** **

**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, 2007** |
| ** **                                           |
| **OR**                                               |
| ** **                                           | ** ** | ** **                                                                                         |
| **o**                                                | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition 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, SUITE 200**

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

 

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

 

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

** **

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

**CommonStock, $0.01 par value**

(Title of class)

 

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

 

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

 

Check if there is no disclosure of delinquentfilers in response to Item 405 of Regulation S-B contained in this form,and no disclosure will be contained, to the best of the registrant’s knowledge,in definitive proxy or information statements incorporated by reference inPart III of this Form 10-KSB or any amendment to thisForm 10-KSB. ý

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

State the issuer’s revenues for its mostrecent fiscal year:  $3,510,000.

 

State the aggregate market value of thevoting and non-voting equity held by non-affiliates computed by reference tothe price at which the common equity was sold, or the average bid and askedprice of such common equity, as of March 14, 2008:  $1,328,965. As of March 14, 2008, 11,638,405 shares of the issuer’s CommonStock were outstanding.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

** **

Portions of the Registrant’s definitive ProxyStatement filed in connection with the Registrant’s 2008 Annual Meeting ofStockholders are incorporated by reference into Part III of thisForm 10-KSB.

 

Transitional Small Business Disclosure Format(Check One):  Yes o  No ý

 

 

 

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**INTRUSION INC.**

**INDEX**

** **
| **PART I**   |   |                                                                                                                                               |       |
|-------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Item  1.          |   | Description  of Business                                                                                                                           | 3          |
| Item  2.          |   | Description  of Property                                                                                                                           | 18         |
| Item 3.           |   | Legal  Proceedings                                                                                                                                 | 18         |
| Item 4.           |   | Submission  of Matters to a Vote of Security Holders                                                                                               | 18         |
| **PART II**  |   |                                                                                                                                               |       |
| Item  5.          |   | Market  for Common Equity and Related Stockholder Matters and Small Business Issuer  Purchases of Equity Securities                                |  

18 |
| Item  6.          |   | Management’s  Discussion and Analysis or Plan of Operations                                                                                   | 20         |
| Item 7.           |   | Financial Statements                                                                                                                               | 27         |
| Item 8.           |   | Changes In and Disagreements  with Accountants on Accounting and Financial Disclosure                                                              | 27         |
| Item 8A(T).       |   | Controls and Procedures                                                                                                                            | 28         |
| Item 8B.          |   | Other Information                                                                                                                                  | 28         |
| **PART III** |   |                                                                                                                                               |       |
| Item 9.           |   | Directors, Executive  Officers, Promoters, Control Persons and Corporate Governance; Compliance  with Section 16(a) of the Exchange Act. |  

28 |
| Item 10.          |   | Executive Compensation                                                                                                                             | 28         |
| Item 11.          |   | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                                                    | 29         |
| Item 12.          |   | Certain Relationships and  Related Transactions, and Director Independence                                                                         | 29         |
| Item 13.          |   | Exhibits                                                                                                                                           | 29         |
| Item 14.          |   | Principal Accountant Fees  and Services                                                                                                            | 31         |
| Signatures        |   |                                                                                                                                               | 32         |

 

2

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**PART I**

 

**Item 1.          Description of Business.**

** **

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

 

**General**

 

We develop, market and support a family of entityidentification, regulated information compliance, data privacy protection andnetwork intrusion prevention/detection products.  Our product families include:  TraceCop for identity discovery anddisclosure, Compliance Commander for regulated information and data privacyprotection, and Intrusion SecureNet for network intrusion prevention anddetection.  Intrusion’s products helpprotect critical information assets by quickly detecting, protecting, analyzingand reporting attacks or misuse of classified, private and regulatedinformation for government and enterprise networks.

 

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

 

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

 

Our principal executive offices are located at 1101East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephonenumber is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries. ComplianceCommanderTM, SecureNetTM and TraceCopTM are trademarks of Intrusion Inc.

 

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

 

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

 

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On March 28, 2005, we completed a privateplacement of 1,065,200 shares of our Series 2 5% Convertible PreferredStock and warrants to purchase 532,600 shares of our common stock for grossproceeds of $2,663,000.  The preferredshares may be converted into 1,065,200 shares of common stock at an initialconversion price of $2.50 per share, and the warrants may be exercised at aprice of $2.77 per share during the five-year period commencing on September 28,2005.  In connection with the closing of this privateplacement, we issued warrants to purchase 60,390 shares of our common stock atan exercise price of $2.77 per share to employees of our financial advisor forthe private placement.

 

On December 2, 2005, we completed an additionalprivate placement of 564,607 shares of our Series 3 5% ConvertiblePreferred Stock and warrants to purchase 282,306 shares of our common stock forgross proceeds of $1,230,843.  Thepreferred shares may be converted into 564,607 shares of common stock at an initialconversion price of $2.18 per share, and the warrants may be exercised at aprice of $0.40 per share during the five-year period commencing on June 2,2006.  In connection with the closing of this privateplacement, we issued warrants to purchase 27,531 shares of our common stock atan exercise price of $2.58 per share to employees of our financial advisor forthe private placement.

 

                On March 29, 2006, weestablished a $1,000,000 line of credit with Silicon Valley Bank which mayincrease to $2,000,000 if we have EBITDA of at least $200,000 for twoconsecutive quarters.  Under the terms ofthis agreement, we may borrow an amount equal up to 80% of eligible accountsreceivable balances.  In addition, we mayobtain inventory advances equal to 35% of finished goods inventory, capped atthe lesser of the inventory availability, $300,000 or 35% of our totalborrowing base.  If our credit lineincreases to $2,000,000, inventory advances will be capped at the lesser of theinventory availability, $600,000 or 35% of our borrowing base.  Amounts we borrow under the credit lineaccrue interest at an annual rate of prime plus 1% and are secured by a lien onall of our assets.  The line of creditwas extended on March 28, 2008, accrued interest on all outstanding amountsis payable monthly in arrears and all outstanding principal and accrued butunpaid interest on the amounts we borrow are due on June 28, 2008.

 

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

 

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

 

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

 

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

 

On January 30,2008, the Company entered into a revolvingpromissory note to borrow up to $700,000 from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.

 

OnMarch 20, 2008, we received a written commitment from our Chief Executive Officer toinvest up to an additional $1,500,000 in the Company until March 2009,should such funding be required by the Company, on terms and conditions yet tobe determined.

 

**Government Sales**

 

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

 

Sales to U.S. government customers accounted for73.2% of our revenues for the year ended December 31, 2007, compared to73.6% of our revenue in 2006.  We expectto continue to derive a substantial portion of our revenues from sales togovernmental entities in the future as we continue to market our entityidentification products, our regulated compliance and data leakage preventionproducts and our network intrusion prevention products to the government.  Sales to the government presents risks inaddition to those involved in sales to commercial customers which couldadversely affect our revenues, including potential disruption due toirregularities in or interruptions to appropriation and spending patterns,delays

 

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inapproving a federal budget and the government’s reservation of the right tocancel contracts and purchase orders for its convenience.

 

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

 

**Industry Background**

 

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

 

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

 

·              Control: the ability to affectnetwork traffic including access to the network or parts thereof in order toenforce a security policy.

 

·              Visibility: the ability to see andunderstand the nature of the network and the traffic on the network, whichassists in decision making as well as crafting and constant improvement of asecurity policy.

 

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

 

**Products**

 

The Intrusion SecureNet, Compliance Commander andTraceCop systems can operate standalone or with our Provider Management System.

 

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

 

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

 

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

 

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

 

# *Intrusion Compliance CommanderProducts*

# * *

Compliance Commander provides protection against theloss and misuse of regulated, classified and commercially sensitive data.  Loss of information assets that containcustomer data has spawned a multitude of federal and state legislation to set astandard of care, use and protection for customer information.  Better known laws that regulate customerinformation include HIPAA, Gramm-Leach-Bliley Act (GLBA) and its UK equivalentPrivacy Act of 1998, and California SB 1386. Penalties for non-compliance include fines, lawsuits, imposed processesand enforced business limitations. Any enterprise that falls within the scope ofthese 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 products leveragethe same Management systems as SecureNet NIP&DS products. Our ComplianceCommander solutions are currently designed to address the security andconfidentiality issues in the following industries and customers:

 

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

 

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

 

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

 

# *Intrusion SecureNetNIP&DS Products*

# * *

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

 

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

 

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

 

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

 

                Our SecureNet Sensors have theirown web browser interface for simplified configuration. SecureNet Sensors alsodeliver complete, stand-alone NIP&DS for the small and medium business withlocal management and monitoring. This 

 

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allowscustomers to use their standard web browser to access a full power,full-featured NIP&DS, without additional hardware or software.

