch offices.

 

•                                          IntrusionSecureNet 2000 Software Sensor for networks up to 10Mb/s.  Seamlessly turns leading servers andworkstations into SecureNet Sensors.

 

•                                          IntrusionSecureNet 2245 Hardware Sensor for remote and branch offices with throughput upto 10Mb/s at about the price of a laptop.

 

**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.  Our primary third-partyrelationship with Check Point Technologies has been significant in previousyears due to sales of our PDS appliances, which are integrated with Check Pointsoftware.  In connection with ourstrategy to focus our sales efforts on our higher-margin SecureNet softwareproducts, the sales of our PDS products and maintenance related to theseproducts have decreased from 16.7% of our revenue in 2003 to 9.7% or ourrevenue in 2004.  As we continue tomigrate our business away from our PDS and other hardware products, we expectour reliance on CheckPoint to continue to decline; however, sales of our newsoftware products may not replace the anticipated decline in sales of our PDSproducts, and our revenues may decline as a result. Our other third-partyrelationship is not material and is not expected to be material as the productoffering is only a complimentary item to our existing product offering.

 

**Customer Services**

 

In addition to offering our network securityproducts, we also offer a wide range of services, including design and 

 

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configuration, project planning, training, installation andmaintenance.

 

**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 user’s tasks so that they can do more with fewerresources, all to achieve market acceptance. We are currently marketingnext-generation network NIP&DS, Compliance Commander RICS and SpySnareproducts to meet emerging market requirements and are continuously engaged intesting to ensure that our products interoperate with other manufacturers’products, which comply with industry standards.

 

During 2004 and 2003, our research anddevelopment expenditures were $2.5 million and $3.5 million, respectively. Allof our expenditures for hardware and software research and development costshave been expensed as incurred. At December 31, 2004, we had 17 employeesengaged in research and product development.

 

**Manufacturing and Supplies**

 

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

 

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

 

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

 

**Intellectual Property and Licenses**

 

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

 

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Value Added Resellers (VARs) and integrators; promotes our products tocurrent and potential customers; and monitors evolving customer requirements.The field sales and technical support force provides training and technicalsupport to our resellers and end users and assists our customers in designingsecure data networking solutions.

 

We currently conduct sales and marketingefforts from our principal office in Richardson (Dallas), Texas and throughforeign sales offices located in England and Malaysia.  In addition, we have sales personnel, salesengineers or sales representatives located in Los Angeles, Eastern Europe andSpain.

 

***    Distributors.***  We have signed distribution agreements withdistributors in the United States, Europe and Asia. In general, theserelationships are non-exclusive. Distributors typically maintain an inventoryof our products. Under these agreements, we provide certain protection to thedistributors for their inventory of our products for price reductions as wellas products that are slow moving or have been discontinued. Recognition ofsales to distributors and related gross profits are deferred until thedistributors resell the merchandise. However, since we have legally sold theinventory to the distributor and we no longer have care, custody or controlover the inventory, we recognize the trade accounts receivable and reduceinventory related to the sale at the time of shipment to the distributor.

 

***    Resellers.***  Resellers such as domestic and internationalsystem integrators and VARs sell our products as stand-alone solutions to endusers and integrate our products with products sold by other vendors intonetwork security systems that are sold to end users. Our field sales force 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.

 

***    Foreign Sales.***  We believe that rapidly evolving internationalmarkets are important sources of future net sales. Our export sales arecurrently being made through a direct sales force supplemented by internationalresellers in Europe, Asia and Canada. Export sales accounted for approximately 19.2% and 31.4% of totalrevenue in 2004 and 2003, respectively. See “Management’s Discussion andAnalysis or Plan of Operations” included in this report for a geographicbreakdown of our product revenue in 2004 and 2003. Sales to foreign customersand resellers generally have been made in United States dollars.

 

***    Marketing.***  We have implemented several methods to marketour products, including public relations and placed articles, regularparticipation in and presenting during trade shows and seminars, advertisement intrade 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 hightechnology, e-commerce, manufacturing, government agencies, military, financialinstitutions, telecommunications, retail, transportation, healthcare,insurance, entertainment, utilities, energy companies, and academicinstitutions.  Essentially, our customersinclude any entity requiring network security solutions for protecting theirmission critical data.  Sales to certaincustomers and groups of customers can be impacted by seasonal capitalexpenditure approval cycles, and sales to customers within certain geographicregions can be subject to seasonal fluctuations in demand.

 

Although we sell our products to manycustomers, through various distribution channels, no one commercial customer orreseller accounted for 10% or more of our total revenue in any of the pastthree fiscal years.  However, in 2004,53.6% of our revenue was derived from a variety of U.S. government entitiesthrough system integrators and resellers. A reduction in our sales to U.S. government entities could have amaterial adverse 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 inventory based upon ourforecast of customer demand and maintain inventories of sub-assemblies andfinished products in advance of receiving firm orders from customers. Ordersare generally fulfilled within two days to two weeks following receipt of anorder. Due to the generally short cycle between order and shipment andoccasional customer-initiated changes in delivery schedules or cancellation oforders that are made without significant penalty, we do not believe that ourbacklog as of any particular date is indicative of

 

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future net sales.

 

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

 

There are numerous companies competing invarious segments of the data security markets. Our principal competitors in thenetwork intrusion prevention and detection market include Internet SecuritySystems, Inc., Cisco Systems, Inc., Symantec, Inc., NetscreenTechnologies, Inc., Network Associates, Inc., Tipping Point Technologies, adivision of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu, Vericept, Reconnex and a small number ofstart-up companies that entered the space within the last two-years. Regardingthe spyware prevention market, we currently directly and indirectly competewith a number of host-based spyware detection systems, such as Ad-Aware, Spybotand Spy Sweeper and some inline proxy solutions such as Blue Coat Systems,Inc.  We expect that some of the currenthost based spyware offerings will also propose inline perimeter spywareprevention systems in the near future.

 

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, which meet evolving customer requirements in a timely manner, therecan be 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, 2004, we employed atotal of 41 persons, including 13 in sales, marketing and technical support, 3in manufacturing and operations, 17 in research and product development and 8in administration and finance.

 

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

 

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

 

**Factors That May Affect Future Results ofOperations**

 

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

 

***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 industry standards.  We must also introduce upgrades to ourproducts rapidly in response to customer needs such as new computer viruses orother novel external attacks on computer networks.  In addition, the nature of the networksecurity industry requires our products to be compatible and interoperable withnumerous security products, networking products, workstation and personalcomputer architectures and computer and network operating systems offered byvarious vendors, including our competitors. As a result, our success depends upon our ability to develop andintroduce in a timely manner new products and enhancements to our existingproducts that meet changing customer requirements and evolving industrystandards. The development of technologically advanced network securityproducts is a complex and uncertain process requiring high levels ofinnovation, rapid response and accurate anticipation of technological andmarket trends.  We cannot assure you thatwe will be able to identify, develop, manufacture, market or support new orenhanced products successfully in a timely manner.  Further, we or our competitors may introducenew products or product enhancements that shorten the life cycle of ourexisting products or cause our existing products to become obsolete.

 

***Our revenues have declinedfrom $6.5 million in 2003 to $6.0 million in 2004 in connection with a shift tosales of our newer product lines. If our network intrusion detection andregulated information compliance system products do not achieve marketacceptance, our revenues will suffer.***

 

Over thepast four years, we have continued to transition our sales strategy from ourlower margin SecureCom and PDS security appliance products to the developmentand sales of our higher margin SecureNet network intrusion detection/preventionproducts.  During this transition, salesof our new products were not enough to counteract the loss in sales associatedwith our older products.  As a result,our net revenues have declined from approximately $6.5 million in 2003, toapproximately $6.0 million in 2004.

 

Our newnetwork security products, regulated information compliance systems and spywareproducts have only been in the market place for a limited period of time andmay have longer sales cycles than our previous products.  Although response to our products has beenpositive, we have not yet received broad market acceptance.  We cannot assure you that our present orfuture products will achieve market acceptance on a sustained basis.

 

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

 

Further,we believe that our status as one ofonly a few****companies toreceive Common Criteria Certification under the National Information AssurancePartnership (NIAP) Common Criteria Evaluation and Validation Scheme for networksecurity products and our efforts to have our security products certified underNIAP higher evaluated assurance levels will provide us an advantage inobtaining market acceptance of our products by government entities and othercommercial users.

 

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However, if we are notable to obtain this additional certification or if our competitors receivecertification of their products, we may not receive advantage with governmentand other customers we expect, and our sales and revenues would suffer.

 

***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, on April 17,2000, we announced our plans to sell our local area networking assets andrelated networking divisions.

 

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

 

•                  the need for our network security products, regulatedinformation compliance systems and spyware products to achieve market acceptanceand produce a sustainable revenue stream;

 

•                  our ability to manage costs and expenses;

 

•                  our dependence on key personnel;

 

•                  our ability to obtain financing on acceptable terms;and

 

•                  our ability to offer greater value than ourcompetitors.

 

Our businessstrategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products, regulated informationcompliance systems and spyware products, our business, financial condition and operatingresults would be materially adversely affected.

 

***We had a net loss of $4.5million and an accumulated deficit of $48.7 million as of the year ending December 31,2004.  As a result, we must generatesubstantially greater revenues from sales in order to achieve profitability.***

 

We haveincurred significant operating losses and are uncertain about our futureoperating results.  For the year ended December 31,2004, we incurred a net loss of $4.5 million and had an accumulated deficit ofapproximately $48.7 million at December 31, 2004.  In addition, our revenues have declined from$6.5 million in 2003, to $6.0 million in 2004. We need to generate and sustain substantially greater revenues from thesales of our products if we are to achieve profitability.  If we are unable to achieve these greaterrevenues, our losses will continue indefinitely, and we may never achieve orsustain profitability or generate positive cash flow.

 

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

 

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

 

Our principal competitors in the networkintrusion prevention and detection market include Internet SecuritySystems, Inc., Cisco Systems, Inc., Symantec, Inc., NetscreenTechnologies, Inc., Network Associates, Inc., Tipping Point Technologies, adivision of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu, Vericept, Reconnex and a small number of startup companies that entered the space within the last two-years. Regarding thespyware prevention market, we currently directly and indirectly compete with anumber of host-based spyware detection systems, such as Ad-Aware, Spybot andSpy Sweeper and some inline proxy solutions such as Blue Coat Systems,Inc.  We expect that some of the currenthost based spyware offerings will also propose

 

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inline perimeter spyware prevention systems in the near future.  Our current and potential competitors mayhave one or more of the following significant advantages over us:

 

•                  greater financial, technical and marketing resources;

 

•                  better name recognition;

 

•                  more comprehensive security solutions;

 

•                  better or more extensive cooperative relationships;and

 

•                  larger customer base.

 

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

 

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

 

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

 

•                  reducing or delaying government or corporate spendingon network security products;

 

•                  increasing the cost and difficulty in obtainingmaterials or shipping products; and

 

•                  affecting our ability to conduct businessinternationally.

 

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

 

***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 technical evaluationand commitment of capital and other resources. This process is also subject to the risk of delays associated withcustomers’ internal budgeting and other procedures for approving capitalexpenditures, deploying new technologies within their networks and testing andaccepting new technologies that affect key operations.  As a result, sales and implementation cyclesfor our products can be lengthy, and we may expend significant time andresources before we receive any revenues from a customer or potentialcustomer.  Our quarterly and annualoperating results could be materially harmed if orders forecasted for aspecific customer for a particular period are not realized.

 

***Our cash, cashequivalents, and investments declined from $2.7 million at December 31,2003 to $2.4 million at December 31, 2004. As a result of our expected continuing net cash outflows, we may nothave sufficient cash to operate our business.***

 

As of December 31,2004, we had cash, cash equivalents and investments in the amount of approximately$2.4 million, down from approximately $2.7 million as of December 31,2003.  Although we believe the additional$2.66 million in gross proceeds we received in connection with a privateplacement of preferred stock and warrants we completed on March 28, 2005 willprovide us with sufficient cash resources to finance our operations for thenext twelve months, the sufficiency of our cash resources may depend to acertain extent on general economic, financial, competitive or other factorsbeyond our control.  In addition, thepayment of accrued dividends on our outstanding preferred stock may reduce ouravailable cash resources.  Moreover,despite our actions to reduce costs and improve profitability, we expect ournet operating losses and

 

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net operating cashoutflows to continue through at least the first half of 2005.  We do not currently have any furtherarrangements for financing, and we may not be able to secure additional debt orequity financing on terms that are acceptable to us, or at all, at the timewhen we need this financing.  If ourbusiness does not generate sufficient cash flow from operations and sufficientfinancing resources are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.

 

***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 $1.0 million inrestructuring charges, severance, and related expenses. The objective of ourrestructuring plan was to reduce our cost structure to a sustainable level thatis consistent with our current cash resources and the general economicclimate.  We have also implemented otherstrategic initiatives to strengthen our operations, such as reductions in ourwork force and facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations andfinancial condition.

 

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

 

Severalof our competitors have acquired security companies with complementarytechnologies in the past, such as the recent acquisition of Tipping PointTechnologies by 3Com and the merger of Symantec and Veritas, and we expectconsolidation in the network security industry to continue in the future.  These acquisitions may permit our competitorsto accelerate the development and commercialization of broader product linesand more comprehensive solutions than we currently offer.  Acquisitions of vendors or other companieswith which we have a strategic relationship by our competitors may limit ouraccess to commercially significant technologies.  Further, business combinations in the networksecurity industry are creating companies with larger market share, customer bases,sales forces, product offerings and technology and marketing expertise, whichmay make it more difficult for us to compete.

 

***Revenues from government entities accountedfor 53.6% of our revenues for the year ended December 31, 2004.  Government customers involve unique risks,which could adversely impact our revenues.***

 

Wederived 53.6% of our revenues from sales to various U.S. government entitiesfor the year ended December 31, 2004. We expect to continue to derive a substantial portion of our revenuesfrom U.S. government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns and the government’s right to cancelcontracts and purchase orders for its convenience.  General political and economic conditions,which we cannot accurately predict, directly and indirectly may affect thequantity and allocation of expenditures by federal departments.  In addition, obtaining government contractsmay involve long purchase and payment cycles, competitive bidding,qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulations withwhich we must comply and which can vary significantly among departments.  As a result, cutbacks or re-allocations inthe federal budget or losses of government sales due to other factors couldhave a material adverse effect on our revenues and operating results.

 

***We derived 19.2% of our revenues frominternational customers for the year ended December 31, 2004.  Our ability to sell our productsinternationally is subject to certain risks, which could harm our business.***

 

Revenuesfrom foreign customers accounted for approximately 19.2% of our revenues forthe year ended December 31, 2004. We expect sales to foreign customers to continue to represent asignificant portion of our revenues in the future.  Our international operations are subject tomany inherent risks that may adversely affect our business, financial conditionand operating results, including:

 

•                  political, social and economic instability;

 

•                  trade restrictions;

 

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•                  increases in duty rates and other potentially adversetax consequences;

 

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

 

•                  burdens of complying with a variety of foreign laws;

 

•                  unexpected changes in regulatory requirements;

 

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

 

•                  fluctuations in currency exchange rates; and

 

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

 

***Sales through indirectchannels accounted for 36.9% of our revenues for the year ended December 31,2004.  Our revenues will suffer if we donot expand our sales through, or receive the anticipated benefits from oursales through, indirect sales channels.***

 

Wederived 36.9% of our revenues for the year ended December 31, 2004 fromsales through indirect sales channels, such as distributors, value addedresellers, system integrators, original equipment manufacturers and managedservice providers.  We believe we mustexpand our sales through these indirect channels in order to increase ourrevenues.  Although we are activelypursuing a strategy to increase the percentage of our revenues generatedthrough these indirect sales channels, we cannot assure you that our productswill gain market acceptance in these indirect sales channels or that salesthrough these indirect sales channels will increase our revenues as expected.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

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

 

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

 

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

 

There arenumerous patents held by many companies relating to the design and manufactureof network security systems.  Although weare not aware of any instances in which our products violate the intellectualproperty rights of others or inappropriately use their technology, it ispossible that third parties in the future may claim that our products infringeon their intellectual property rights. Any claim, with or without merit, could consume our management’s time,result in costly litigation, cause delays in sales or implementations of ourproducts or require us to enter into royalty or licensing agreements. Royaltyand licensing agreements, if required and available, may be on terms unacceptableto us or detrimental to our business. Moreover, a successful claim of product infringement against us or ourfailure or inability to license the infringed or similar technology oncommercially reasonable terms could seriously harm our business.

 

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

 

Ouroperating results have varied significantly from quarter to quarter in thepast, and we expect our operating results to vary from quarter to quarter inthe future due to a variety of factors, many of which are outside of ourcontrol.  Although our revenues aresubject to fluctuation, significant portions of our expenses are not variablein the short term, and we cannot reduce them quickly to respond to decreases inrevenues.  Therefore, if revenues arebelow our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly we may not attain positive

 

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operating margins infuture quarters.  Any of these factorscould cause our operating results to be below the expectations of securitiesanalysts and investors, which likely would negatively affect the price of ourcommon stock.

 

***The price of our commonstock has been volatile in the past and may continue to be volatile in thefuture due 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 2004, the market price of our common stockon The NASDAQ SmallCap Market fluctuated between $0.86 to $4.40 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

•                  variations in our quarterly operating results;

 

•                  changes in estimates of our financial performance bysecurities analysts;

 

•                  changes in market valuations of our competitors;

 

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

 

•                  product or design flaws, product recalls or similaroccurrences;

 

•                  additions or departures of key personnel;

 

•                  sales of common stock in the future; and

 

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

 

***Our recent 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 haveemployment agreements with relatively few**ofour key technical, sales and senior management personnel.  As a result, our employees could resign withlittle or no prior notice.  We may not beable to attract, assimilate or retain other highly qualified technical, salesand managerial personnel in the future, especially given our recent reductionsin force.  The loss of any of our keytechnical, sales and senior management personnel or our inability to attract,train and retain additional qualified personnel could seriously harm ourbusiness.

 

***Certain rights of theholders of our preferred stock may hinder our ability to raise additionalfinancing.***

 

We cannotissue shares of capital stock with rights senior to those of our existing 5%preferred stock or Series 2 5% preferred stock without the approval of at leasta majority of the holders of our 5% preferred stock and all of the holders ofour Series 2 5% preferred stock, voting or acting as separate classes.  We also cannot incur certain indebtednesswithout the approval of at least a majority of the holders of our 5% preferredstock.  In addition, holders of the Series2 5% preferred stock who are not executive officers or directors have the rightto purchase a pro rata portion of certain future issuances of securities byus.  The combination of these provisionscould hinder or delay our ability to raise additional debt or equity financing.

 

***You will experiencesubstantial dilution upon the conversion of the shares of preferred stock andexercise of warrants that we issued in our recent private placements.***

 

On March 25, 2004, we completed a$5,000,000 private placement in connection with which we issued 1,000,000shares of our 5% Convertible Preferred Stock and warrants to acquire 556,619shares of our common stock.  Theconversion price for the preferred stock and the exercise price of the warrantsis $3.144 per share.  We also issued ourplacement agent a warrant for 64,408 shares of our common stock at an exerciseprice of $3.144 per share.  As of March 28,2005, there were 439,392 shares of 5% preferred stock, representing 698,776shares of common stock upon conversion, and warrants to purchase 556,619 sharesof common stock outstanding.

 

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In addition, on March 28, 2005, we completeda $2,663,000 private placement in connection with which we issued 1,065,200 sharesof our Series 2 5% Convertible Preferred Stock and warrants to acquire 532,600shares or our common stock.  Theconversion price for the preferred stock is $2.50 per share and the exerciseprice of the warrants is $2.77 per share.

 

On March 28, 2005, we had 6,058,030shares of common stock outstanding.  As aresult, we expect the private placements to result in a further dilution toholders of our common stock upon conversion of the preferred stock and exerciseof the warrants of 2,853,195 shares of common stock, or an approximately 47.1%increase in the number of shares of our common stock outstanding.

 

***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 5% preferred stock and warrants we issued on March 25,2004, may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to aneffective registration statement we filed on August 6, 2004.  As of February 28, 2005, 560,608 sharesof preferred stock had converted into 891,551 shares of common stock.  In December 2004, we received noticethat 160,000 preferred shares converted into 254,452 shares of common stock andin January 2005 we received notice that 400,608 preferred shares convertedinto 637,099 shares of common stock.  Inaddition, upon the effectiveness of the registration statements related to our March28, 2005 private placement, the holders of Series 2 5% preferred stock andwarrants we issued in that private placements will be able to freely converttheir shares of preferred stock and exercise their warrants and sell theirunderlying shares of common stock.

 

For thefour weeks ended on February 25, 2005, the average daily trading volume ofour common stock on The NASDAQ SmallCap Market was 100,153 shares.  Consequently, if holders of preferred stockor warrants elect to convert their remaining shares or exercise their warrantsand sell a material amount of their underlying shares of common stock on theopen market, the increase in selling activity could cause a decline in themarket price of our common stock. Furthermore, these sales, or the potential for these sales, couldencourage short sales, causing additional downward pressure on the market priceof our common stock.

 

***The percentage of our revenues attributableto sales of our PDS products integrated with software of Check Point SoftwareTechnologies decreased from 16.7% in 2003 to 9.7% in 2004.  Because sales of our newer products may notoffset the reduced sales of our PDS products, a change in our relationship withCheck Point could have a negative effect on our operating results.***

 

Our PDSfamily of security appliances, which are integrated with Check Point SoftwareTechnologies’ market-leading VPN-1®/FireWall-1® software, represented 9.7% ofour revenues for the year ended December 31, 2004.  These percentages are down from 16.7% of ourrevenues for the year ended December 31, 2003.  We expect the percentage of our salesattributable to our PDS products to decline in the future; however, ourreliance on newer product sales may not replace the anticipated decline inrevenue from sales of our PDS products. Although we are a certified appliance partner of Check Point and our PDSproducts have received Check Point certification, we have no long-termagreement or exclusive relationship with Check Point.  As a result, the loss or significant changein our relationship with Check Point, the failure of our PDS products tomaintain or receive Check Point certification, the business failure of CheckPoint or its acquisition by or of one of our competitors and the loss of marketshare of Check Point or market acceptance of its products could each have amaterial adverse effect on our business, financial condition and results ofoperations.

 

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

 

We havemade acquisitions in the past and, in the future we may acquire or invest inadditional companies, business units, product lines or technologies toaccelerate the development of products and sales channels complementary to ourexisting products and sales channels. Negotiation of potential acquisitions and integration of acquiredproducts, technologies or businesses could divert our management’s time andresources.  Future acquisitions couldcause us to issue equity securities that would dilute your ownership of us,incur debt or contingent liabilities, amortize intangible assets or write offin-process research and development, goodwill and other acquisition-relatedexpenses that could seriously harm our financial condition and operatingresults.  Further, if we are not able toproperly integrate acquired products, technologies or

 

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businesses with ourexisting products and operations, train, retain and motivate personnel from theacquired business or combine potentially different corporate cultures, we maynot receive the intended benefits of our acquisitions, which could adverselyaffect our business, operating results and financial condition.

 

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

 

Shares ofour 5% convertible preferred stock accrue cash dividends equal to $0.25 pershare per annum, payable in arrears on March 31 and September 30 of eachyear, and shares of our Series 2 5% convertible preferred stock accrue cashdividends equal to $0.125 per share per annum, payable in arrears on the firstbusiness day of March, June, September and December of each year.  During 2004, we paid $129 thousand individends related to our 5% convertible preferred stock and at December 31,2004, we have dividends accrued related to the 5% convertible preferred stockof $63 thousand.

 

Delawarelaw provides that we may only pay dividends out of our capital surplus or, ifno surplus is available, out of our net profits for the fiscal year thedividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years, and as of December 31, 2004. However, we did have sufficient capital surplus, defined as the amountby which our net assets exceed our stated capital, based on par value of ouroutstanding shares as provided by Delaware law. Although we are currently able to pay accrued dividends on ouroutstanding shares of preferred stock, we cannot assure you that our net assetswill continue to exceed our stated capital or that we will have net profits inorder to pay these dividends in the future. These dividends continue to accrue on our outstanding shares ofpreferred stock, regardless of whether we are legally able to pay them.  The accrual of these dividends may adverselyaffect our operating results.  Inaddition, the payment of these dividends could strain our available cashresources, which could adversely affect our ability to operate or grow ourbusiness.  Furthermore, our inability topay dividends could adversely affect our ability to raise equity financing inthe future if required.

 

***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.

 

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

 

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

 

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

 

As of March 28,2005, our executive officers, directors and preferred stockholders beneficiallyown approximately 42% 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.

 

**Item 2**.           Description of Property.

** **

Our headquarters are located in a two-storybuilding in Richardson, Texas.  We occupyapproximately 30,000 square feet of floor space in this facility. This facilityincludes our corporate administration, operations, marketing, research anddevelopment, sales and technical support personnel.  During 2004, we renegotiated our lease toreduce our square footage and increase the term of our lease.  We will occupy 30,000 square feet in thisfacility through February 2010.

 

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Approximately one-half of our securitysoftware research and development staff is located in a 6,464 square footleased property in San Diego, California. This lease was renewed in August 2004 and will expire in August 2006.  Research and development personnel occupythis facility.

 

In addition, we lease small amounts of officespace for sales and technical support personnel domestically andinternationally in England, Germany and Malaysia. We believe that the existingfacilities at December 31, 2004 will be adequate to meet our requirementsthrough 2005.  See Note 4 of Notesto Consolidated Financial Statements for additional information regarding ourobligations under leases.

 

**Item 3**.           Legal Proceedings.

** **

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

 

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

** **

There were no matters submitted to a vote ofour security holders during the fourth quarter of 2004.

 

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## **PART II**

## ** **

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

** **

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

 

Our common stock trades on The NASDAQSmallCap Market, where it is currently listed under the symbol “INTZ.”  As of February 28, 2005, there wereapproximately 91 registered holders of record of the common stock. Thefollowing table sets forth, for the periods indicated, the high and low pershare intra-day sales prices for the common stock, as reported by The NASDAQStock Market.  Market values for 2003 throughFirst Quarter 2004 have been retroactively adjusted to give effect to theone-for-four reverse stock split effective March 29, 2004.

 
| ** **     | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|           |       |     |       |     |       |   |   |   |   |
| First Quarter  |       | $        | 4.40       |     | $          | 1.60 |   | $ | 2.00 |   | $ | 0.60 |   |
| Second Quarter |       | 3.88     |       | 1.44     |       | 4.60 |   | 0.48 |   |
| Third Quarter  |       | 2.00     |       | 0.86     |       | 4.80 |   | 2.24 |   |
| Fourth Quarter |       | 3.75     |       | 1.30     |       | 5.52 |   | 1.96 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

We havenot declared or paid cash dividends on our common stock in our two most recentfiscal years. We intend to retain any earnings for use in our business and donot anticipate paying any cash dividends on our common stock in the foreseeablefuture. Future dividends on common stock, if any, will be determined by ourBoard of Directors.  However, shares ofour 5% convertible preferred stock accrue cash dividends equal to $0.25 pershare per annum, payable in arrears on March 31 and September 30 of eachyear, and shares of our Series 2 5% convertible preferred stock accrue cashdividends equal to $0.125 per share per annum payable in arrears on the firstbusiness day of March, June, September and December of each year.  During 2004, we paid $129 thousand individends related to our 5% convertible preferred stock and at December 31,2004, we have dividends accrued related to the 5% convertible preferred stockof $63 thousand.