 

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

 

# *Intrusion TraceCopProducts*

# * *

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

 

**Third-Party Products**

 

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

 

We currently have three third-party productrelationships.  We do not consider any ofthese third-party relationships to be material and we do not expect the salesfrom these relationships to be material, as the product offerings are onlycomplementary to our existing product offerings.

 

**Customer Services**

 

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

 

**Product Development**

 

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

 

During 2007 and 2006, our research and developmentexpenditures were $1.7 million and $2.1 million, respectively. All of ourexpenditures for research and development have been expensed as incurred.  At December 31, 2007, we had 13employees engaged in research and product development.

 

**Manufacturing and Supplies**

 

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

 

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

 

**Intellectual Property and Licenses**

 

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

 

We have entered into software and product licenseagreements with various suppliers. These license agreements provide us withadditional software and hardware components that add value to our securityproducts. These license 

 

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agreementsdo not provide proprietary rights that are unique or exclusive to us and aregenerally available to other parties on the same or similar terms andconditions, subject to payment of applicable license fees and royalties.  We do not consider any of the productlicense, software or supplier agreements to be material to our business, butrather complementary to our business and product offerings.

 

**Sales, Marketing and Customers**

 

***   Field Sales Force.***  Our direct sales organization focuses onmajor account sales, channel partners including distributors, Value AddedResellers (VARs) and integrators; promotes our products to current andpotential customers; and monitors

 

evolvingcustomer requirements. The field sales and technical support force providestraining and technical support to our resellers and end users and assists ourcustomers in designing secure data networking solutions.

 

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

 

***   Distributors.***  Wehave signed distribution agreements with distributors in the United States,Europe and Asia. In general, these relationships are non-exclusive.

 

***   Resellers.*** Resellers such as domestic and international system integrators and VARssell our products as stand-alone solutions to end users and integrate ourproducts with products sold by other vendors into network security systems thatare sold to end users. Our field sales force and technical support organizationprovide support to these resellers. Our agreements with resellers arenon-exclusive, and our resellers generally sell other products that may competewith our products. Resellers may place higher priority on products of othersuppliers who are larger than and have more name recognition than us, and therecan be no assurance that resellers will continue to sell and support ourproducts.

 

***   Foreign Sales.***  Webelieve that rapidly evolving international markets are important sources offuture net sales. Our export sales are currently being made through an indirectsales force comprised of international resellers in Europe, Asia andCanada.  Export sales accounted forapproximately 9.2% and 9.4% of total revenue in 2007 and 2006,respectively.  See “Management’sDiscussion and Analysis or Plan of Operations” included in this report for ageographic breakdown of our revenue in 2007 and 2006. Sales to foreigncustomers and resellers generally have been made in United States dollars.

 

***   Marketing.***  Wehave implemented several methods to market our products, including publicrelations and placed articles, regular participation in and presenting duringtrade shows and seminars, advertisement in trade journals, telemarketing,distribution of sales literature and product specifications and ongoingcommunication with our resellers and installed base of end-user customers.

 

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

 

Although we sell our products to many customersthrough various distribution channels, no one commercial customer or reselleraccounted for 10% or more of our total revenue in any of the past three fiscalyears.  However, in 2007, 73.2% of our revenuewas derived from a variety of U.S. government entities through direct sales andindirectly through system integrators and resellers.  In 2007, 66.5% of our total revenues areattributable to two customers; a U.S. Government customer exceeds 10% of ourtotal revenues individually. Comparatively, sales to the U.S. Government through direct and indirectchannels totaled 73.6% of total revenues for 2006 and 65.6% of our totalrevenues in 2006 were attributable to three customers, one of which exceeded 10%of our total revenues individually.  Areduction in our sales to U.S. government entities could have a materialadverse effect on our business and operating results if not replaced.

 

***   Backlog.***  We believethat only a small portion of our order backlog is non-cancelable and that thedollar amount associated with the non-cancelable portion is immaterial. Wepurchase or contract inventory based upon our forecast of customer demand andmaintain inventories in advance of receiving firm orders from customers.Commercial orders are generally fulfilled within two days to two weeksfollowing receipt of an order. Certain government orders may be scheduled overseveral months, generally not exceeding one year.

 

***   Customer Support, Service and Warranty.***  We service, repair and provide technicalsupport for our products. Our field sales and technical support force worksclosely with resellers and end-user customers on-site and by telephone toassist with 

 

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pre-and post-sales support services such as network security design, systeminstallation and technical consulting. By working closely with our customers,our employees increase their understanding of end-user requirements and provideinput to the product development process.

 

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

 

**Competition**

 

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

 

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

 

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

 

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

 

**Employees**

 

As of December 31, 2007, we employed a total of27 persons, including 9 in sales, marketing and technical support, 1 inmanufacturing and operations, 13 in research and product development and 4 inadministration and finance.

 

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

 

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

 

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**Factors That May Affect FutureResults of Operations**

 

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

 

***Our cash, cashequivalents, and investments decreased from $0.9 million at December 31,2006 to $0.4 million at December 31, 2007. As a result of our expected continuing net cash outflows, we may nothave sufficient cash to operate our business and may not be able to maintaincertain liquidity requirements. Additional debt and equity offerings to fund future operations may notbe available and, if available, may significantly dilute the value of ourcurrently outstanding common stock.***

 

As of December 31, 2007, we had cash, cashequivalents and investments of approximately $0.4 million, down fromapproximately $0.9 million as of December 31, 2006.  We expect our net operating losses andoperating cash outflows to continue through at least the first quarter of 2008and possibly throughout the remainder of fiscal year 2008.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources.  As of February 29, 2008 we had cash and cash equivalents of $40,000and $6,000 available funding under our line of credit at Silicon Valley Bankand $220,000 available from our promissory note to borrow up to $700,000 from G.Ward Paxton, the Company’s Chairman, President and Chief ExecutiveOfficer.  We expect to fund our operations through additionalinvestments of private equity and debt, which, if we are able to obtain, willhave the effect of diluting our existing common stockholders, perhapssignificantly.  Specifically, we have a March 20,2008 written commitment from our Chief Executive Officer to invest up to anadditional $1,500,000 in the Company until March 2009, should such fundingbe required by the Company, on terms and conditions yet to be determined.    Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders. If ouroperations do not generate positive cash flow in the next few months, or if weare not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

 

***Our revenues declined from$5.2 million in 2006 to $3.5 million in 2007 in connection with a shift infocus from SecureNet products to Compliance Commander and TraceCopproducts.   If our newer products do notachieve market acceptance, our revenues will continue to suffer.***

 

We havetransitioned our sales strategy focus from SecureNet to Compliance Commanderand TraceCop.  During this transition,sales of our newer products have not offset the losses in sales associated withour older products.  As a result, our netrevenues declined from $5.2 million in 2006 to $3.5 million in 2007.  We can provide no assurances that sales ofour newer products will ever offset the losses in sales of older products orgenerate sufficient revenues to sustain our business.

 

Our newnetwork security products, regulated information compliance systems and entityidentification products have only been in the market place for a limited periodof time and may have longer sales cycles than our previous products.  Accordingly, we may not achieve themeaningful revenue growth needed to sustain operations.  If we are unable to recognize revenues due tolonger sales cycles or other problems, our results of operations will beadversely affected, perhaps materially.

 

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

 

***We had a net loss of $2.4million for the year ended December 31, 2007 and have an accumulateddeficit of $57.5 million as of December 31, 2007.  To achieve profitability, we must generatesubstantially greater revenues.***

 

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

 

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

 

                A large percentage of our revenues resultfrom sales to U.S. government entities.  If we were to lose one or more of these keyrelationships, our revenues could decline and our business and prospects may bematerially harmed. We expect that even if we are successful in developingrelationships with non-governmental customers, our revenues will continue to beconcentrated among government entities. For the years ended December 31,2005, 2006****and 2007, sales to U.S.government entities collectively accounted for 70.7%, 73.6% and 73.2% of ourtotal net revenues, respectively. The loss of any of these key relationshipsmay send a negative message to other U.S. government entities or non-governmental customers concerning ourproduct offering.  We cannot assure youthat U.S. governmententitieswill be customers of ours in future periods or that we will be able todiversify our customer portfolio to adequately mitigate the risk of loss of anyof these customers.

 

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

 

We expectto continue to derive a substantial portion of our revenues from U.S.government customers in the future. Sales to the government present risks in addition to those involved insales to commercial customers, including potential disruption due toappropriation and spending patterns, delays in approving a federal budget andthe government’s right to cancel contracts and purchase orders for itsconvenience.  General political andeconomic conditions, which we cannot accurately predict, directly andindirectly may affect the quantity and allocation of expenditures by federaldepartments.  In addition, obtaininggovernment contracts may involve long purchase and payment cycles, competitivebidding, qualification requirements, delays or changes in funding, budgetaryconstraints, political agendas, extensive specification development and pricenegotiations and milestone requirements. Each government entity also maintains its own rules and regulationswith which we must comply and which can vary significantly amongdepartments.  As a result, cutbacks orre-allocations in the federal budget or losses of government sales due to otherfactors could have a material adverse effect on our revenues and operatingresults.