 

Delawarelaw provides that we may only pay dividends out of our capital surplus or, ifno surplus is available, out of our net profits for the fiscal year thedividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years, and as of December 31, 2004. However, we did have sufficient capital surplus, defined as the amountby which our net assets exceed our stated capital, based on par value of ouroutstanding shares as provided by Delaware law. Although we are currently able to pay accrued dividends on ouroutstanding shares of preferred stock, we cannot assure you that our net assetswill continue to exceed our stated capital or that we will have net profits inorder to pay these dividends in the future. These dividends continue to accrue on our outstanding shares ofpreferred stock, regardless of whether we are legally able to pay them.  The accrual of these dividends may adverselyaffect our operating results.  Inaddition, the payment of these dividends could strain our available cashresources, which could adversely affect our ability to operate or grow ourbusiness.  Furthermore, our inability topay dividends could adversely affect our ability to raise equity financing inthe future if required.

 

All stock option plans under which our commonstock is reserved for issuance have previously been approved by ourshareholders. The following table provides summary information as of December 31,2004 for all of our stock option plans (in thousands, except per share data).See Note 7 to our consolidated financial statements for additionaldiscussion.

 

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| ** **                                                  | ** ** | **Number of Shares of  Common Stock to be  Issued upon Exercise  of Outstanding  Options** | ** ** | **Weighted Average Exercise Price  of Outstanding Options, Excludes  Warrants Rights** | ** ** | **No. of Shares of  Common Stock  Remaining Available  for Future Issuance** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
|                                                        |       |                                                                                       |       |                                                                                   |       |                                                                         |       |
| Equity compensation plans approved by  security holders     |       | 404                                                                                        | (1)        | $                                                                                      | 11.08      |                                                                         | 423        | (2) |
| Equity compensation plans not approved by  security holders |       | —                                                                                     |       | —                                                                                 |       | —                                                                       |       |
| Total                                                       |       | 404                                                                                        |       | $                                                                                      | 11.08      |                                                                         | 423        |   |

 

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(1)          Included in the outstanding options are358,187 from the 1995 Plan, 3,400 from the 1987 Plan and 42,500 from the 1995Non-Employee Director Plan.

 

(2)          Does not include Employee Stock PurchasePlan. At December 31, 2004, 79,298 shares were available for futureissuance under this plan.

 

**Item6****.****           Management’s Discussionand Analysis of Financial Condition and Results of Operations.**

 

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

 

This Annual Report, other than historicalinformation, may include forward-looking statements, including statements withrespect to financial results, product introductions, market demand, saleschannels, industry trends, sufficiency of cash resources and certain othermatters. These statements are made under the “safe harbor” provisions of thePrivate Securities Litigation Reform Act of 1995 and involve risks anduncertainties which could cause actual results to differ materially from thosein the forward-looking statements, including those discussed in the section entitled“Factors That May Affect Future Results of Operations” in Item 1 and elsewherein this Annual Report on Form 10-KSB and other filings with the Securitiesand Exchange Commission.

 

This report may include various non-GAAPfinancial measures (as defined by SEC Regulation G), including our cash used inoperations excluding costs associated with a litigation settlement and severancecharges.  Our management believes thesemeasures provide useful information to investors about our financial conditionand results of operations for the period presented by eliminating the affectsof one-time and other transactions that can distort underlying operationalresults in order to provide greater comparability of our financial performanceon a year-to-year basis. The most directly comparable GAAP financial measuresand reconciliation of the difference between GAAP and non-GAAP financial measurescan be found in the text of this report and our consolidated financialstatements included in this report.

 

**Overview**

 

We develop, market and support a family ofnetwork intrusion prevention, intrusion detection, regulated informationcompliance and data privacy protection products.  Our product families include the ComplianceCommanderÔ for regulatedinformation and data privacy protection, Intrusion SpySnareÔfor real-time inline blocking of spyware and unwanted peer-to-peer (P2P)applications, and Intrusion SecureNetÔ for networkintrusion prevention and detection. Intrusion’s products help protect critical information assets by quicklydetecting, protecting, analyzing and reporting attacks or misuse of classified,private and regulated information for government and enterprise networks.

 

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

 

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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 NASDAQ ticker symbol from ODSI to INTZ toreflect our 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.

 

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

 

Our revenues have decreased over the past twoyears due primarily to the change in our product focus from networking hardwareto network security software products and a decrease in sales volume related tothis transition.  As a result, ourrevenues have declined over the past two years from $6.5 million in 2003, to$6.0 million in 2004.  To date, we havenot encountered significant competition in the market, which has caused adecrease in our sales prices when compared to sales prices in previous years.  To help counteract our declining revenues andbring our operations in line with our new strategic focus, we reduced ouremployee headcount and discontinued manufacturing operations.  Our global headcount has declined over thepast two years in an effort to reduce costs and align our efforts with our coresoftware based products.  As we continuedour migration away from the hardware based products, our global headcountdeclined from 44 employees in 2003, to 41 employees in 2004.  As a result of our migration tosoftware-based solutions and the discontinuance of manufacturing operations,our margins have increased over the past two years from 38.4% in 2003, to 51.0%in 2004.  We have also restructured ourpersonnel and operations around the development and sale of our core softwareproducts.  As a result of these efforts,we believe we have reduced operating expenses to a level that will remainconsistent going forward.

 

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

 

In order for us to operate and grow our business,we must achieve and sustain operating profits and become cash flowpositive.  This will require us tocounteract reduced sales of our hardware products by generating additionalrevenues from sales of our intrusion detection, intrusion prevention and regulatedinformation compliance software products. In order to obtain these sales, our products must gain acceptance inintensely competitive and emerging markets. We believe the Common Criteria Certification of our network securitysoftware products, our ability to introduce our regulated informationcompliance products into the marketplace in a timely manner and our efforts tomaintain our reduced spending 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, intangible assets, income taxes, warranty obligations,restructuring, maintenance contracts and contingencies. We base our estimateson historical experience and on various other assumptions that are believed tobe reasonable under the circumstances, the results of which form the basis formaking judgments about the carrying values of assets and liabilities that arenot readily apparent from other sources. Actual results may differ from theseestimates under different assumptions or conditions.

 

23

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

 

*Revenue Recognition*

 

We generally recognize product revenue 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 revenue fromthe licensing of our products is not recognized until all four of the followingcriteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectibility is probable. Bundled hardware andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical sales informationon our product offerings.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

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

 

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

 

*Allowance for Doubtful Accounts and Returns*

 

We maintain allowances for doubtful accountsfor estimated losses resulting from the inability of our customers to makerequired payments. Our receivables are uncollaterized and we expect to continuethis policy in the future.  If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments,

 

24

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additional allowances may be required. Historically, our estimates for sales returns and doubtful accounts havenot 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.

 

**Results of Operations**

 

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

 
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **2004**                         | ** ** | **2003** | ** ** |
|                                              |       |                             |       |   |   |
| Net product revenue                               |       | 72.5                             | %          | 64.8 | % |
| Net customer support and maintenance  revenue     |       | 27.5                             |       | 35.2 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0 |   |
| Cost of product revenue                           |       | 46.3                             |       | 50.1 |   |
| Cost of customer support and maintenance  revenue |       | 2.7                              |       | 11.5 |   |
| Total cost of revenue                             |       | 49.0                             |       | 61.6 |   |
| Gross profit                                      |       | 51.0                             |       | 38.4 |   |
| Operating expenses:                               |       |                             |       |   |   |
| Sales and marketing                               |       | 61.3                             |       | 96.2 |   |
| Research and development                          |       | 42.4                             |       | 54.0 |   |
| General and administrative                        |       | 19.0                             |       | 25.2 |   |
| Litigation settlement                             |       | —                           |       | 6.9 |   |
| Severance costs                                   |       | 4.5                              |       | 7.3 |   |
| Operating loss                                    |       | (76.2                            | )          | (151.2 | ) |
| Interest income, net                              |       | 0.7                              |       | 2.8 |   |
| Other income, net                                 |       | 0.3                              |       | 0.2 |   |
| Loss from operations before income taxes          |       | (75.2                            | )          | (148.2 | ) |
| Income tax provision                              |       | —                           |       | — |   |
| Net loss                                          |       | (75.2                            | )          | (148.2 | ) |
| Preferred stock dividends accrued                 |       | (3.2                             | )          | — |   |
| Beneficial conversion feature on preferred  stock |       | (15.6                            | )          | — |   |
| Net loss attributable to common  stockholders     |       | (94.0                            | )%         | (148.2 | )% |

 
| ** **         | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
|               |       |     |       |     |       |
| Domestic revenue   |       | 80.8     | %          | 68.6     | %          |
| Export revenue to: |       |     |       |     |       |
| Europe             |       | 11.2     |       | 23.0     |       |
| Canada             |       | 4.5      |       | 0.9      |       |
| Asia               |       | 3.2      |       | 7.4      |       |
| Latin America      |       | 0.3      |       | 0.1      |       |
| Net revenue        |       | 100.0    | %          | 100.0    | %          |

 

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**2004 compared with 2003**

 

***Net Revenue***

 

Total revenue decreased 7.1% to$6.0 million in 2004 from $6.5 million in 2003.  This decline is related to the transitionaway from our hardware-based products, which carried higher sales prices andlower margins to our software-based products, which carry lower sales pricesand higher margins.  Our customer supportand maintenance revenue decreased 27.3% from $2.3 million in 2003 to $1.7million in 2004.  This decline is mainlydue to the expiration of maintenance contracts related to our legacy productsand lower support and maintenance revenues associated with our lower pricedsoftware-based products.  Further salesof our newer software based products have not been sufficient to counteract ourgradual discontinuation of sales of our PDS firewall products.  In addition, we believe a continued sluggishgeneral worldwide economy has negatively impacted sales of our SecureNetproduct line. In 2004 total revenues related to our SecureNet product lineincreased 17.8% or $0.8 million from $4.6 million in 2003 to $5.4 million in2004, and our non-core product lines, including our PDS and SecureCom hardwareproducts decreased 68.6% or $1.3 million from $1.9 million in 2003 to $0.6million in 2004.  Our product revenuesincreased 3.9% from $4.2 million in 2003 to $4.4 million in 2004.  This increase was the result of our increasein our product sales of the SecureNet product family.  We expect this trend to continue in thefuture.

 

Export sales in 2004 decreased to$1.2 million, or 19.2% of net revenue, compared to $2.0 million, or31.4% of net revenue in 2003 primarily due to a continued economic decline, ourfocus on domestic revenues and a decrease in international technologyspending.  As part of our headcountreductions, we have focused most of our sales personnel on the domestic market.  Although we do expect to continue to derive asignificant portion of our revenues from international sales, we do not rely onany one country, region or customer for these sales.  Sales of our products internationally may besubject to exchange risk, which may cause our products to effectively increasein price, if the exchange rate moves significantly and the dollar gains valueover the foreign currency.

 

Historically,due to the timing of our sales cycle, a 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. The monthly trend was exaggerated at December 2004and December 2003, due to unusually high sales volume occurring in thelast half of each of these months.

 

***Gross Profit***

 

Gross profit increased 23.3% to$3.1 million in 2004 from $2.5 million in 2003. As a percentage ofnet revenue, gross profit increased to 51.0% for 2004 from 38.4% in 2003. Thisincrease is primarily associated with a more profitable product mix in2004.  Gross profit on products increasedfrom 22.7% in 2003 to 36.1% in 2004 due to the shift in a more profitableproduct mix, namely our software-based products.  Gross profit on customer support andmaintenance increased from 67.4% in 2003 to 90.1% in 2004.  The increase in gross profit on customersupport and maintenance was mainly due to lower hardware related repair costsin conjunction with our strategic decision to move towards software-basedsolutions.  As we continue to migratefrom our older hardware-based products to our newer software-based products, weexpect our margins to continue to increase.

 

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

 

***Sales and Marketing***

 

Sales and marketing expenses decreased 40.8%to $3.7 million in 2004 from $6.2 million in 2003 as we focused oursales force domestically, including headcount reductions, to respond to thedecline in sales. As a percentage of net revenue,

 

26

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sales and marketing expenses decreased to 61.3% in 2004 from 96.2% in2003. We expect sales and marketing expenses to remain relatively consistent in2005 compared to 2004 as we believe we have recognized the full benefit fromrestructuring actions taken throughout 2003 and 2004.  We also expect sales and marketing expenses,as a percentage of net revenue, to decrease in 2005 compared to 2004 as werecognize the full year benefit of restructuring efforts in 2004 along with anexpected increase in revenue in 2005.

 

***Research and Development***

 

Research and development expenses decreased27.1% to $2.5 million, or 42.4% of net revenue, in 2004 compared to$3.5 million, or 54.0% of net revenue, in 2003 as we recognized the fullbenefit of headcount reductions and restructuring actions taken during 2003 and2004. Our research and development costs are expensed in the period in whichthey are incurred. We expect research and development expenses to remainrelatively consistent in 2005 compared to 2004. We expect research and development, as a percentage of net revenue, alsoto decrease in 2005 compared to 2004 as our revenue increases.