 

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

 

                For the years ended December 31, 2005, 2006 and2007, we derived 36.2%, 17.3% and 19.2% of our revenues from sales throughindirect sales channels, such as distributors, value-added resellers, systemintegrators, original equipment manufacturers and managed serviceproviders.  We must expand our salesthrough these indirect channels in order to increase our revenues.  We cannot assure you that our products willgain market acceptance in these indirect sales channels or that sales throughthese indirect sales channels will increase our revenues.  Further, many of our competitors are alsotrying to sell their products through these indirect sales channels, whichcould result in lower prices and reduced profit margins for sales of ourproducts.

 

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

 

Revenuesfrom foreign customers for the fiscal years ended December 31, 2005, 2006and 2007 accounted for approximately 10.7%, 9.4% and 9.2%, respectively, of ourrevenues.  We expect sales to foreigncustomers to continue to represent a significant portion of our revenues in thefuture.  Our international operations aresubject to many inherent risks that may adversely affect our business,financial condition and operating results, including:

 

·      political,social and economic instability;

 

·      traderestrictions;

 

·      increasesin duty rates and other potentially adverse tax consequences;

 

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

 

·      burdensof complying with a variety of foreign laws;

 

·      unexpectedchanges in regulatory requirements;

 

·      importand export license requirements and restrictions of the United States and eachother country where we operate;

 

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·      fluctuationsin currency exchange rates; and

 

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

 

                Any interruptions or declines in our internationalsales would result in a significant adverse impact on our results of operationsand business.

 

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

 

On March 25, 2004, we completed a $5,000,000 private placementpursuant to which we issued 1,000,000 shares of our 5% Convertible PreferredStock (the “Series 1 Preferred Stock”) and warrants to acquire 556,619shares of our common stock.  Theconversion price for the Series 1 Preferred Stock and the exercise priceof the warrants is $3.144 per share.  Asof February 29, 2008, there were 259,696 shares of the Series 1Preferred Stock outstanding, representing approximately 413,003 shares ofcommon stock upon conversion.

 

On March 28, 2005, we completed a $2,663,000 private placementpursuant to which we issued 1,065,200 shares of our Series 2 5%Convertible Preferred Stock (the “Series 2 Preferred Stock”) and warrantsto acquire 532,600 shares of our common stock. The conversion price for the Series 2 Preferred Stock is $2.50 pershare and the exercise price of the warrants is $2.77 per share.  As of February 29, 2008, there were460,000 shares of the Series 2 Preferred Stock outstanding, representing460,000 shares of common stock upon conversion.

 

On December 2, 2005, we completed a $1,230,843private placement pursuant to which we issued 564,607 shares of our Series 35% preferred stock  (the “Series 3Preferred Stock”) and warrants to acquire 282,306 shares of our common stock...The preferred shares may be converted into 564,607 shares of common stock atan initial conversion price of $2.18 per share, and the warrants may beexercised at a price of $0.40 per share during the five-year period commencingon June 2, 2006.  As of February 29,2008, there were 354,056 shares of Series 3 Preferred Stock outstanding,representing 354,056 shares of common stock upon conversion.

 

                During the fiscal year ended December 31,2007, we paid $65,000 in dividends to the holders of our 5% Preferred Stock,$58,000 in dividends to the holders of our Series 2 5% Preferred Stock and$51,000 in dividends to the holders of our Series 3 5% PreferredStock.  At December 31, 2007, wehave dividends accrued of $16,364 related to our 5% Preferred Stock, $4,884related to our Series 2 5% Preferred Stock and $3,826 related to our Series 35% Preferred Stock.

 

Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years ended as of December 31, 2007.  We also, as of December 31, 2007, didnot have sufficient capital surplus, defined as the amount by which our netassets exceed our stated capital, based on par value of our outstanding sharesas provided by Delaware law.  We cannotassure you that our net assets will exceed our stated capital or that we willhave net profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  The accrual of thesedividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect our abilityto operate or grow our business.

 

                Ifwe are unable to pay dividends on our preferred stock, we will accrue anadditional late fee penalty of 18% per annum on the unpaid dividends for the Series 2Preferred Stock and Series 3 Preferred Stock, and we could be required toredeem the outstanding shares of Series 2 Preferred Stock and Series 3Preferred Stock for shares of our common stock issued at a price equal to 75%of the average of the volume weighted average price of our common stock for theten days ending on the day immediately preceding an election to redeem,subject, in the case of the Series 3 Preferred Stock, to a floor of$0.87.  As a result, the issuance orpotential issuance of these additional shares of common stock could cause ourstock price to decline.  Furthermore, ourinability to pay dividends could adversely affect our ability to raise equityfinancing in the future if required.

 

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

 

On March 14, 2008, we had 11,638,405 shares of common stockoutstanding.  Upon conversion of alloutstanding shares of our preferred stock and exercise of the warrants, we willhave 14,389,318 shares of common stock outstanding, approximately a 25.0%increase in the number of shares of our common stock outstanding.

 

 

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                Further, theoccurrence of certain events could entitle holders of our Series 2Preferred Stock and Series 3 Preferred Stock to require us to redeem theirshares for a certain number of shares of our common stock.  Assuming (i) we have paid all liquidateddamages and other amounts to the holders, (ii) incurred accrued but unpaiddividends on February 29, 2008 of $17,000, (iii) a volume weightedaverage price of $0.17, which was the ten-day volume weighted average closingprice of our common stock on February 29, 2008, and (iv) our11,638,405shares ofcommon stock outstanding on February 29, 2008, upon exercise of theirredemption right by the holders of the Series 3 Preferred Stock and the Series 2Preferred Stock, we would be obligated to issue approximately 19,512,924 sharesof our common stock.  This wouldrepresent an increase of approximately 167.7% in the number of shares of ourcommon stock as of February 29, 2008.

 

                In addition,management may issue additional shares of common stock or securitiesexercisable or convertible into shares of common stock in order to finance ourcontinuing operations.  Any futureissuances of such securities would have additional dilutive effects on theexisting holders of our Common Stock.

 

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

 

Theholders of the shares of our 5% Preferred Stock and warrants we issued inconnection with the sale of our 5% Preferred Stock may freely convert theirshares of preferred stock and exercise their warrants and sell the underlyingshares of common stock pursuant to Rule 144 of the Securities and ExchangeCommission.  As of February 29,2008, 740,304 shares of our 5% Preferred Stock had converted into1,177,327 shares of common stock.

 

Theholders of the shares of Series 2 5% Preferred Stock andwarrants we issued in connection with the sale of our Series 2 PreferredStock may freely convert their shares of preferred stock and exercise theirwarrants and sell the underlying shares of common stock pursuant to Rule 144of the Securities and Exchange Commission. As of February 29, 2008, 605,200 shares of Series 2 Preferred Stock had converted into 605,200 shares of common stock.

 

Theholders of the shares of Series 3 5% Preferred Stock andwarrants we issued in connection with the sale of our Series 3 PreferredStock, may freely convert their shares of Series 3 Preferred Stock and exercise their warrants and sell the underlying shares of commonstock pursuant to Rule 144 of the Securities and Exchange Commission.  As of February 29, 2008, 210,551 sharesof Series 3 PreferredStock had converted into 210,551 shares of common stock.

 

For thefour weeks ended on February 29, 2008, the average daily trading volume ofour common stock on The OTCBB was 9,050 shares. Consequently, if holders of preferred stock or warrants elect to converttheir remaining shares or exercise their warrants and sell a material amount oftheir underlying shares of common stock on the open market, the increase inselling activity could cause a decline in the market price of our common stock.  Furthermore, these sales, or the potentialfor these sales, could encourage short sales, causing additional downwardpressure on the market price of our common stock.

 

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

 

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

 

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

 

Since webegan restructuring in 2002, we have incurred approximately $1.1 million inrestructuring charges, severance, and related expenses. We have alsoimplemented other strategic initiatives, such as reductions in our work forceand facilities and aligning our organization around our businessobjectives.  Any further work forcereductions could result in temporary reduced productivity of our remainingemployees.  Additionally, our customersand prospects may delay or forgo purchasing our products due to a perceiveduncertainty caused by our restructuring and other changes.  Failure to achieve the desired results of ourinitiatives could seriously harm our business, results of operations and financialcondition.