 

***General and Administrative***

 

General and administrative expenses decreased29.8% to $1.1 million in 2004 from $1.6 million in 2003 as werealized the full benefit of headcount reductions in 2004.  As a percentage of net revenue, general andadministrative expenses decreased to 19.0% in 2004 from 25.2% in 2003.  We expect general and administration expensesto remain consistent in 2005 compared to 2004.

 

***Litigation Settlement***

 

Litigation settlement expenses were $0.5million in 2003, due to a settlement of a pending lawsuit with Morgan Newtonduring the third quarter of 2003.

 

***Severance Costs***

 

In connection with our strategic alignment ofour sales force domestically and our continued shift to our new intrusiondetection and security appliance product lines during 2004, we streamlinedoperations and activities that are not aligned with these core markets andstrategies. During 2004, we recorded severance charges of $0.3 million forseverance as a result of reductions in force. All severance obligations related to the 2004 charge were paid prior to December 31,2004 and we were not receiving any benefits from those severed individualsafter December 31, 2004.

 

Severance costs decreased 42.2% to$0.3 million in 2004 from $0.5 million in 2003 as we continued tostreamline our operations in 2004.  As apercentage of net revenue, severance costs decreased to 4.5% in 2004 from 7.3%in 2003.  We do not expect significantseverance costs in 2005.

 

***Interest Income, Net***

 

Net interest income decreased 76.9% to $42thousand in 2004 from $182 thousand in 2003 primarily due to a decrease inaverage cash and interest-bearing investment balances and lower interest rates.We do not expect net interest income to decrease in 2005 compared to 2004 as weexpect our average cash and interest-bearing investment balances to increase in2005 when compared to 2004 as a result of our private placement in the firstquarter of 2005 and our anticipated increase in revenue in 2005.  However, we do expect interest rates toremain low, resulting in a lower return on investment. Net interest income willvary in the future based on our cash flow and rate of return on investments.

 

***Income Taxes***

 

Our effective income tax rate was 0% in 2004and 2003 as valuation allowances have been recorded for the entire amount ofthe net deferred tax assets due to uncertainty of realization.  We have fully utilized our net operating losscarryback.

 

27

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**Liquidity and Capital Resources**

 

Our principal sources of liquidity at December 31,2004 were $2.3 million of cash and cash equivalents and $0.1 millionof short-term investments. As of December 31, 2004, we do not holdinvestments with a stated maturity beyond one year. Working capital at December 31,2004 was $2.5 million compared to $2.4 million as of December 31,2003.

 

Net cash used in operations in 2004 was$4.7 million, primarily due to an operating loss of $4.5 million for theyear, a decrease in accounts payable, and accrued expenses of $0.6 million anda increase in accounts receivable of $0.2 million, offset by depreciation of$0.2 million, and decreases in inventories of $0.3 million and other assets of$0.1 million.  Future fluctuations inaccounts receivable, inventory balances and accounts payable will be dependentupon several factors, including but not limited to quarterly sales, timelycollection of accounts receivable, and the accuracy of our forecasts of productdemand and component requirements.

 

During 2004, our cash, cash equivalents andinvestments declined $0.3 million from $2.7 million on December 31,2003 to $2.4 million on December 31, 2004. During 2004 we continuedto streamline our operations to better align our workforce with our strategicdomestic focus and industry trends.

 

Net cash provided by investing activities in2004 was $1.4 million, which consisted of the net maturity of$1.6 million of available for sale securities and the net purchase ofproperty and equipment of $0.2 million.

 

Net cash provided by financing activities in 2004was $4.6 million, consisting of net financing proceeds from a private placementof $4.7 million, dividends paid on preferred stock of $0.1 million and theproceeds from the exercise of employee stock options of $6 thousand.

 

At December 31, 2004, we did not haveany material commitments for capital expenditures. Operating lease commitmentsof $2.2 million are detailed below. During 2004, we funded our operationsthrough the use of available cash, cash equivalents and investments.

 

As of December 31, 2004, we had cash,cash equivalents and investments in the amount of approximately$2.4 million, down from approximately $2.7 million as of December 31,2003.  However, throughout 2004, wecontinued to reduce expenses and realized the full benefit of cost-cuttingactions taken in 2003.  As a result, ourcash used in operations in the fourth quarter was approximately $1.0million.  On March 28, 2005, we closed a$2.66 million private placement of Series 2 5% Convertible Preferred Stock andwarrants, the proceeds of which we intend to use for general corporate andworking capital purposes.  Based onfourth quarter actual results, we believe that our current cash resources,which include the private placement we completed first quarter of 2005 and ourprojections for increased revenues in 2005, are sufficient to finance ouroperations and expected capital expenditures for the next twelve months.  The sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  In addition,the payment of accrued dividends on our outstanding preferred stock may reduceour available cash resources.  We do notcurrently have any further arrangements for financing, and we may not be ableto secure additional debt or equity financing on terms that are acceptable tous, or at all, at the time when we need such funding. If our business does notgenerate sufficient cash flow from operations and sufficient financings are notavailable, we may not be able to operate or grow our business, pay our expenseswhen due or fund our other liquidity needs.

 

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.

 

28

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### **ContractualObligations**

###  

The following table sets forth certain information concerning thefuture contractual obligations under our operating leases at December 31,2004.  We have no other significantcontractual obligations at December 31, 2004.

 

**Future minimum lease payments consisted ofthe following on December 31, 2004 (in thousands):**

 
| 2005                |   | $      | 515    |   |
|---------------------|--------|--------|--------|--------|
| 2006                |   | 432    |   |
| 2007                |   | 378    |   |
| 2008                |   | 393    |   |
| 2009                |   | 409    |   |
| 2010 and thereafter |   | 68     |   |
|                |   |   |   |
|                |   | $      | 2,195  |   |

 

### **Off-BalanceSheet Arrangements**

###  

As of December 31, 2004, we did not have any significantoff-balance sheet arrangements, as defined in Item 303(c)(2) of Regulation S-B.

 

**Quantitative and Qualitative DisclosuresAbout Market Risk.**

 

Foreign Exchange.  Our revenueoriginating outside the U.S. in 2004 and 2003 was 19.2% and 31.4% of totalrevenues, respectively.  Revenuesgenerated from the European region in 2004 and 2003 were 11.2% and 23.0% oftotal revenues, respectively.  Revenuesgenerated from the Asia region in 2004 and 2003 were 3.2% and 7.4% of totalrevenues, respectively.  Internationalsales are generated primarily from our foreign sales subsidiaries in the localcountries and are typically denominated in U.S. dollars.  These subsidiaries incur substantially all oftheir expenses in the local currency.

 

Our international business is subject to risks typical of aninternational business, including differing economic conditions, changes inpolitical climate, differing tax structures, import and export regulations,other regulations and restrictions, and foreign exchange rate volatility.Accordingly, our results could be materially adversely impacted by changes inthese or other factors. The effect of foreign exchange rate fluctuations on ourbusiness in 2004 and 2003 was not material.

 

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

 

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

 

Investments in fixed rate interest earning instruments carry a degreeof interest rate risk.  Fixed ratesecurities may have their fair market value adversely impacted due to a rise ininterest rates.  Due in part to thesefactors, our future investment income may fall short of expectations due tochanges in interest rates or we may suffer losses in principal if forced tosell securities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  The weighted-average interest rate oninvestment securities at December 31, 2004 was 6.5%. The fair value ofinvestments held at December 31, 2004 approximated amortized cost.

 

**Item7****.****           Financial Statements.**

 

The information required by this item is included in Part IV Item7.

 

29

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**Item8****.****           Changes In and Disagreementswith Accountants on Accounting and Financial Disclosure.**

 

None.

 

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

###  

We have carried out an evaluation, under the supervision and theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of December 31, 2004 pursuant to Rule 13a-15(b) under theExchange Act.  Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures are effective in ensuring thatinformation required to be disclosed is recorded, processed, summarized andreported in a timely manner.

 

We have carried out an evaluation, under the supervision andparticipation of our management, including our Chief Executive Officer andChief Financial Officer, of any changes in our internal controls over financialreporting that occurred during the quarterly period ended December 31,2004, and our Chief Executive Officer and Chief Financial Officer haveconcluded that there was no change during the quarterly period ended December 31,2004 that has a materially affected or is reasonably expected to materiallyaffect our internal control over financial reporting.

 

**Item8B****. OtherInformation**

 

Not applicable.

 

30

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**PART III**

 

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

 

**Item9****.****           Directors and ExecutiveOfficers of Intrusion Inc.**

 

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

 

**Item10****.****    Executive Compensation.**

 

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

 

*Compensation Committee Interlocks and InsiderParticipation*

 

The members of the Compensation Committee of our Board of Directors forthe entire 2004 fiscal year were J. Fred Bucy, Jr. (Chairman), Donald M.Johnston, and James F. Gero, each of whom is an independent director.

 

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

 

*March 25, 2004 Private Placement*

 

On March 25, 2004, we completed a $5,000,000 private placement of1,000,000 shares of our 5% convertible preferred stock and warrants to purchase556,619 shares of our common stock at an initial exercise price of $3.144 pershare to various purchasers.  Mr. Gero, adirector and one of the members of the Compensation Committee, invested $300,000in the private placement in consideration for 60,000 shares of preferred stockand warrants to purchase 33,397 shares of common stock.  Mr. Gero participated in the privateplacement on the same terms and conditions as other investors, except that he isnot entitled to a preemptive right to purchase a pro rata portion of certainfuture sales of securities by us.  Inaddition, as a director, Mr. Gero agreed not to sell any shares of common stockowned by him until the registration statement described below is declaredeffective by the SEC.

 

As part of this private placement, we entered into a RegistrationRights Agreement, pursuant to which we are required to file a registrationstatement to register the shares of common Stock issuable upon the conversionof the preferred stock and upon the exercise of the warrants issued to theinvestors in the private placement.  Wefailed to file the registration statement by April 24, 2004 and did nothave the registration statement declared effective by July 24, 2004.  As a result, we paid liquidated damages equalto 2% of the aggregate purchase price paid to us in the private placement foreach thirty-day period, pro rated for any shorter period, that the filing oreffectiveness of the registration statement is delayed.  Mr. Gero waived his right for any liquidateddamages related to our late filing of the registration statement.  In accordance with this obligation, we fileda registration statement on Form S-3 including these shares of common stock on April 20,2004.  The registration statementincludes the 128,817 shares of common stock underlying the preferred stock andwarrants purchased by Mr. Gero in the private placement as well as 125,000shares previously acquired by Mr. Gero in a private transaction with a thirdparty.

 

*March 28, 2005 Private Placement*

 

On March 28, 2005, we completed a $2,663,000 private placement of 1,065,200shares of our convertible preferred stock and warrants to purchase 532,600shares of our common stock at an initial exercise price of $2.77 per share tovarious purchasers.  Mr. Gero invested$150,000 in this private placement in consideration for 60,000 shares ofpreferred stock and warrants to purchase 30,000 shares of common stock.  Mr. Gero participated in the privateplacement on the same terms and conditions as other investors except that he isnot entitled to a preemptive right to purchase a pro rata portion of certainfuture sales of securities by us or to receive liquidated damages under theprovisions of the Registrations Rights Agreement we executed in connection withthis private placement.  In addition, Mr.Gero will not be able to convert his shares of preferred stock into, orexercise his warrants for, shares of common stock unless and until approved byour stockholders to the extent required by NASDAQ rules.

 

31

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**Item11****.****    Security Ownership of CertainBeneficial Owners and Management.**

 

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

 

**Item12****.****    Certain Relationships andRelated Transactions.**

 

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

 

**Item13****.****    Exhibits, Financial StatementSchedules, and Reports on Form 8-K.**

 

(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                                                  |   |
|-----------------------------------------------------------------------------------------------------------|--------|
| Consolidated Balance Sheets at December 31, 2004 and 2003                                            |   |
| Consolidated Statements of Operations for  the years ended December 31, 2004, and 2003               |   |
| Consolidated Statements of Stockholders’  Equity for the years ended December 31, 2004 and 2003 |   |
| Consolidated Statements of Cash Flows for  the years ended December 31, 2004 and 2003                |   |
| Notes to Consolidated Financial Statements                                                           |   |

 

2.**                                       FinancialStatement Schedules.**

 

All schedules are omitted because they are either not required or notapplicable or the required information is shown in the Consolidated FinancialStatements or Notes thereto.

 

(b)**                                 Reportson Form 8-K.**

 

During the quarter ended December 31, 2004, we did not file anyreports on Form 8-K.