 

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

 

From ourfounding in 1983 until 2000, we derived substantially all of our revenue fromthe design, manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenues generatedfrom the sale of our network security products, which have received limitedmarket acceptance.  We have recentlyintroduced our regulated information compliance systems and entityidentification products, and the market for these products has only begun toemerge.  We can provide no assurancesthat our newly introduced products will ever achieve widespread marketacceptance or that an adequate market for these products will ever emerge.  Consequently, we resemble a developmentalstage company and will face the following inherent risks and uncertainties:

 

·      theneed for our network security products, regulated information compliancesystems and entity identification products to achieve market acceptance andproduce a sustainable revenue stream;

 

·      ourability to manage costs and expenses;

 

·      ourdependence on key personnel;

 

·      ourability to obtain financing on acceptable terms; and

 

·      ourability to offer greater value than our competitors.

 

                Our business strategy may not successfully addressthese risks.  If we fail to recognizesignificant revenues from the sales of our network security products, regulatedinformation compliance systems and entity identification products, ourbusiness, financial condition and operating results would be materially adverselyaffected.

 

***Our management and larger stockholdersexercise significant control over our company and have the ability to approveor take actions that may be adverse to your interests.***

 

As of March 14,2008, our executive officers, directors and preferred stockholders beneficiallyown approximately 38.7% of our voting power. As a result, these stockholders will be able to exercise significantcontrol over all matters requiring stockholder approval, including the electionof directors and approval of significant corporate transactions, which coulddelay or prevent someone from acquiring or merging with us.  These stockholders may use their influence toapprove or take actions that may be adverse to your interests.  Further, we contemplate the possible issuanceof shares of our Common Stock or of securities exercisable or convertible intoshares of our Common Stock in the future by our Chief Executive Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer and our management groupbeneficially holds.

 

***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 network intrusionprevention and detection market include Internet Security Systems, Inc.(IBM), Cisco Systems, Inc., Symantec, Inc., Juniper Networks, Inc.,McAfee Inc., Tipping Point Technologies, a division of 3Com Corporation, andNFR Security, Inc.  Our competitorsin the regulated information compliance market include Vontu (Symantec), PortAuthority (Websense), Vericept, Reconnex, Tablus and a small number of start-upcompanies that entered the space within the last two years. Our current andpotential competitors may have one or more of the following significantadvantages over us:

 

·      greaterfinancial, technical and marketing resources;

 

·      bettername recognition;

 

·      morecomprehensive security solutions;

 

 

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·      betteror more extensive cooperative relationships; and

 

·      largercustomer base.

 

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

 

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

 

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

 

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

 

                Our products are highlytechnical and complex, are critical to the operation of many networks and, inthe case of our security products, provide and monitor network security and mayprotect valuable information. Our products have contained and may contain oneor more undetected errors, defects or security vulnerabilities. Some errors inour products may only be discovered after a product has been installed and usedby end customers. Any errors or security vulnerabilities discovered in ourproducts after commercial release could result in loss of revenues or delay inrevenue recognition, loss of customers and increased service and warranty cost,any of which could adversely affect our business and results of operations. Inaddition, we could face claims for product liability, tort or breach ofwarranty. Defending a lawsuit, regardless of its merit, is costly and maydivert management’s attention. In addition, if our business liability insurancecoverage is inadequate or future coverage is unavailable on acceptable terms orat all, our financial condition could be harmed.

 

***Abreach of network security could harm public perception of our securityproducts, which could cause us to lose revenues.***

 

                If an actual or perceived breachof network security occurs in the network of a customer of our securityproducts, regardless of whether the breach is attributable to our products, themarket perception of the effectiveness of our products could be harmed. Thiscould cause us to lose current and potential end customers or cause us to losecurrent and potential value-added resellers and distributors. Because thetechniques used by computer hackers to access or sabotage networks changefrequently and generally are not recognized until launched against a target, wemay be unable to anticipate these techniques.

 

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

 

                Our products are designed tointerface with our customers’ existing networks, each of which have differentspecifications and utilize multiple protocol standards and products from othervendors. Many of our customers’ networks contain multiple generations ofproducts that have been added over time as these networks have grown andevolved. Our products will be required to interoperate with many or all of theproducts within these networks as well as future products in order to meet ourcustomers’ requirements. If we find errors in the existing software or defectsin the hardware used in our customers’ networks, we may have to modify oursoftware or hardware to fix or overcome these errors so that our products will 

 

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interoperate andscale with the existing software and hardware, which could be costly andnegatively impact our operating results. In addition, if our products do notinteroperate with those of our customers’ networks, demand for our productscould be adversely affected, orders for our products could be cancelled or ourproducts could be returned. This could hurt our operating results, damage ourreputation and seriously harm our business and prospects.

 

***Whilewe believe that we currently have adequate internal control over financialreporting, we are exposed to risks from recent legislation requiring companiesto evaluate those internal controls.***

 

                Section 404 of theSarbanes-Oxley Act of 2002 requires our management to report on theeffectiveness of our internal control over financial reporting. We have anongoing program to perform the system and process evaluation and testingnecessary to comply with these requirements. We have and will continue to incursignificant expenses and devote management resources to Section 404compliance on an ongoing basis. In the event that our chief executive officer,chief financial officer or independent registered public accounting firmdetermine in the future that our internal controls over financial reporting arenot effective as defined under Section 404, investor perceptions may beadversely affected and could cause a decline in the market price of our stock.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

There arenumerous patents held by many companies relating to the design and manufactureof network security systems.  Thirdparties may claim that our products infringe on their intellectual propertyrights.  Any claim, with or withoutmerit, could consume our management’s time, result in costly litigation, causedelays in sales or implementations of our products or require us to enter intoroyalty or licensing agreements. Royalty and licensing agreements, if requiredand available, may be on terms unacceptable to us or detrimental to ourbusiness.  Moreover, a successful claimof product infringement against us or our failure or inability to license theinfringed or similar technology on commercially reasonable terms couldseriously harm our business.

 

 

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

 

Our operating results have varied significantly fromquarter to quarter in the past, and we expect our operating results to varyfrom quarter to quarter in the future due to a variety of factors, many ofwhich are outside of our control. Significant portions of our expenses are not variable in the short termand we cannot reduce them quickly to respond to unexpected decreases inrevenues.  Therefore, if revenues arebelow our expectations, this shortfall is likely to adversely and disproportionatelyaffect our operating results. Accordingly, we may not attain positive operating margins in futurequarters.  Any of these factors couldcause our operating results to be below the expectations of securities analystsand investors, which likely would negatively affect the price of our commonstock.

 

***The price of our commonstock has been volatile in the past and may continue to be volatile in thefuture due to factors outside of our control.***

 

Themarket price of our common stock has been highly volatile in the past and maycontinue to be volatile in the future. For example, in fiscal year 2007, the market price of our common stockon The OTCBB Market fluctuated between $0.17 and $0.75 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

·      variationsin our quarterly operating results;

 

·      changesin estimates of our financial performance by securities analysts;

 

·      changesin market valuations of our competitors;

 

·      announcementsby us or our competitors of new products, significant contracts, acquisitions,strategic relationships, joint ventures or capital commitments;

 

·      productor design flaws, product recalls or similar occurrences;

 

·      additionsor departures of key personnel;

 

·      salesof common stock in the future; and

 

·      fluctuationsin stock market prices and volume, which can be particularly common amongnetwork security and other high technology companies.

 

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

 

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

 

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

 

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

 

 

17

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***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.

 

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

 

UnitedStates military actions or other events occurring in response to or in connectionwith them, including future terrorist attacks, actual conflicts involving theUnited States or its allies or military or trade disruptions could impact ouroperations by:

 

·      reducingor delaying government, military or corporate spending on network securityproducts;

 

·      increasingthe cost and difficulty in obtaining materials or shipping products; and

 

·      affectingour ability to conduct business internationally.

 

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

 

**Item 2.          Description of Property.**

** **

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

 

Approximatelythirty percent of our security software research and development staff islocated in two separate small facilities in San Diego, California.  These leases are currently set to expire in February 2009.  Research and development personnel occupythese facilities.

 

We believe that the existing facilities at December 31,2007 will be adequate to meet our requirements through 2008.  We believe that all facilities are adequatelycovered by appropriate property insurance. See Note 4 of Notes to Consolidated Financial Statements foradditional information regarding our obligations under leases.

 

**Item 3.          Legal Proceedings.**

** **

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

 

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

** **

There were no matters submitted to a vote of oursecurity holders during the fourth quarter of 2007.

 

**PART II**

 

**Item 5.          Market for Common Equity and Related Stockholder Matters andSmall Business Issuer Purchases of Equity Securities.**

** **

 

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Our common stock trades on The OTCBB, where it iscurrently listed under the symbol “INTZ.” As of February 29, 2008, there were approximately 125 registeredholders of record of the common stock. The following table sets forth, for theperiods indicated, the high and low per share bid information for the commonstock, as reported by The OTCBB.  Thesequotations reflect inter-dealer prices, without retail mark-up, mark-down orcommission and may not represent actual transactions.

 
| ** **     | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|           |       |     |       |     |       |   |   |   |   |
| First Quarter  |       | $        | .75        |     | $          | .43 |   | $ | 2.87 |   | $ | 1.28 |   |
| Second Quarter |       | .52      |       | .37      |       | 1.52 |   | .40 |   |
| Third Quarter  |       | .43      |       | .35      |       | .72 |   | .28 |   |
| Fourth Quarter |       | .42      |       | .17      |       | .53 |   | .22 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

We havenot declared or paid cash dividends on our common stock in our two most recentfiscal years.  We intend to retain anyearnings for use in our business and do not anticipate paying any cashdividends on our common stock in the foreseeable future.  Future dividends on common stock, if any,will be determined by our Board of Directors. However, shares of our 5% convertible preferred stock accrue cashdividends equal to $0.25 per share per annum, payable in arrears on March 31and September 30 of each year, and shares of our Series 2 5% and Series 35% convertible preferred stock accrue cash dividends equal to $0.125 per shareper annum payable in arrears on the first business day of March, June, September andDecember of each year.  We paid $173thousand in dividends related to all of our 5% convertible preferred stockduring 2007 and at December 31, 2007, we have dividends accrued related toall of our 5% convertible preferred stock of $25 thousand.  The terms of our outstanding preferred stockprohibit us from paying any dividends on our common stock unless all accrueddividends on the preferred stock have been paid.

 

Delaware law provides that we may only pay dividends out of our capitalsurplus or, if no surplus is available, out of our net profits for the fiscalyear the dividend is declared and/or the preceding fiscal year.  We have not had net profits for the last twofiscal years ended as of December 31, 2007.  We also, as of December 31, 2007, didnot have sufficient capital surplus, defined as the amount by which our netassets exceed our stated capital, based on par value of our outstanding sharesas provided by Delaware law.  We cannotassure you that our net assets will exceed our stated capital or that we willhave net profits in order to pay these dividends in the future.  These dividends continue to accrue on all ouroutstanding shares of preferred stock, regardless of whether we are legallyable to pay them.  The accrual of thesedividends may adversely affect our operating results.  Moreover, the payment of these dividendscould strain our available cash resources, which could adversely affect ourability to operate or grow our business. Furthermore, our inability to pay dividends couldadversely affect our ability to raise equity financing in the future, ifrequired.  The terms of our credit line withSilicon Valley Bank also prohibit us from paying any dividends on our commonstock.

 

All stock option plans under which our common stockis reserved for issuance have previously been approved by our shareholders. Thefollowing table provides summary information as of December 31, 2007 forall of our equity compensation plans (in thousands, except per share data). SeeNote 8 to our consolidated financial statements for additional discussion.

 
| ** **                                                   | ** ** | **Number of shares of  common stock to be  issued upon exercise  of outstanding  options** | ** ** | **Weighted average exercise price of outstanding options** | ** ** | **No. of shares of  common stock  remaining available  for future issuance under equity compensation plans** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
|                                                         |       |                                                                                       |       |                                                       |       |                                                                                                              |       |
| Equity compensation plans approved   by security holders     |       | 1,141                                                                                      | (1)        | $                                                          | 2.30       |                                                                                                              | 669        |   |
| Equity compensation plans not   approved by security holders |       | —                                                                                     |       | —                                                     |       | —                                                                                                            |       |
| Total                                                        |       | 1,141                                                                                      |       | $                                                          | 2.30       |                                                                                                              | 669        |   |

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(1)           Includedin the outstanding options are 831,500 from the 2005 Plan, 277,380 from the1995 Plan and 32,500 from the 1995 Non-Employee Director Plan.

 

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**Item 6.          Management’s Discussion and Analysis of Financial Condition andResults of Operations.**

 

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

 

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

 

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

 

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

 

·      ourstatus as a developmental stage company;

 

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

 

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

 

·      disruptionto our business due to military actions;

 

·      longsales and implementation cycles of our products;

 

·      insufficientcash to operate our business;

 

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

 

·      theeffect of consolidation in the network security industry;

 

·      risksinvolved with Government and international customers;

 

·      ourinability to expand our sales;

 

·      failureto adequately protect our intellectual property; or

 

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

 

                If one or more ofthese or other risks or uncertainties materialize, or if our underlyingassumptions prove to be incorrect, actual results may vary significantly fromwhat we projected. Any forward-looking statement you read in this filingreflects our current views with respect to future events and is subject tothese and other risks, uncertainties and assumptions relating to ouroperations, results of operations, growth strategy and liquidity. We assume noobligation to publicly update or revise these forward-looking statements forany reason, or to update the reasons actual results could differ materiallyfrom those anticipated in these forward-looking statements, even if newinformation becomes available in the future.

 

The Private Securities Litigation Reform Act of 1995 and Section 27Aof the Securities Act, each of which provide protection in connection withcertain forward-looking statements, do not directly protect any statements wemake in connection with this Annual Report.

 

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**Overview**

 

We develop, market and support a family of entityidentification products, regulated information compliance and data privacyprotection, and network intrusion prevention/detection products.  Our product families include TraceCop foridentity identification, Compliance Commander for regulated informationcompliance and data privacy protection and Intrusion SecureNet 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 adirect sales force to end-users, distributors and numerous system integrators,managed service providers and value-added resellers. Our end-user customersinclude banks, credit unions, other financial institutions, U.S. federalgovernment entities, foreign government entities and local government entities,high technology, e-commerce and telecommunication companies, hospital and otherhealthcare providers and academic institutions. Essentially, our end-user can be defined as ‘any end-user requiringnetwork security solutions for protecting their mission critical data’.

 

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

 

Our principal executive offices are located at 1101East Arapaho Road, Suite 200, Richardson, Texas 75081, and our telephonenumber is (972) 234-6400.  Ourwebsite URL is www.intrusion.com. References to “we”, “us”, “our” or “Intrusion Inc.” refer toIntrusion Inc. and its subsidiaries. ComplianceCommanderTM, SecureNetTM and TraceCopTM are registered trademarks of IntrusionInc.

 

Our revenues have decreased over the past few yearsdue primarily to the change in our product focus from networking hardware tonetwork security software products with a corresponding decrease in our salesvolume related to this change in our product mix.  To date, we have not encountered significantcompetition in the market that has caused us to decrease our sales prices whencompared to sales prices in previous years. To help counteract our declining revenues and bring our operations inline with our new strategic focus, we reduced our employee headcount in2007.  At December 31, 2006 weemployed 32 employees and at December 31, 2007 we employed 24employees.  As a result of our migrationto software-based solutions, our margins have increased over the past threeyears from 58.0% in 2005 and 2006, to 60.8% in 2007.  We have also restructured our personnel andoperations around the development and sale of our core software products.  As a result of these efforts, we believe wehave reduced operating expenses to a level that will remain consistent goingforward.

 

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

 

**Critical Accounting Policies and Estimates**

 

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

 

 

 

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Webelieve the following critical accounting policies affect our more significantjudgments and estimates used in the preparation of our consolidated financialstatements.

 

*Revenue Recognition*

 

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

 

We recognize software revenue from the licensing ofour software products in accordance with Statement of Position (“SOP”) No. 97-2“Software Revenue Recognition”, SOP 98-9 “Modification of 97-2, SoftwareRevenue Recognition, 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 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) collectability is probable. Bundled hardware andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easily obtainedfor all of our product offerings, as we have historical sales information onour 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.