 

(c)**                                  Exhibits**

 

32

----

 

The following Exhibits are filed herewithpursuant to Item 601 of Regulation S-B or incorporated herein by referenceto previous filings as noted:

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                                            |
|---------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(5)              |       | Certificate of Ownership and Merger Merging Intrusion.com, Inc. into  Intrusion Inc.                                                                                                                  |
| 3.1(5)              |       | Amended and Restated Certificate of Incorporation of the Registrant.                                                                                                                                  |
| 3.2(7)              |       | Certificate of Amendment to Certificate of Incorporation of  Registrant                                                                                                                               |
| 3.3(8)              |       | Certificate of Designation for the Registrant’s 5% Convertible  Preferred Stock                                                                                                                  |
| 3.4(4)              |       | Bylaws of the Registrant.                                                                                                                                                                             |
| 4.1(9)              |       | Specimen Common Stock Certificate.                                                                                                                                                                    |
| 4.2(8)              |       | Specimen 5% Convertible Preferred Stock Certificate                                                                                                                                                   |
| 4.3(8)              |       | Form of Warrant to Purchase Shares of Common Stock                                                                                                                                                    |
| 4.4(8)              |       | Warrant to Purchase Common Stock dated March 25, 2004, issued by  the Registrant to Black Point Partners                                                                                         |
| 4.5(8)              |       | Registration Rights Agreement dated as of March 25, 2004, by and  among the Registrant and the entities listed on Schedule A thereto                                                        |
| 4.6(8)              |       | Form of Lock-Up Agreement                                                                                                                                                                             |
| 10.1(1)             |       | 1983 Incentive Stock Option Plan of the Registrant, as amended.                                                                                                                                       |
| 10.2(1)             |       | 1987 Incentive Stock Option Plan of the Registrant, as amended.                                                                                                                                       |
| 10.3(1)             |       | Form of Indemnification Agreement.                                                                                                                                                                    |
| 10.4(5)             |       | 1995 Stock Option Plan of the Registrant as amended April 26,  2001.                                                                                                                             |
| 10.5(2)             |       | 1995 Non-Employee Directors Stock Option Plan of the Registrant  (amended and restated as of January 10, 2002).                                                                                  |
| 10.7(9)             |       | Lease Agreement between CalWest Industrial Holdings Texas, L.P. and  Intrusion Inc.                                                                                                                   |
| 10.8(8)             |       | Securities Purchase Agreement dated as of March 25, 2004, by and  among the Registrant and the purchasers listed on Exhibit A thereto.                                                           |
| 10.9(4)             |       | Amended and Restated 401(k) Savings Plan of the Registrant.                                                                                                                                           |
| 10.10(4)            |       | 1997 Employee Stock Purchase Plan of the Registrant, as amended  January 17, 2001.                                                                                                               |
| 10.11(3)            |       | Employment Agreement with Aaron Bawcom dated February 4, 2003                                                                                                                                    |
| 10.12(6)            |       | Intrusion Inc. 401(k) Savings Plan Summary of Material Modifications.                                                                                                                                 |
| 10.13(10)           |       | Waiver of Liquidated  Damages dated as of July 23, 2004, by and among Intrusion, G. Ward  Paxton and James F. Gero.                                                                              |
| 21(5)               |       | List of Subsidiaries of Registrant                                                                                                                                                                    |
| 23.1(11)            |       | Consent of KBA Group LLP, Independent Registered Public Accounting  Firm                                                                                                                              |
| 31.1(11)            |       | Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)  of the Exchange Act.                                                                                                             |
| 31.2(11)            |       | Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)  of the Exchange Act.                                                                                                             |
| 32.1(11)            |       | 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(11)            |       | 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 inthe Registrant’s Registration Statement on Form S-1, as amended (FileNo. 33-6899), which was declared effective on May 21, 1992, by theSecurities and Exchange Commission, which Exhibit is incorporated herein byreference.

 

(2)                                  Filed as an Exhibitto the Registrant’s Definitive Proxy Statement on Schedule 14A inconnection with the solicitation of proxies for its 2002 Annual Meeting ofStockholders, which Exhibit is incorporated herein by reference.

 

(3)                                  Filed as an Exhibitto the Registrant’s Quarterly Report on Form 10-Q for the quarter ended March 31,2003, which Exhibit is incorporated herein by reference.

 

(4)                                  Filed as an Exhibitto the Registrants’ Annual Report on Form 10-K, for the fiscal year ended December 31,2000.

 

33

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(5)                                  Filed as an Exhibitto the Registrant’s Annual Report on Form 10-K for the fiscal year ended December 31,2001, which Exhibit is incorporated herein by reference.

 

(6)                                  Filed as an Exhibitto 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 Exhibitto the Registrant’s Definitive Proxy Statement on Schedule 14A inconnection with the solicitation of proxies for its Special Meeting ofStockholders held March 18, 2004, which Exhibit is incorporated herein byreference.

 

(8)                                  Filed as an Exhibitto the Registrant’s Current Report on Form 8-K dated March 26, 2004 (asamended), which Exhibit is incorporated by reference.

 

(9)                                  Filed as an Exhibitto 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 theRegistrant’s Quarterly Report on Form 10-Q for the quarter ended September 30,2004, which Exhibit is incorporated herein by reference

 

(11)                            Filed herewith.

 

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

###  

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

 

34

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**SIGNATURES**

 

Pursuant to the requirements of Section 13or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
| Dated: March 29, 2005 | INTRUSION INC. |
|----------------------------|---------------------|
|                       | (Registrant)        |
|                       |                |
|                       | By:                 | /s/ G. WARD PAXTON |   |
|                       |                | G. Ward Paxton |   |
|                       |                | *Chairman, President, and Chief Executive  Officer* |   |
|                       |                | *(Principal Executive Officer)* |   |

 

Pursuant to the requirements of the Securities Exchange Act of 1934,this report has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title**                                    | ** ** | **Date**            |
|------------------------|------------|----------------------------------------------|------------|---------------------|
|                   |       |                                         |       |                |
| /s/ G. WARD PAXTON     |       | Chairman, President,                         |       | March 29, 2005 |
| G. Ward Paxton         |       | Chief Executive Officer, and Director        |       |
|                   |       |                                         |       |                |
| /s/ T. JOE HEAD        |       | Vice Chairman, Vice President                |       | March 29, 2005 |
| T. Joe Head            |       | and Director                                 |       |
|                   |       |                                         |       |                |
|                   |       | Vice President, Chief Financial              |       | March 29, 2005 |
| /s/ MICHAEL L. PAXTON  |       | Officer, Treasurer and Secretary             |       |
| Michael L. Paxton      |       | (Principal Financial and Accounting Officer) |       |
|                   |       |                                         |       |                |
| /s/ JAMES F. GERO      |       | Director                                     |       | March 29, 2005 |
| James F. Gero          |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ J. FRED BUCY, JR.  |       | Director                                     |       | March 29, 2005 |
| J. Fred Bucy, Jr.      |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ DONALD M. JOHNSTON |       | Director                                     |       | March 29, 2005 |
| Donald M. Johnston     |       |                                         |       |                |
|                   |       |                                         |       |                |

 

35

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**ANNUAL REPORT ON FORM 10-KSB**

**ITEM 7**

**FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2004 and 2003**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

----

 

**REPORT OF INDEPENDENT REGISTERED PUB****LIC 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 31,2004 and 2003, and the related consolidated statements of operations,stockholders’ equity, 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. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes 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, 2004 and 2003,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.

 

 

KBA Group LLP

Dallas, Texas

February 4, 2005, except for Note 10 to which the date is March 28,2005

 

F-1

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

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

 
| ** **                                                                                                                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets**                                                                                                                                |       |                  |       |   |   |
| Current Assets:                                                                                                                           |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                 |       | $                     | 2,315      |   | $ | 974 |   |
| Short-term investments                                                                                                                    |       | 75                    |       | 1,705 |   |
| Accounts receivable, net of allowance for  doubtful accounts and returns of $508 in 2004 and $574 in 2003                                 |       | 1,220                 |       | 972 |   |
| Inventories, net                                                                                                                          |       | 950                   |       | 1,286 |   |
| Prepaid expenses                                                                                                                          |       | 393                   |       | 449 |   |
| Total current assets                                                                                                                      |       | 4,953                 |       | 5,386 |   |
| Property and Equipment:                                                                                                                   |       |                  |       |   |   |
| Machinery and equipment                                                                                                                   |       | 942                   |       | 2,424 |   |
| Furniture and fixtures                                                                                                                    |       | 46                    |       | 77 |   |
| Leasehold improvements                                                                                                                    |       | 100                   |       | 178 |   |
|                                                                                                                                      |       | 1,088                 |       | 2,679 |   |
| Accumulated depreciation and amortization                                                                                                 |       | (789                  | )          | (2,382 | ) |
|                                                                                                                                      |       | 299                   |       | 297 |   |
| Other assets                                                                                                                              |       | 64                    |       | 77 |   |
| **TOTAL ASSETS**                                                                                                                          |       | $                     | 5,316      |   | $ | 5,760 |   |
| ** **                                                                                                                                |       |                  |       |   |   |
| **Liabilities and Stockholders’ Equity**                                                                                             |       |                  |       |   |   |
| Current Liabilities:                                                                                                                      |       |                  |       |   |   |
| Accounts payable, trade                                                                                                                   |       | $                     | 791        |   | $ | 1,080 |   |
| Accrued vacation expense                                                                                                                  |       | 256                   |       | 303 |   |
| Accrued warranty expense                                                                                                                  |       | 125                   |       | 200 |   |
| Other accrued expenses                                                                                                                    |       | 495                   |       | 605 |   |
| Deferred revenue                                                                                                                          |       | 799                   |       | 788 |   |
| Total current liabilities                                                                                                                 |       | 2,466                 |       | 2,976 |   |
| **TOTAL LIABILITIES**                                                                                                                     |       | 2,466                 |       | 2,976 |   |
|                                                                                                                                      |       |                  |       |   |   |
| Stockholders’ Equity:                                                                                                                |       |                  |       |   |   |
| Preferred stock, $0.01 par value:                                                                                                         |       |                  |       |   |   |
| Authorized shares—5,000 Shares issued and outstanding—840  Liquidation preference of $4,263,000                                 |       | 2,968                 |       | — |   |
| Common stock, $0.01 par value:                                                                                                            |       |                  |       |   |   |
| Authorized shares—80,000 Issued shares—5,431  in 2004 and 5,173 in 2003 Outstanding shares—5,421 in 2004 and 5,163 in 2003 |       | 54                    |       | 52 |   |
| Common stock held in treasury, at cost—10  shares                                                                                    |       | (362                  | )          | (362 | ) |
| Additional paid-in-capital                                                                                                                |       | 49,095                |       | 47,526 |   |
| Accumulated deficit                                                                                                                       |       | (48,732               | )          | (44,204 | ) |
| Accumulated other comprehensive loss                                                                                                      |       | (173                  | )          | (228 | ) |
| Total stockholders’ equity                                                                                                           |       | 2,850                 |       | 2,784 |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                       |       | $                     | 5,316      |   | $ | 5,760 |   |

 

See accompanying notes.

 

F-2

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

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

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2004**                         | ** ** | **2003** | ** ** |
|                                                                        |       |                             |       |   |   |
| Net product revenue                                                         |       | $                                | 4,364      |   | $ | 4,200 |   |
| Net customer support and maintenance  revenue                               |       | 1,655                            |       | 2,278 |   |
| Total revenue                                                               |       | 6,019                            |       | 6,478 |   |
| Cost of product revenue                                                     |       | 2,787                            |       | 3,245 |   |
| Cost of customer support and maintenance  revenue                           |       | 163                              |       | 743 |   |
| Total cost of revenue                                                       |       | 2,950                            |       | 3,988 |   |
| Gross profit                                                                |       | 3,069                            |       | 2,490 |   |
| Operating expenses:                                                         |       |                             |       |   |   |
| Sales and marketing                                                         |       | 3,690                            |       | 6,230 |   |
| Research and development                                                    |       | 2,549                            |       | 3,498 |   |
| General and administrative                                                  |       | 1,146                            |       | 1,632 |   |
| Litigation settlement                                                       |       | —                           |       | 450 |   |
| Severance costs                                                             |       | 273                              |       | 472 |   |
| Operating loss                                                              |       | (4,589                           | )          | (9,792 | ) |
| Interest income, net                                                        |       | 42                               |       | 182 |   |
| Other income, net                                                           |       | 19                               |       | 10 |   |
| Loss from operations before income taxes                                    |       | (4,528                           | )          | (9,600 | ) |
| Income tax provision                                                        |       | —                           |       | — |   |
| Net loss                                                                    |       | (4,528                           | )          | (9,600 | ) |
| Preferred stock dividends                                                   |       | (192                             | )          | — |   |
| Beneficial conversion feature on preferred  stock                           |       | (938                             | )          | — |   |
| Net loss attributable to common  stockholders                               |       | $                                | (5,658     | ) | $ | (9,600 | ) |
|                                                                        |       |                             |       |   |   |
| Net loss per share attributable to common  stockholders (basic and diluted) |       | $                                | (1.09      | ) | $ | (1.86 | ) |
| Weighted average common shares outstanding—(basic  and diluted)        |       | 5,177                            |       | 5,162 |   |

 

See accompanying notes.

 

F-3

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**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(In thousands)**

 
| ** **                                                                                         | ** ** | **YEAR ENDED DECEMBER 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                         | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| **NUMBER OF PREFERRED SHARES—ISSUED AND  OUTSTANDING**                                        |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | —                           |       | — |   |
| Issuance of preferred shares pursuant to  private placement                                        |       | 1,000                            |       | — |   |
| Conversion of preferred shares to common  shares                                                   |       | (160                             | )          | — |   |
| Balance, end of year                                                                               |       | 840                              |       | — |   |
| **PREFERRED STOCK**                                                                                |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | $                                | —     |   | $ | — |   |
| Issuance of preferred shares pursuant to  private placement, net of warrants and transaction costs |       | 3,534                            |       | — |   |
| Conversion of preferred shares to common  shares                                                   |       | (566                             | )          | — |   |
| Balance, end of year                                                                               |       | $                                | 2,968      |   | $ | — |   |
| **NUMBER OF COMMON SHARES—ISSUED**                                                            |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | 5,173                            |       | 5,172 |   |
| Issuance of common shares under stock  options and purchase plans                                  |       | 4                                |       | 1 |   |
| Conversion of preferred shares to common  shares                                                   |       | 254                              |       | — |   |
| Balance, end of year                                                                               |       | 5,431                            |       | 5,173 |   |
| **COMMON STOCK**                                                                                   |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | $                                | 52         |   | $ | 52 |   |
| Issuance of common shares under stock  options and purchase plans                                  |       | —                           |       | — |   |
| Conversion of preferred shares to common  shares                                                   |       | 2                                |       | — |   |
| Balance, end of year                                                                               |       | $                                | 54         |   | $ | 52 |   |
| **TREASURY SHARES**                                                                                |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | $                                | (362       | ) | $ | (362 | ) |
| Purchase of treasury shares                                                                        |       | —                           |       | — |   |
| Balance, end of year                                                                               |       | $                                | (362       | ) | $ | (362 | ) |
| **ADDITIONAL PAID-IN-CAPITAL**                                                                     |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | $                                | 47,526     |   | $ | 47,526 |   |
| Issuance of warrants with preferred stock  private placement                                       |       | 1,191                            |       | — |   |
| Conversion of preferred shares to common  shares                                                   |       | 564                              |       | — |   |
| Issuance of common shares under stock  options                                                     |       | 6                                |       | — |   |
| Preferred stock dividends                                                                          |       | (192                             | )          | — |   |
| Balance, end of year                                                                               |       | $                                | 49,095     |   | $ | 47,526 |   |
| **ACCUMULATED DEFICIT**                                                                            |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | $                                | (44,204    | ) | $ | (34,604 | ) |
| Net loss (b)                                                                                       |       | (4,528                           | )          | (9,600 | ) |
| Balance, end of year                                                                               |       | $                                | (48,732    | ) | $ | (44,204 | ) |
| **ACCUMULATED OTHER COMPREHENSIVE LOSS**                                                           |       |                             |       |   |   |
| Balance, beginning of year                                                                         |       | $                                | (228       | ) | $ | (228 | ) |
| Foreign currency translation adjustment (a)                                                        |       | 55                               |       | — |   |
| Balance, end of year                                                                               |       | $                                | (173       | ) | $ | (228 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                |       | $                                | 2,850      |   | $ | 2,784 |   |
| **TOTAL COMPREHENSIVE LOSS (a+b)**                                                                 |       | $                                | (4,473     | ) | $ | (9,600 | ) |

 

See accompanying notes.

 

F-4

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**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                      | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                      | ** ** | **2004**                         | ** ** | **2003** | ** ** |
| Operating Activities:                                                           |       |                             |       |   |   |
| Net loss                                                                        |       | $                                | (4,528     | ) | $ | (9,600 | ) |
| Adjustments to reconcile net loss to net  cash used in operating activities:    |       |                             |       |   |   |
| Depreciation and amortization                                                   |       | 201                              |       | 1,400 |   |
| Provision for doubtful accounts                                                 |       | (66                              | )          | — |   |
| Loss on disposal of property and equipment                                      |       | 7                                |       | — |   |
| Changes in operating assets and  liabilities:                                   |       |                             |       |   |   |
| Accounts receivable                                                             |       | (182                             | )          | 1,391 |   |
| Inventories                                                                     |       | 336                              |       | 125 |   |
| Other assets                                                                    |       | 69                               |       | 319 |   |
| Accounts payable and accrued expenses                                           |       | (584                             | )          | (717 | ) |
| Deferred revenue                                                                |       | 11                               |       | (862 | ) |
| Net cash used in operating activities                                           |       | (4,736                           | )          | (7,944 | ) |
| Investing Activities:                                                           |       |                             |       |   |   |
| Purchases of short-term investments                                             |       | (3,100                           | )          | (3,475 | ) |
| Maturities of short-term investments                                            |       | 4,730                            |       | 9,595 |   |
| Proceeds from sale of property and  equipment                                   |       | 17                               |       | — |   |
| Purchases of property and equipment                                             |       | (227                             | )          | (100 | ) |
| Net cash provided by investing activities                                       |       | 1,420                            |       | 6,020 |   |
| Financing Activities:                                                           |       |                             |       |   |   |
| Proceeds from exercise of employee stock  options                               |       | 6                                |       | — |   |
| Proceeds from the issuance of preferred  stock and warrants, net                |       | 4,725                            |       | — |   |
| Dividends paid on preferred stock                                               |       | (129                             | )          | — |   |
| Net cash provided by financing activities                                       |       | 4,602                            |       | — |   |
| Effect of foreign currency translation  adjustment on cash and cash equivalents |       | 55                               |       | — |   |
| Net increase (decrease) in cash and cash  equivalents                           |       | 1,341                            |       | (1,924 | ) |
| Cash and cash equivalents at beginning of  year                                 |       | 974                              |       | 2,898 |   |
| Cash and cash equivalents at end of year                                        |       | $                                | 2,315      |   | $ | 974 |   |
|                                                                            |       |                             |       |   |   |
| SUPPLEMENTAL  CASHFLOW INFORMATION:                                             |       |                             |       |   |   |
| Interest paid                                                                   |       | $                                | —     |   | $ | — |   |
| Income taxes paid                                                               |       | $                                | —     |   | $ | — |   |
|                                                                            |       |                             |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON CASH  FINANCING ACTIVITIES:                      |       |                             |       |   |   |
| Fair value of warrants issued in connection  with sale of preferred stock       |       | $                                | 1,191      |   | $ | — |   |
| Preferred stock beneficial conversion  feature                                  |       | $                                | 938        |   | $ | — |   |
| Preferred stock dividend accrued                                                |       | $                                | 63         |   | $ | — |   |

 

See accompanying notes.

 

F-5

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**INTRUSION INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL****STATEMENTS**

 

**1. Description of Business**

 

We develop, market and support a family of network intrusion prevention,intrusion detection, regulated information compliance and data privacyprotection products.  Our productfamilies include the Compliance CommanderÔfor regulated information and data privacy protection, Intrusion SpySnareÔfor real-time inline blocking of spyware and unwanted peer-to-peer (P2P)applications, and Intrusion SecureNetÔ for networkintrusion prevention and detection. Intrusion’s products help protect critical information assets by quicklydetecting, protecting, analyzing and reporting attacks or misuse of classified,private and regulated information for government and enterprise networks.

 

We market and distribute our products through a direct sales force toend-users, distributors and numerous domestic and international systemintegrators, managed service providers and value-added resellers. Our end-usercustomers include high technology, e-commerce, manufacturing, governmentagencies, military, financial institutions, telecommunications, retail,transportation, healthcare, insurance, entertainment, utilities, energycompanies, and academic institutions. Essentially, our end-user can be defined as ‘any end-user requiringnetwork security solutions for protecting their mission critical data’.

 

We were organized in Texas in September 1983 and reincorporated inDelaware in October 1995. For more than 15 years, we provided localarea networking equipment and were known as Optical Data Systems or ODSNetworks. On April 17, 2000, we sold, or otherwise disposed of, ournetworking divisions, which included our Essential Communications division andour local area networking assets. On June 1, 2000, we changed our namefrom ODS Networks, Inc. to Intrusion.com, Inc., and our NASDAQ tickersymbol from ODSI to INTZ to reflect our focus on intrusion prevention anddetection solutions, along with information compliance and data privacyprotection products. On November 1, 2001, we changed our name fromIntrusion.com, Inc. to Intrusion Inc.

 

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

 

References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries.

 

Effective March 29, 2004, we effected a one-for-four reverse stocksplit of our common stock.  All sharenumbers and common stock numbers, such as earnings per share and outstandingoptions have been retroactively restated to reflect the reverse stock split.

 

As of December 31, 2004, we had cash, cash equivalents andinvestments in the amount of approximately $2.4 million, down fromapproximately $2.7 million as of December 31, 2003.  On March 28, 2005, we closed a $2.66 millionprivate placement of Convertible Preferred Stock and warrants.  With this financing and our projections forincreased revenues in 2005, we believe that we have sufficient cash resourcesto finance our operations and expected capital expenditures for the next twelvemonths.  The sufficiency of our cashresources may depend to a certain extent on general economic, financial,competitive or other factors beyond our control.  In addition, the payment of accrued dividendson our outstanding preferred stock may reduce our available cash resources.  Moreover, despite actions to reduce our costand improve our profitability, we expect our operating losses and net operatingcash outflows to continue through at least the first quarter of 2005.  We do not currently have any furtherarrangements for financing, and we may not be able to secure additional debt orequity financing on terms that are acceptable to us, or at all, at the timewhen we need such funding.  If ourbusiness does not generate sufficient cash flows from operations and sufficientfinancings are not available, we may not be able to operate or grow ourbusiness, pay our expenses when due or fund our other liquidity needs.

 

F-6

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**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.

 

***Short-termInvestments***

 

Short-term investments consist of U.S. government obligations andcorporate securities with maturities between 90 days and one year as ofthe balance sheet date. Short-term investments are classified as available forsale. These investments are valued at market value, which approximatesamortized cost. The difference between fair market value and amortized cost isnot significant.  Realized gains andlosses from the sale of short-term investments are included in other income,net and are derived using the specific identification method for determiningthe cost of securities.

 

***RiskConcentration***

 

Financial instruments, which potentially subject us to concentrationsof credit risk, are primarily cash and cash equivalents, investments andaccounts receivable. We place our investments in U.S. government obligations,corporate securities and money market funds. Substantially all of our cash,cash equivalents and investments are maintained with two major U.S. financialinstitutions.

 

We sell our products to customers in diversified industries worldwide,primarily in North America, Europe, Asia and Latin America. Fluctuations incurrency exchange rates and adverse economic developments in foreign countriescould adversely affect the Company’s operating results. We perform ongoingcredit evaluations of our customers’ financial condition and generally requireno collateral. We maintain reserves for potential credit losses, and suchlosses, in the aggregate, 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 are available from one or a limited number of suppliers. Theinability of any supplier or manufacturer to fulfill supply requirements of theCompany could impact future results.

 

***AccountsReceivable, Allowance for Doubtful Accounts and Returns***

 

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 collectibilityof 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 a credit to a valuationallowance.  Balances that remainoutstanding after we have used reasonable collection efforts are written offthrough a charge to the valuation allowance and a credit to accountsreceivable.

 

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

 

Inventories are stated at the lower of cost or market. Effective April 1,2004, we changed our method of valuing inventories from standard cost toaverage cost, which approximates actual cost on a first-in, first-out basis. Theeffect of

 

F-7

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this change in accounting method is minimal, as the standard cost usedpreviously also approximated actual cost. Our management estimates the allowance required to state inventory atthe lower of cost or market. There is a risk that we will forecast demand forour products and market conditions incorrectly and maintain excess inventories.Therefore, there can be no assurance that we will not maintain excess inventoryand incur inventory lower of cost or market charges in the future.

 

***Propertyand Equipment***

 

Property and equipment is stated at cost less accumulated depreciationand is depreciated on a straight-line basis over the estimated useful lives ofthe assets. Such lives vary from 3 to 7 years. Leasehold improvements areamortized over the shorter of their useful lives or the remaining terms of theleases. Expenditures for major renewals and betterments that extend the usefullives of property and equipment are capitalized.  Repair and maintenance costs are expensed asincurred. Depreciation and amortization expense totaled approximately $0.2 and$1.4 million for the years ended December 31, 2004 and 2003,respectively.

 

***Long-Lived Assets***

 

We follow the guidance in SFAS 144 “Accounting for the Impairment orDisposal of Long-Lived Assets” and review long-lived assets, including propertyand equipment for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.Recoverability of assets to be held and used is measured by a comparison of thecarrying amount of an asset to future net cash flows to be generated by theasset. If such assets are considered to be impaired, the impairment to berecognized is measured by the amount by which the carrying amount of the assetsexceeds the fair value of the assets. Assets to be disposed of are reported atthe lower of the carrying amount or fair value less costs to sell. As of December 31,2004, there was no impairment of long-lived assets.

 

***ForeignCurrency Translation***

 

Beginning with fiscal year 2003, we determined that our internationalsubsidiaries should use the United States dollar as their functional currency,as allowed under SFAS No. 52, “Foreign Currency Translation”.  Although, our international offices payoperating expenses in their local currency, they are fully funded by us inUnited States dollars, and we exchange the United States dollars locally tosettle operating expenses incurred.  Asoutlined in SFAS 52, assets and liabilities are translated at the exchange ratein effect at the balance sheet date, and income and expense accounts at averageexchange rates during the year. Resulting translation adjustments totaling approximately $33,000 and$50,000 were recorded as operating expenses in the statement of operationsduring 2004 and 2003, respectively. Additionally, we recorded approximately $55,000 in operating expenses in2004, which represents the accumulated foreign currency translation related toforeign offices that were closed during the year.  This amount also represents the change in theaccumulated other comprehensive loss during 2004.

 

***Accountingfor Stock Options***

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation-Transition and Disclosure”. SFAS 148 amendsSFAS No. 123, “Accounting for Stock-Based Compensation”, to providealternative methods of transition to SFAS 123’s fair value method ofaccounting for stock-based employee compensation.