 

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

 

*Allowance for Doubtful Accounts and Returns*

 

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

 

*Inventory*

 

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

 

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**Results of Operations**

 

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

 
| ** **                                        | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                              |       |                             |       |   |   |
| Net product revenue                               |       | 80.2                             | %          | 78.3 | % |
| Net customer support and  maintenance revenue     |       | 19.8                             |       | 21.7 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0 |   |
| Cost of product revenue                           |       | 37.2                             |       | 38.2 |   |
| Cost of customer support  and maintenance revenue |       | 2.0                              |       | 3.8 |   |
| Total cost of revenue                             |       | 39.2                             |       | 42.0 |   |
| Gross profit                                      |       | 60.8                             |       | 58.0 |   |
| Operating expenses:                               |       |                             |       |   |   |
| Sales and marketing                               |       | 55.0                             |       | 51.8 |   |
| Research and development                          |       | 47.2                             |       | 39.4 |   |
| General and administrative                        |       | 26.4                             |       | 23.7 |   |
| Operating loss                                    |       | (68.4                            | )          | (57.3 | ) |
| Interest income, net                              |       | 0.2                              |       | 0.8 |   |
| Other income, net                                 |       | —                           |       | (1.2 | ) |
| Loss from operations  before income taxes         |       | (68.2                            | )          | (57.7 | ) |
| Income tax provision                              |       | —                           |       | — |   |
| Net loss                                          |       | (68.2                            | )          | (57.7 | ) |
| Preferred stock dividends  accrued                |       | (4.9                             | )          | (3.3 | ) |
| Beneficial conversion  feature on preferred stock |       | —                           |       | — |   |
| Net loss attributable to  common stockholders     |       | (73.1                            | )%         | (61.0 | )% |
|                                              |       |                             |       |   |   |
|                                              |       |                             |       |   |   |
| ** **                                        | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                              |       |                             |       |   |   |
| Domestic revenue                                  |       | 90.8                             | %          | 90.6 | % |
| Export revenue to:                                |       |                             |       |   |   |
| Europe                                            |       | 8.2                              |       | 7.1 |   |
| Canada                                            |       | 0.1                              |       | 1.6 |   |
| Asia                                              |       | 0.8                              |       | 0.6 |   |
| Latin America                                     |       | 0.1                              |       | 0.1 |   |
| Net revenue                                       |       | 100.0                            | %          | 100.0 | % |
|                                                   |            |                                  |            |  |  |  |

 

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**2007 compared with 2006**

 

***Net Revenue***

 

Total revenue decreased to $3.5 million in 2007from $5.2 million in 2006.  The declinein revenue is related to shifting our focus from our SecureNet IPS product lineto our Compliance Commander and TraceCop product lines.  Our customer support and maintenance revenuedecreased 36.4% from $1.1 million in 2006 to $0.7 million in 2007.  This decline is mainly due to the expirationof maintenance contracts related to SecureNet. In 2007, total revenues related to our SecureNet product line decreased41.2% or $0.7 million from $1.7 million in 2006 to $1.0 million in 2007, andour non-core product lines, including our PDS and SecureCom hardware productsremained constant at $0.1 million for 2007 and 2006.  Our product revenues decreased 31.7% from$4.1 million in 2006 to $2.8 million in 2007.  We expect our product revenues to increase in the future as the marketacceptance of our Compliance Commander and TraceCop product lines increase.

 

Export sales in 2007 decreased to $0.3 million,or 9.2% of net revenue, compared to $0.5 million, or 9.4% of net revenuein 2006 primarily due our focus on domestic revenue sales.  As part of our headcount reductions, we havefocused most of our sales personnel on the domestic market.  Sales of our products internationally may besubject to exchange risk, which may cause our products to effectively increasein price, if the exchange rate moves significantly and the dollar gains valueover the foreign currency.

 

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

 

***Gross Profit***

 

Gross profit decreased 30% to $2.1 million in 2007from $3.0 million in 2006. As a percentage of net revenue, gross profitincreased 2.8% from 58.0% in 2006 to 60.8% in 2007.  Gross profit on products increased from 51.3%in 2006 to 53.7% in 2007 due to the shift in a more profitable product mix,namely our software-based products.  Thedecrease in gross profit during 2007 was due to lack of revenue growth asrelated to shifting our focus from our SecureNet IPS product line to ourCompliance Commander and TraceCop product lines.  Gross profit on customer support andmaintenance increased from 82.2% in 2006 to 89.6% in 2007.  The decrease in gross profit on customersupport and maintenance was relatively small and our gross profit in this areashould remain strong as our hardware-related repair costs in conjunction withour strategic decision to move towards software-based solutions should remainlow.  As we continue to migrate from ourolder hardware-based products to our newer software-based products, we expectour product margins to continue to increase.

 

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

 

***Sales and Marketing***

 

Sales and marketing expenses decreased 29.6% to$1.9 million in 2007 from $2.7 million in 2006, as we reducedexpenses to respond to the decline in sales. As a percentage of net revenue,sales and marketing expenses increased to 55.0% in 2007 from 51.8% in 2006. Weexpect sales and marketing expenses to decrease in 2008 compared to 2007 as aresult of a decrease in expenses related to the Compliance Commander productline.  We also expect sales and marketingexpenses, as a percentage of net revenue, to decrease in 2008 compared to 2007as we expect an increase in revenue in 2008.

 

***Research and Development***

 

Research and development expenses decreased to$1.7 million, or 47.2% of net revenue, in 2007 compared to$2.1 million, or 39.4% of net revenue, in 2006.  Our research and development costs areexpensed in the period in which they are incurred. We expect research anddevelopment expenses to remain relatively constant in 2008 compared to2007.  We expect research anddevelopment, as a percentage of net revenue, also to decrease in 2008 comparedto 2007 as our revenue increases.

 

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***General and Administrative***

 

General and administrative expenses decreased to$0.9 million, or 26.6% of net revenue in 2007 compared to $1.3 million or 23.9% of net revenue in 2006 as a result of decreases in payroll, benefits, legal,consulting and other administrative expenses associated with a decrease incompany size.  We expect general andadministration expenses to remain relatively constant in 2008 compared to 2007.

 

***Interest Income, Net***

 

Net interest income decreased 64.4% to $16 thousandin 2007 from $45 thousand in 2006 primarily due to a decrease in average cashand interest-bearing investment balances. We expect net interest income toremain consistent in 2008 compared to 2007. Net interest income will vary in the future based on our cash flow andrate of return on investments.

 

***Income Taxes***

 

Our effective income tax rate was 0% in 2007 and2006 as valuation allowances have been recorded for the entire amount of thenet deferred tax assets due to uncertainty of realization.  We have fully utilized our net operating losscarryback.

 

**Liquidity and Capital Resources**

 

Our principal sources of liquidity at December 31,2007 were $0.4 million of cash and cash equivalents. As of December 31,2007, we do not hold investments with a stated maturity beyond one year.Working capital at December 31, 2007 was $(0.4) million compared to$0.5 million as of December 31, 2006.

 

Net cash used in operations in 2007 was$1.8 million, primarily due to a net loss of $2.4 million for the year andthe following uses of cash: a $410 thousand decrease in accounts payable andaccrued expenses, a $55 thousand reduction in deferred revenue and a $50thousand reduction in the allowance for doubtful accounts.   This was partially offset by the followingsources of cash and non-cash items: a $784 thousand decrease in accountsreceivable, a $63 thousand decrease in inventories, a $125 thousand decrease inprepaid expenses and other assets, $123 thousand in stock-based compensationand $56 thousand in depreciation expense. Net cash used in operations in 2006 was $2.9 million, primarily dueto a net loss of $3.0 million for the year, a decrease in deferred revenue of$0.2 million, an increase in accounts receivable of $0.4 million, offset bydepreciation and amortization of $0.1 million and stock-based compensationexpense of $0.4 million.   Futurefluctuations in accounts receivable, inventory balances and accounts payable willbe dependent upon several factors, including quarterly sales, timely collectionof accounts receivable, and the accuracy of our forecasts of product demand andcomponent requirements.

 

Net cash used in investing activities in 2007 was$39 thousand for net purchases of property and equipment. Net cash provided byinvesting activities in 2006 was $0.5 million, which consisted ofmaturities of short term investments of $0.5 million of available for salesecurities.

 

Cashprovided by financing activities in 2007 was $1.2 million, primarily consistingof net financing proceeds from private placements consisting of the proceeds of$1.5 million, partially offset by payment of dividends on preferred stock of$173 thousand, and a net reduction in the line of credit of $100 thousand;compared to net cash provided by financing activities in 2006 was $0.5 million,consisting of net financing proceeds from private placements of $0.5 million,net proceeds from line of credit of $.2 million offset by dividends paid onpreferred stock of $0.2 million.

 

At December 31, 2007, we did not have anymaterial commitments for capital expenditures. Operating lease commitments of$0.9 million are detailed below. During 2007, we funded our operationsthrough the use of available cash, cash equivalents and investments, which wasraised primarily through private offerings of common stock.

 

Asof December 31, 2007, we had cash, cash equivalents and investments in theamount of approximately $0.4 million, down from approximately$0.9 million as of December 31, 2006. However, throughout 2007, we continued to reduce expenses and realizethe benefit of cost-cutting actions taken in previous years.

 

On January 30,2008, the Company entered into a revolvingpromissory note to borrow up to $700,000 from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.