 

SFAS 148 also amends the disclosure provisions of SFAS 123and APB Opinion No. 28, “Interim Financial Reporting,” to requiredisclosure in the summary of significant accounting policies of the effects ofan entity’s accounting policy with respect to stock-based employee compensationon reported net income and earnings per share in annual and interim financialstatements.  While SFAS 148 does notamend SFAS 123 to require companies to account for employee stock optionsusing the fair value method, the disclosure provisions of SFAS 148 areapplicable to all companies with stock-based employee compensation, regardlessof whether they account for that compensation using the fair value method ofSFAS 123 or the intrinsic value method of APB Opinion No. 25, “Accountingfor Stock Issued to Employees” (“APB 25”). Under APB 25, if the exercise price of an employee’s stock optionequals or exceeds the

 

F-8

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market price of the underlying stock on the date of grant, nocompensation expense is recognized. However, if the exercise price of an employee’s stock option is lessthan the market price of the underlying stock on the date of grant,compensation expense is recorded for the difference in the exercise price andthe market price.  As permitted bySFAS 123, we have elected to continue to utilize the accounting methodprescribed by APB 25 and have adopted the disclosure requirements ofSFAS 123 and SFAS 148.

 

The following table summarizes relevant information as to the reportedresults under our intrinsic value method of accounting for stock awards, withsupplemental information as if the fair value recognition provision ofSFAS 123 had been applied for the years ended December 31, 2004 and2003 (in thousands, except per share data):

 
| ** **                                                                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                                 |       |     |       |     |       |
| Net loss attributable to common  stockholders                                                        |       | $        | (5,658     | )        | $          | (9,600 | ) |
| (Deduct): Total stock-based compensation  determined under fair value-based method for all awards    |       | (228     | )          | —   |       |
| Add: Total stock-based compensation credit  determined under fair value-based methods for all awards |       | —   |       | 256      |       |
| Pro forma net loss attributable to common  stockholders                                              |       | $        | (5,886     | )        | $          | (9,344 | ) |
|                                                                                                 |       |     |       |     |       |
| Net loss per share attributable to common  stockholders:                                             |       |     |       |     |       |
| As reported (basic and diluted)                                                                      |       | $        | (1.09      | )        | $          | (1.86 | ) |
| Pro forma (basic and diluted)                                                                        |       | $        | (1.14      | )        | $          | (1.81 | ) |
| Weighted-average common shares used in  computation:                                                 |       |     |       |     |       |
| Basic and diluted                                                                                    |       | 5,177    |       | 5,162    |       |

 

As required, the pro forma disclosures above include options grantedsince January 1, 1995. Consequently, the effects of applying SFAS 123for providing pro forma disclosures may not be representative of the effects onreported operating results for future years until all options outstanding areincluded in the pro forma disclosures. For purposes of pro forma disclosures,the estimated fair value of stock-based compensation plans and other optionsare amortized to expense primarily over the vesting period. See Note 7 forfurther discussion of our stock-based employee compensation.

 

***NetLoss Per Share***

 

We report two separate earnings per share (“EPS”) numbers, basic EPSand diluted EPS.  Basic net lossattributable to common stockholders per share is computed by dividing net lossattributable to common stockholders for the year by the weighted average numberof common shares outstanding for the year. Diluted net loss attributable to common stockholders per share iscomputed by dividing the net loss attributable to common stockholders for theyear by the weighted average number of common shares and common stockequivalents outstanding for the year.  Ourcommon stock equivalents include all common stock issuable upon conversion ofconvertible preferred stock and the exercise of outstanding options andwarrants.  The aggregate number of commonstock equivalents excluded from the loss per share calculation at December 31,2004 and 2003 totaled 2,360,987 and 373,911, respectively.  Common stock equivalents are notincluded in the diluted loss per share for the years ended December 31,2004 and 2003, 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.  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 will decrease.  To the extent that our warranty costs exceedour expectations, we will increase our

 

F-9

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warranty reserve to compensate for the additional expense expected tobe incurred.  We review these estimatesperiodically and determine the appropriate reserve percentage.  However, to date, warranty costs and salesreturns have not been material.  Thecustomer may return a product only under very limited circumstances during thefirst thirty days from delivery for a replacement if the product is damaged orfor a full refund if the product does not perform as intended.  Historically, most or our sales returns wererelated to hardware-based products.  Aswe continue to migrate away from the hardware-based products, these returnshave declined.  In addition, the costrelated to the returns for repair and refurbishment have also declined, as ourhardware costs and assembly costs have declined.  Most of our returns have been related toinventory held at distributors, as they have stock rotation privileges.  Since these returns are not related to sales,as they are maintained in deferred revenue until the distributors sell theproduct, these returns have not impacted our sales return allowancemethodology.

 

We recognize software revenue from the licensing of our softwareproducts in accordance with Statement of Position (“SOP”) No. 97-2 “SoftwareRevenue Recognition”, SOP 98-9 “Modification of 97-2, Software RevenueRecognition, with respect to certain transactions” and Staff AccountingBulletin (“SAB”) No. 104, “Revenue Recognition” whereby revenue from thelicensing of our products is not recognized until all four of the followinghave been met: i) execution of a written agreement; ii) delivery ofthe product has occurred; iii) the fee is fixed and determinable; andiv) collectibility is probable. Bundled hardware and software productsales are 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 easily 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.

 

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

 

Our normal payment terms offered to customers, distributors andresellers are net 30 days domestically and net 45 days internationally.  We do not offer payments terms that extendbeyond one year and rarely do we extend payment terms beyond our normalterms.  If certain customers do not meetour credit standards, we do require payment in advance to limit our 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.

 

We have signed distribution agreements with distributors in the UnitedStates, Europe and Asia. In general, these relationships are non-exclusive.Distributors typically maintain an inventory of our products. Under theseagreements, we provide certain protection to the distributors for theirinventory of our products for price reductions as well as products that areslow moving or have been discontinued by us. Historically, returns from ourdistributors and charges related to price reductions on inventory held bydistributors have not been material. Recognition of sales to distributors and related gross profits aredeferred until the distributors resell the merchandise. However, since we havelegally sold the inventory to the distributor and we no longer have care,custody or control over the inventory, we recognize the trade accounts receivableand reduce inventory related to the sale at the time of shipment to thedistributor. Revenue, offset by deferred cost of sales, is included in deferredrevenue in the accompanying financial statements.  Net deferred revenue related to distributors atboth December 31, 2004 and 2003 was approximately $0.1 million.  This balance is comprised of the net amountsrelated to the accounts receivable of $0.2 million and $0.1 million andinventory held by distributors of $0.1 million and $0.1 million for 2004 and2003, respectively.

 

***AdvertisingCosts***

 

Advertising expense is charged to operations in the period in whichsuch costs are incurred. Total advertising

 

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expense included in sales and marketing expenses was $0.02 million and$0.03 million for the years ended December 31, 2004 and 2003,respectively.

 

***Researchand Development Costs***

 

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

 

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

 

***SeveranceCharges***

 

In connection with our continued shift to our new intrusion detectionand security appliance product lines during 2003 and 2004, we streamlinedoperations and activities that are not aligned with these core markets andstrategies.  In 2003, the continued shiftin demand resulted in a charge of $0.5 million for severance as a resultof reductions in force.  During 2004, werecorded $0.3 million for severance as a result of reductions in force.  Severance obligations were paid prior to December 31,2004, and we were not receiving further benefit from the severed individualsafter December 31, 2004.

 

***Useof Estimates***

 

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

 

***IncomeTaxes***

 

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

 

***Recent AccountingPronouncements***

 

In December 2004, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standards No. 123 (revised 2004), “Share-BasedPayment” (SFAS 123R), which replaces SFAS 123 and supercedes APB Opinion No.25. SFAS 123R requires all share-based payments to employees, including grantsof employee stock options, to be recognized in the financial statements basedon their fair values. The pro forma disclosures previously permitted under SFAS123 no longer will be an alternative to financial statement recognition. Forthe

 

F-11

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Company, SFAS 123R is effective for periods beginning after December 15,2005. Early application of SFAS 123R is encouraged, but not required. We planto adopt SFAS 123R on January 1, 2006 using the modified prospectiveapplication method described in the statement. Under the modified prospectiveapplication method, we will apply the standard to new awards and to awardsmodified, repurchased, or cancelled after the required effective date.Additionally, compensation cost for the unvested portion of awards outstandingas of the required effective date will be recognized as compensation expense asthe requisite service is rendered after the required effective date.

 

We are evaluating the impact of adopting SFAS 123R and expect that wewill record substantial non-cash stock compensation expenses. The adoption ofSFAS 123R is not expected to have a significant effect on our financialcondition or cash flows but is expected to have a significant, adverse effecton our results of operations.  The futureimpact of the adoption of SFAS 123R cannot be predicted at this time because itwill depend on levels of share-based payments granted by us in the future.  However, had we adopted SFAS 123R in priorperiods, the impact of that standard would have approximated the impact of SFAS123 as described in the disclosure of pro forma net loss attributable to commonstockholders included in the *Accounting for StockOptions* policy footnote.

 

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

 

**Inventories**

 
| ** **            | ** ** | **December 31,** | ** ** |
|-----------------------|------------|-----------------------|------------|
| ** **            | ** ** | **2004**              | ** ** | **2003** | ** ** |
| Finished products     |       | $                     | 743        |   | $ | 851 |   |
| Work in process       |       | 18                    |       | 261 |   |
| Demonstration systems |       | 189                   |       | 174 |   |
|                  |       | $                     | 950        |   | $ | 1,286 |   |

 

**Other Accrued Expenses**

 
| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2004**              | ** ** | **2003** | ** ** |
|                      |       |                  |       |   |   |
| Accrued sales commissions |       | $                     | 75         |   | $ | 99 |   |
| Accrued payroll           |       | 137                   |       | 110 |   |
| Accrued property taxes    |       | 122                   |       | 144 |   |
| Accrued taxes—other  |       | 59                    |       | 60 |   |
| Other                     |       | 102                   |       | 192 |   |
|                      |       | $                     | 495        |   | $ | 605 |   |

 

**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 securitysoftware research and development staff under an operating lease that expires inAugust 2006.  In addition, we leaseoffice space for our U.S. and international sales and engineering offices.Total rental expense of $0.5 million and $1.1 million was charged tooperations during 2004 and 2003, respectively.

 

F-12

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The following table sets forth certain information concerning ourcontractual obligations at December 31, 2004 and outlines the expectedfuture payments to be made under such obligations and commitments.

 

Future minimum lease payments consisted of the following on December 31,2004 (in thousands):

 
| 2005                |   | $   | 515    |   |
|---------------------|--------|-----|--------|--------|
| 2006                |   | 432 |   |
| 2007                |   | 378 |   |
| 2008                |   | 393 |   |
| 2009                |   | 409 |   |
| 2010 and thereafter |   | 68  |   |
|                |   | $   | 2,195  |   |

 

***LegalProceedings***

 

We are subject to legal proceedings and claims that arise in the ordinarycourse of business. We do not believe that the outcome of those matters willhave a material adverse affect on our consolidated financial position,operating results or cash flows. However, there can be no assurance such legalproceedings will not have a material impact.

 

On March 22, 2002, Morgan Newton Company, L.P. (“Morgan Newton”)filed suit against us in Dallas County District Court, Case No. DV02-02339-C,alleging claims for breach of contract, promissory estoppel, and fraud.  The claims arose out of an alleged oralrepresentation to Morgan Newton concerning a request for quotation for thepurchase of a large amount of Morgan Newton’s products.  Morgan Newton did not specify the amount ofdamages it was seeking in the lawsuit. During the third quarter of 2003, thecase was settled out of court.  Inaccordance with the settlement, Intrusion paid Morgan Newton $450 thousandduring the fourth quarter of 2003.  Thesettlement amount of this claim is recorded as litigation settlement in thestatement of operations for 2003.  Thisclaim was completely satisfied at December 31, 2003 and did not have afinancial impact on our operating results in 2004.

 

We are not aware of any material claims outstanding or pending againstIntrusion at December 31, 2004.

 

**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 have been reservedfor issuance. Eligible employees may designate not more than 10% of theircompensation to be deducted each pay period for the purchase of common stockunder the Purchase Plan. The Purchase Plan was amended January 17, 2001 toincrease the maximum number of shares that can be purchased per participantfrom 500 shares to 1,000 shares per offering. Each participant maypurchase up to 2,000 shares in any one calendar year. On January 31and July 31 of each calendar year, shares of common stock are purchasedwith the employees’ payroll deductions over the immediately preceding sixmonths at a price per share of 85% of the lesser of the market price of thecommon stock on the purchase date or the market price on the first day of thesix-month period. The Purchase Plan will terminate no later than April 24,2007. Total employee purchases of shares under the Purchase Plan were 500 and1,000 for the years ended December 31, 2004 and 2003, respectively.  A total of 45,702 shares have been issuedunder the Purchase Plan and 79,298 shares are available for purchase as of December 31,2004.

 

***Employee401(k) Plan***

 

We adopted a plan known as the Intrusion Inc. 401(k) Savings Plan(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) of theInternal Revenue Code, the Plan provides tax deferred salary

 

F-13

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deductions for eligible employees.

 

The Plan was amended on January 10, 2002 to allow employees tocontribute from 1% to 25% of their annual compensation to the Plan, limited toa maximum amount as set by the Internal Revenue Service.  This limit was increased from 19%.  A feature was also added to the Plan to allowparticipants who are over the age of 50 to contribute an additional amount oftheir salary per year, as defined annually by the Internal RevenueService.  We match employee contributionsat the rate of $0.25 per each $1.00 of contribution on the first 4% ofcompensation.  Matching contributions tothe Plan were approximately $18,000 and $17,000 for the years ended December 31,2004 and 2003, respectively.