 

25

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OnMarch 29, 2006, we established a $1,000,000 line of credit with SiliconValley Bank.  Under the terms of thisagreement, we may borrow an amount equal up to 80% of eligible accountsreceivable balances.  In addition, we mayobtain inventory advances equal to 35% of finished good inventory, capped atthe lesser of the inventory availability, $300,000 or 35% of our totalborrowing base.  If our credit lineincreases to $2,000,000, inventory advances will be capped at the lesser of theinventory availability, $600,000 or 35% of our borrowing base.  Amounts we borrow under the credit lineaccrue interest at an annual rate of prime plus 1% and are secured by a lien onall of our assets.  Accrued interest onall outstanding amounts is payable monthly in arrears and all outstandingprincipal and accrued but unpaid interest on the amounts we borrow are due on June 30,2008.  Our ability to receive advancesunder this credit line will increase if we generate additional receivables andinventory from the sale of our products. We have $14,000 outstanding under this credit line as of February 29,2008.  Also, at February 29, 2008,we could borrow an additional $6,000 based on our borrowing basecalculation.  The line of credit wasextended on March 28, 2008 until June 28, 2008.  Accrued interest on all outstanding amountsis payable monthly in arrears and all outstanding principal and accrued butunpaid interest on the amounts we borrow are due on June 30, 2008.  At or before June 30, 2008, it isanticipated that we will put a new credit facility in place with Silicon ValleyBank.

 

We expect our net operating losses and operatingcash outflows to continue through at least the first quarter of 2008 andpossibly throughout the remainder of fiscal year 2008.  The sufficiency of our cash resources maydepend to a certain extent on general economic, financial, competitive or otherfactors beyond our control.  In addition,we are obligated to make payments of accrued dividends on all our outstandingshares of preferred stock that will reduce our available cash resources.   As of February 29, 2008 we had cash andcash equivalents of $40,000 and $6,000 available funding under our line ofcredit at Silicon Valley Bank and $220,000 available from our promissory note to borrow up to$700,000 from G. Ward Paxton, the Company’s Chairman, President and ChiefExecutive Officer. Based on projections for increased revenues in 2008and a commitment from the Company’s CEO to advance the Company up to $1.5million in additional funding should it be necessary, we believe that ouravailable credit line and available cash resources will provide sufficient cashresources to finance our operations and expected capital expenditures for thenext twelve months.  We expect to fund our operations throughadditional investments of private equity and debt, which, if we are able toobtain, will have the effect of diluting our existing common stockholders, perhapssignificantly.  Specifically, we have a March 20,2008 written commitment from our Chief Executive Officer to invest up to anadditional $1,500,000 in the Company until March 2009, should such fundingbe required by the Company, on terms and conditions yet to be determined.    Any equity or debt financings, if availableat all, may be on terms which are not favorable to us and, in the case ofequity financings, may result in dilution to our stockholders. If ouroperations do not generate positive cash flow in the next few months, or if weare not able to obtain additional debt or equity financing on terms andconditions acceptable to us, if at all, we may be unable to implement ourbusiness plan, fund our liquidity needs or even continue our operations.

 

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

 

26

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### **Contractual Obligations**

### ** **

Thefollowing table sets forth certain information concerning the futurecontractual obligations under our operating leases at December 31,2007.  We have no other significantcontractual obligations at December 31, 2007.

 

**Future minimum lease payments consisted of the following on December 31,2007 (in thousands):**

 
| 2008   |   | 393 |   |
|--------|--------|-----|--------|
| 2009   |   | 409 |   |
| 2010   |   | 68  |   |
|   |   | $   | 870    |   |
|        |        |     |        |  |

 

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

### ** **

Asof December 31, 2007, we did not have any significant off-balance sheetarrangements, as defined in Item 303(c)(2) of Regulation S-B.

 

**Quantitative and Qualitative Disclosures About Market Risk.**

 

ForeignExchange.  Our revenue originatingoutside the U.S. in 2007 and 2006 was 9.2% and 9.4% of total revenues,respectively.  Revenues generated fromthe European region in 2007 and 2006 were 8.2% and 7.1% of total revenues,respectively.  Revenues generated fromthe Asia region in 2007 and 2006 were 0.8% and 0.6% of total revenues,respectively.  International sales aregenerated primarily from our foreign sales subsidiaries in the local countriesand are typically denominated in U.S. dollars. These subsidiaries incur substantially all of their expenses in thelocal currency.

 

Theeffect of foreign exchange rate fluctuations on our business in 2007 and 2006was not material.

 

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

 

Investmentsin fixed-rate interest-earning instruments carry a degree of interest raterisk.  Fixed-rate securities may havetheir fair market values adversely impacted due to a rise in interestrates.  Due in part to these factors, ourfuture investment income may fall short of expectations due to changes ininterest rates or we may suffer losses in principal if forced to sellsecurities, which have seen a decline in market value due to changes ininterest rates.  Our investmentsecurities are held for purposes other than trading.  We held noshort-term investments at December 31, 2007.

 

**Item 7.          Financial Statements.**

 

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

 

**Item 8.          Changes In and Disagreements withAccountants on Accounting and Financial Disclosure.**

 

None.

 

27

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### ** **

### **Item 8A(T).  Management’s Report on Internal Control andFinancial Reporting**

### ** **

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting as defined in Rule 13a-15(f) of the SecuritiesExchange Act of 1934.  Our internal control system was designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial reporting and the preparation of financialstatements for external purposes, in accordance with generally acceptedaccounting principles.  Because of its inherent limitations, internalcontrol over financial reporting may not prevent or detectmisstatements.  Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Our management, includingour President, who serves as our principal executive officer, and our ChiefFinancial Officer, who serves as our principal financial officer, conducted anevaluation of the effectiveness of internal control over financial reportingusing the criteria set forth by the Committee of Sponsoring Organizations ofthe Treadway Commission in Internal Control — IntegratedFramework.  Based on its evaluation, our management concluded thatour internal control over financial reporting was effective as of December 31,2007.

 

This Annual Report doesnot include an attestation report of our independent registered publicaccounting firm regarding internal control over financialreporting.  Management’s report was not subject to attestation by ourindependent registered public accounting firm pursuant to temporary rules ofthe Securities and Exchange Commission that permit us to provide only management’sreport in this Annual Report.

 

There have not been anychanges in our internal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Securities Exchange Act ) that occurred during thefiscal quarter ended December 31, 2007 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

 

This report shall not bedeemed to be filed for purposes of Section 18 of the Securities ExchangeAct of 1934, or otherwise subject to the liabilities of that section, and isnot incorporated by reference into any filing of the Company, whether madebefore or after the date hereof, regardless of any general incorporationlanguage in such filing.

 

**Item 8B.       Other Information**

 

Notapplicable.

 

**PART III**

 

Certaininformation required by Part III is omitted from this Form 10-KSBbecause we will file a definitive Proxy Statement for our 2008 annualmeeting of stockholders pursuant to Regulation 14A (the “Proxy Statement”)no later than 120 days after the end of the fiscal year covered by this Form 10-KSB,and certain information to be included therein is incorporated herein byreference.

 

**Item 9.          Directors, Executive Officers,Promoters, Control Persons and Corporate Governance; Compliance with Section 16(a) ofthe Exchange Act.**

 

Theinformation required regarding Directors and Executive Officers of IntrusionInc. appearing under the captions “Election of Directors”, “Compliance with Section 16Reporting Requirements” and “Executive Officers” contained in the ProxyStatement is incorporated herein by reference.

 

**Item 10.        Executive Compensation.**

 

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

 

28

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**Item 11.        Security Ownership of Certain BeneficialOwners and Management.**

 

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

 

**Item 12.        Certain Relationships and RelatedTransactions.**

 

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

 

**Item 13.        Exhibits.**

 

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

 

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

 
| Report  of Independent Registered Public Accounting Firm                                                   |   | F-1 |
|------------------------------------------------------------------------------------------------------------|--------|-----|
| Consolidated  Balance Sheets at December 31, 2007 and 2006                                            |   | F-2 |
| Consolidated  Statements of Operations for the years ended December 31, 2007 and 2006                 |   | F-3 |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31, 2007  and 2006 |   | F-4 |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2007 and 2006                 |   | F-5 |
| Notes  to Consolidated Financial Statements                                                                |   | F-6 |

 

(b)**           Exhibits**

 