 

**6. 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, 2004 and2003.  Significant components of ourdeferred tax assets as of December 31, 2004 and 2003 are as follows (inthousands):

 
| ** **                                            | ** ** | **December 31** | ** ** |
|-------------------------------------------------------|------------|----------------------|------------|
| ** **                                            | ** ** | **2004**             | ** ** | **2003** | ** ** |
| ** **                                            | ** ** | ** **           | ** ** | ** ** | ** ** |
| Foreign subsidiaries net operating loss  carryforward |       | $                    | 374        |   | $ | 374 |   |
| Net operating loss carryforwards                      |       | 27,780               |       | 25,968 |   |
| Book over tax depreciation                            |       | 67                   |       | 61 |   |
| Intangibles                                           |       | 1,298                |       | 1,478 |   |
| Equity investments                                    |       | 458                  |       | 458 |   |
| Vacation accrual                                      |       | 94                   |       | 111 |   |
| Allowance for doubtful accounts and returns           |       | 140                  |       | 164 |   |
| Warranty accrual                                      |       | 46                   |       | 73 |   |
| Inventory allowance                                   |       | 73                   |       | 469 |   |
| Other                                                 |       | 1,178                |       | 689 |   |
| Deferred tax assets                                   |       | 31,508               |       | 29,845 |   |
| Valuation allowance for deferred tax assets           |       | (31,508              | )          | (29,845 | ) |
| 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 has consideredthese factors in determining the valuation allowance for 2004 and 2003.

 

The differences between the provision for income taxes and income taxescomputed using the federal statutory rate for the years ended December 31,2004 and 2003 are as follows (in thousands):

 

| ** **                                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Reconciliation of income tax benefit to  statutory rate: |       |     |       |     |       |
| Income tax benefit at statutory rate                     |       | $        | (1,539     | )        | $          | (3,264 | ) |
| State income taxes, net of federal income  tax benefit   |       | (120     | )          | (256     | )          |
| Change in valuation allowance                            |       | 1,663    |       | 3,509    |       |
| Other                                                    |       | (4       | )          | 11       |       |
|                                                     |       | $        | —     |     | $          | — |   |

 

F-14

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At December 31, 2004, we had federal net operating losscarryforwards of $75.8 million for income tax purposes that begin to expire in2008 and are subject to the ownership change limitations under Internal RevenueCode Section 382. We also had $89.1 million of state net operatingloss carryforwards. Net operating loss carryforwards of the foreignsubsidiaries of $0.7 million at December 31, 2004 are availableindefinitely for offset only against taxable income generated by the foreignsubsidiaries.

 

We made no federal tax payments during 2004 and 2003, and did notreceive any federal income tax refunds in 2004 or 2003 for income taxes paid inprevious years.

 

**7. Stock Options and Warrants**

 

At December 31, 2004, we had four stock-based compensation plans,which are described below. These plans were developed to retain and attract keyemployees and directors.

 

In 1987, an Incentive Stock Option Plan was established, which providesfor the issuance of options to key employees of the Company to purchase ourcommon stock.  The 1987 Incentive StockOption Plan was terminated on January 26, 1997.  The 1987 plan provided for the issuance of upto 300,000 shares of common stock upon exercise of options granted pursuant tothe plan.  Options to purchase a total of3,400 shares of common stock are outstanding with no optionsremaining available for issuance for the 1987 plan.

 

In 1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), whichprovides for the issuance of up to 400,000 shares of common stock upon exerciseof options granted pursuant to the 1995 Plan. On April 19, 2000, ourstockholders approved a 212,500 share increase, and on April 26, 2001, ourstockholders approved an additional 212,500 share increase to the 1995 Plan.Therefore, the overall number of shares available for issuance pursuant to theplan was increased to 825,000 shares of common stock. The 1995 Plan providesfor the issuance of both non-qualified and incentive stock options to ouremployees, officers, and employee-directors. At December 31, 2004, 65,863employee options have been exercised, employee options to purchase a total of358,187 shares of common stock are outstanding and employee options for400,950 shares remain available for future grant.

 

In 1995, we adopted the 1995 Non-Employee Director Stock Option Plan(the “1995 Non-Employee Director Plan”) which provided for the issuance of upto 40,000 shares of common stock upon exercise of options granted pursuantto the 1995 Non-Employee Director Plan. On April 25, 2002, ourstockholders approved an amendment to the 1995 Non-Employee Director Plan. Thisamendment increased the number of shares available for option to 65,000 shares,replaced the automatic grant feature prospectively from 5,000 on the fifthanniversary to 2,500 shares annually and reduced the vesting schedule fromfive years to three years for options granted prospectively. The 1995Non-Employee Director Plan provides for the issuance of non-qualified stockoptions to non-employee directors. No shares have been exercised under the 1995Non-Employee Director Plan. Non-employee options to purchase a total of42,500 shares of common stock are outstanding and non-employee options for22,500 shares remain available for issuance. Since inception,62,500 shares have been granted to directors pursuant to the 1995Non-Employee Director Plan, of which, 20,000 have been cancelled.

 

Common shares reserved for future issuance, including conversions ofpreferred stock, warrants, outstanding options, under all of the stock optionplans and employee stock purchase plans total approximately 2,863,735 millionshares at December 31, 2004.

 

F-15

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| **(In  thousands)**             | ** ** | **Outstanding** | ** ** | **Available for  Future Grant** | ** ** |
|---------------------------------|------------|-----------------|------------|---------------------------------|------------|
|                            |       |            |       |                            |       |
| Preferred Stock                 |       | 1,336           |       | —                          |       |
| Warrants                        |       | 621             |       | —                          |       |
| 1987 Plan                       |       | 3               |       | —                          |       |
| 1995 Plan                       |       | 358             |       | 401                             |       |
| 1995 Non-Employee Director Plan |       | 43              |       | 23                              |       |
| Employee Stock Purchase Plan    |       | —          |       | 79                              |       |
| Total                           |       | 2,361           |       | 503                             |       |

 

The Compensation Committee of our Board of Directors determines theterm of each option, option exercise price within limits set forth in theplans, number of shares for which each option is granted and the rate at whicheach option is exercisable (generally ratably over one, three or five yearsfrom grant date). However, the exercise price of any incentive stock option maynot be less than the fair market value of the shares on the date granted (orless than 110% of the fair market value in the case of optionees holding morethan 10% of our voting stock of the Company), and the term cannot exceed tenyears (five years for incentive stock options granted to holders of more than10% of our voting stock).

 

A summary of our stock option activity and related information for theyears ended December 31, 2004 and 2003 is as follows:

 

| ** **                         | ** ** | **2004**                               | ** ** | **2003**                               | ** ** |
|------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                         | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                         | ** ** | ** **                             | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at beginning of year   |       | 374                                    |       | $                                      | 15.10      |   | 421 |   | $ | 19.54 |   |
| Granted                            |       | 162                                    |       | 1.93                                   |       | 163 |   | 2.04 |   |
| Exercised                          |       | (3                                     | )          | 1.97                                   |       | — |   | — |   |
| Cancelled                          |       | (129                                   | )          | 11.43                                  |       | (210 | ) | 13.91 |   |
|                               |       |                                   |       |                                   |       |   |   |   |   |
| Outstanding at end of year         |       | 404                                    |       | 11.08                                  |       | 374 |   | 15.10 |   |
| Options exercisable at end of year |       | 214                                    |       | $                                      | 18.56      |   | 201 |   | $ | 23.33 |   |

 

F-16

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Information related to stock options outstanding at December 31,2004, is summarized below:

 
| ** **                    | ** ** | **Options Outstanding**                      | ** ** | **Options Exercisable**                             | ** ** |
|-------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|
| **Range  of Exercise Prices** | ** ** | **Outstanding at  12/31/04 (in  thousands)** | ** ** | **Weighted  Average  Remaining   Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable at  12/31/04 (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                          |       |                                         |       |                                                |       |   |   |   |   |   |   |
| $ 0.76-$4.44             |       | 257                                          |       | 8.24 years                                          |       | $ | 1.98 |   | 74 |   | $ | 2.17 |   |
| $ 5.08-$10.00            |       | 62                                           |       | 6.75 years                                          |       | $ | 6.12 |   | 57 |   | $ | 6.10 |   |
| $ 17.52-$30.00           |       | 43                                           |       | 5.54 years                                          |       | $ | 20.78 |   | 43 |   | $ | 20.78 |   |
| $ 38.00-$93.00           |       | 42                                           |       | 3.71 years                                          |       | $ | 64.42 |   | 40 |   | $ | 64.49 |   |
|                          |       | 404                                          |       | 7.26 years                                          |       | $ | 11.08 |   | 214 |   | $ | 18.56 |   |

 

Pro forma information regarding net loss and net loss per share, asdisclosed in Note 2, has been determined as if we had accounted foremployee stock-based compensation plans and other stock options under the fairvalue method of SFAS 123. The fair value for these options was estimatedat the date of grant using a Black-Scholes option-pricing model with thefollowing weighted average assumptions used for grants under the option plans:

 
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
|                     |       |     |       |     |       |
| Expected dividend yield  |       | 0.0      | %          | 0.0      | %          |
| Risk-free interest rate  |       | 2.7      | %          | 2.4      | %          |
| Expected volatility      |       | 154.5    | %          | 147.0    | %          |
| Expected life (in years) |       | 4.5      |       | 3.3      |       |

 

The Black-Scholes option valuation model was developed for use inestimating the fair value of traded options that have no vesting restrictionsand are fully transferable. In addition, option valuation models require theinput of highly subjective assumptions including the expected stock pricevolatility. Because our employee stock options have characteristicssignificantly different from those of traded options, and because changes inthe subjective input assumptions can materially affect the fair value estimate,in management’s opinion, the existing models do not necessarily provide areliable single measure of the fair value of its employee stock options.

 

Information relating to the fair value of option grants made during2004 and 2003 is as follows:

 
| ** **                                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                         |       |     |       |     |       |
| Options granted (with exercise price equal  to fair value of common stock):                  |       |     |       |     |       |
| Number of options (in thousands)                                                             |       | 145      |       | 150      |       |
| Weighted average exercise price per share                                                    |       | $        | 1.94       |     | $          | 1.97 |   |
| Weighted average fair value of stock  options grants per Black-Sholes option valuation model |       | $        | 1.73       |     | $          | 1.64 |   |
| Options granted (with exercise price  greater than fair value of common stock):              |       |     |       |     |       |
| Number of options (in thousands)                                                             |       | 17       |       | 13       |       |
| Weighted average exercise price per share                                                    |       | $        | 1.89       |     | $          | 2.74 |   |
| Weighted average fair value of stock  options grants per Black-Sholes option valuation model |       | $        | 1.47       |     | $          | 1.96 |   |

 

F-17

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**8. Preferred Stock**

 

On March 25, 2004, we completed a $5.0 million private placementof 5% Convertible Preferred Stock and warrants. In the private placement, we sold 1,000,000 shares of preferred stock ata price of $5.00 per share for gross proceeds of $5.0 million, less $275,000 ofissuance costs.  The preferred shares wereinitially convertible into 1,590,331 shares of common stock at a conversionprice of $3.144 per share.

 

The 5% dividends related to the preferred stock are paid semi-annuallyon the last business day in March and September of each year,beginning with September 2004. Preferred stockholders vote together with common stockholders on an asconverted to common stock basis.  Basedon the conversion rate of the preferred stock, holders of preferred stock willreceive 1.5903 votes per share rounded to the nearest whole number.  The liquidation preference for the preferredstock is an amount equal to $5.00 per share plus any accrued and unpaiddividends.  Holders of preferred stockhave liquidation preference rights over common stock holders.

 

Included in this transaction were warrants to purchase 556,619 sharesof common stock at an exercise price of $3.144 per share.  In connection with the closing of thisprivate placement, we issued warrants to purchase 64,408 shares of our commonstock at an exercise price of $3.144 per share to our financial advisor forassistance with the private placement.  Allof the warrants were immediately exercisable and expire on March 25,2009.  These 621,027 warrants were valuedat $1.2 million using the Black-Scholes model and have been treated as adiscount to the Preferred Stock and recorded as an increase in additional paidin capital.  The issuance of the warrantsresulted in a beneficial conversion feature to the Preferred Stock valued at$0.9 million.  The beneficial conversionfeature was immediately amortized as the shares were immediately convertible.

 

The Preferred Stock was recorded as the financing proceeds of $5.0million less $275,000 issuance costs and the fair value of the warrants issuedin conjunction with the Preferred Stock of $1.2 million.

 

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

 

During December 2004, 160,000 shares of preferred stock wereconverted into 254,452 shares of our common stock.  At December 31, 2004 there are 840,000shares of preferred stock outstanding.

 

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

 

Our operations are concentrated in one area—security software andappliances. Sales to the U.S. Government through direct and indirect channelstotaled 53.6% of total revenues for 2004 and 17% of total revenues for 2003.  During 2004 approximately 44.7% of totalrevenues are attributable to three customers. One of these customers, representing 11.2% of the total revenues, alsocomprised approximately 65.4% of accounts receivable at December 31,2004.  There were no individual customersin 2003 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.

 

Export sales (based on our customers location), primarily to Europe,Asia, Latin America and Canada, were $1.2 million in 2004 and$2.0 million in 2003. No significant long-lived assets are deployedoutside of the United States.  Ourforeign operations act only as sales support offices in those regions.

 

**10. Subsequent Events**

 

On March 28, 2005, we completed a $2.66 million private placement of Series2 5% Convertible Preferred Stock and warrants. In the private placement, the Company sold 1,065,200 shares of preferredstock at a price of $2.50 per share, which convert into 1,065,200 shares ofcommon stock at an initial conversion price of $2.50 per share, and warrants topurchase 532,600 shares of common stock at an exercise price of $2.77 pershare.

 

F-18

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