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

 
| **Exhibit  Number** | ** ** | **Description of Exhibit**                                                                                                                                                       |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1(5)              |       | Amended  and Restated Certificate of Incorporation of the Registrant                                                                                                             |
| 3.2(7)              |       | Certificate  of Amendment to Certificate of Incorporation of Registrant                                                                                                          |
| 3.3(8)              |       | Certificate  of Designations for the Registrant’s 5% Convertible Preferred Stock                                                                                            |
| 3.4(10)             |       | Certificate of Designations of  the Registrant’s Series 2 5% Convertible Preferred Stock                                                                               |
| 3.5(11)             |       | Certificate of Designations for the Registrant’s  Series 3 5% Convertible Preferred Stock                                                                              |
| 3.6(4)              |       | Bylaws  of the Registrant                                                                                                                                                        |
| 4.1(9)              |       | Specimen  Common Stock Certificate                                                                                                                                               |
| 4.2(8)              |       | Specimen  5% Convertible Preferred Stock Certificate                                                                                                                             |
| 4.3(10)             |       | Specimen Series 2 5% Convertible Preferred Stock  Certificate                                                                                                               |
| 4.4(11)             |       | Specimen Series 3 5% Convertible Preferred Stock  Certificate                                                                                                               |
| 4.5(8)              |       | Form of  Warrant to Purchase Shares of Common Stock issued to the investors in the  Registrant’s March 25, 2004 private placement                                 |
| 4.6(8)              |       | Warrant  to Purchase Common Stock dated March 25, 2004, issued by the Registrant  to Black Point Partners                                                                   |
| 4.9(10)             |       | Form of Common Stock  Purchaser Warrant issued to the investors in the Registrant’s March 28,  2005 private placement                                             |
| 4.10(10)            |       | Form of Representative’s Warrant  for the Purchase of Shares of Common Stock issued to certain affiliates of  Stonegate Securities, Inc. on March 28, 2005   |
| 4.15(11)            |       | Form of Common Stock  Purchaser Warrant issued to the investors in the Registrant’s  December 2, 2005 private placement                                           |
| 4.16(11)            |       | Form of Representative’s  Warrant for the Purchase of Shares of Common Stock issued to certain  affiliates of Stonegate Securities, Inc. on December 2, 2005 |
| 10.2(1)             |       | 1995  Stock Option Plan of the Registrant, as amended                                                                                                                            |
| 10.3(1)             |       | Form of  Indemnification Agreement                                                                                                                                          |
| 10.4(2)             |       | 1995  Non-Employee Directors Stock Option Plan of the Registrant (amended and  restated as of January 10, 2002)                                                             |

 

29

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| 10.5(9)   |   | Lease  Agreement between CalWest Industrial Holdings Texas, L.P. and Intrusion Inc.                                                                                                                             |
|-----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6(8)   |   | Securities  Purchase Agreement dated as of March 25, 2004, by and among the  Registrant and the purchasers listed on Exhibit A thereto                                                                |
| 10.7(4)   |   | Amended  and Restated 401(k) Savings Plan of the Registrant                                                                                                                                                |
| 10.8(4)   |   | 1997  Employee Stock Purchase Plan of the Registrant, as amended January 17,  2001                                                                                                                         |
| 10.9(6)   |   | Intrusion  Inc. 401(k) Savings Plan Summary of Material Modifications                                                                                                                                      |
| 10.10(12) |   | 2005 Stock Incentive Plan of the  Registrant (amended and restated as of May 30, 2007)                                                                                                                     |
| 10.11(12) |   | Form of Notice of Grant of  Stock Option                                                                                                                                                                   |
| 10.12(12) |   | Form of Stock Option  Agreement                                                                                                                                                                            |
| 10.13(12) |   | Form of Stock Issuance  Agreement                                                                                                                                                                          |
| 10.14(12) |   | Form of Notice of Grant of  Non-Employee Director Automatic Stock Option (Initial Grant)                                                                                                                   |
| 10.15(12) |   | Form of Notice of Grant of  Non-Employee Director Automatic Stock Option (Annual Grant)                                                                                                                    |
| 10.16(12) |   | Form of Automatic Stock  Option Agreement                                                                                                                                                                  |
| 10.17(10) |   | Securities Purchase Agreement dated as of  March 28, 2005, by and among the Registrant and the investors listed on Exhibit A  thereto                                                                 |
| 10.18(11) |   | Securities Purchase Agreement dated as of  December 2, 2005, by and among the Registrant and the investors listed  on Exhibit A thereto                                                               |
| 10.19(14) |   | Loan and Security Agreement dated  as of March 29, 2006, by and between the Registrant and Silicon Valley  Bank (extended on March 28, 2008)                                                          |
|      |   |                                                                                                                                                                                                            |
| 10.20(14) |   | Intellectual Property Security  Agreement dated as of March 29, 2006, by and between the Registrant and  Silicon Valley Bank                                                                               |
| 10.21(15) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated December 28, 2006.                                                                          |
| 10.21(15) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and Michael L. Paxton,  dated December 28, 2006.                                                                       |
| 10.21(16) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated March 15, 2007.                                                                             |
| 10.21(16) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and Michael L. Paxton,  dated March 15, 2007.                                                                          |
| 10.21(17) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated June 27, 2007.                                                                              |
| 10.21(17) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and Michael L. Paxton,  dated June 27, 2007.                                                                           |
| 10.21(18) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated September 26, 2007.                                                                         |
| 10.21(19) |   | Promissory Note dated as of  January 30, 2008, by and between the Registrant and G. Ward Paxton                                                                                                            |
| 21(5)     |   | List  of Subsidiaries of Registrant                                                                                                                                                                             |
| 23.1(20)  |   | Consent  of KBA Group LLP, Independent Registered Public Accounting Firm                                                                                                                                        |
| 31.1(20)  |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) of the  Exchange Act                                                                                                             |
| 31.2(20)  |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) of the  Exchange Act                                                                                                             |
| 32.1(20)  |   | 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(20)  |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(b) of the  Exchange Act and 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |

----

 

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

 

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

 

(3)           Filed as an Exhibit to theRegistrant’s Definitive Proxy Statement on Schedule 14A in connection withthe solicitation of proxies for its 2002 Annual Meeting of Stockholders, which Exhibit isincorporated herein by reference.

 

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

 

30

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(5)           Filed as an Exhibit to the Registrant’s Annual Reporton Form 10-K for the fiscal year ended December 31, 2001, which Exhibit isincorporated herein by reference.

 

(6)           Filedas an Exhibit to the Registrant’s Quarterly Report on Form 10-Q forthe quarter ended March 31, 2002, which Exhibit is incorporatedherein by reference.

 

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

 

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

 

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

 

(10)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated March 29, 2005, which Exhibit is incorporatedherein by reference

 

(11)         Filed as an Exhibit to theRegistrant’s Current Report on Form 8-K dated December 6, 2005, whichExhibit is incorporated herein by reference.

 

(12)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated June 15, 2005, which Exhibit is incorporatedherein by reference.

 

(13)         Filed as an Exhibit to the Registrant’s QuarterlyReport on Form 10-Q for the quarter ended September 30, 2004, which Exhibit isincorporated herein by reference.

 

(14)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated March 29, 2006, which Exhibit is incorporatedherein by reference.

 

(15)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated January 4, 2007, which Exhibit is incorporatedherein by reference.

 

(16)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated March 16, 2007, which Exhibit is incorporatedherein by reference.

 

(17)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated June 28, 2007, which Exhibit is incorporatedherein by reference.

 

(18)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated September 27, 2007, which Exhibit isincorporated herein by reference.

 

(19)         Filed as an Exhibit to the Registrant’s Current Reporton Form 8-K dated January 31, 2008, which Exhibit isincorporated herein by reference.

 

(20)         Filedherewith.

 

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

### ** **

Theinformation set forth under “Fees Paid to Independent Public Accountants”contained in the Proxy Statement is incorporated herein by reference.

 

 

31

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**SIGNATURES**

 

Inaccordance with Section 13 or 15(d) of the Exchange Act, theregistrant caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
| Dated:  March 28, 2008 | INTRUSION INC. |
|-----------------------------|---------------------|
|                        | (Registrant)        |
|                        |                |   |
|                        | By:                 | /s/  G. WARD PAXTON |
|                        |                | G.  Ward Paxton |
| * *                    | * *            | *Chairman, President, and Chief Executive Officer* |
| * *                    | * *            | *(Principal Executive Officer)* |

 

Inaccordance with the Securities Exchange Act, this report has been signed belowby the following persons on behalf of the registrant and in the capacities andon the dates indicated.

 
| **Signature**          | ** ** | **Title**                                     | ** ** | **Date**            |
|------------------------|------------|-----------------------------------------------|------------|---------------------|
|                   |       |                                          |       |                |
| /s/ G. WARD PAXTON     |       | Chairman,  President,                         |       | March 28, 2008 |
| G. Ward Paxton         |       | Chief  Executive Officer, and Director        |       |                |
|                   |       |                                          |       |                |
| /s/ T. JOE HEAD        |       | Vice  Chairman, Vice President                |       | March 28, 2008 |
| T. Joe Head            |       | and  Director                                 |       |                |
|                   |       |                                          |       |                |
| /s/ MICHAEL L. PAXTON  |       | Vice  President, Chief Financial              |       | March 28, 2008 |
| Michael L. Paxton      |       | Officer,  Treasurer and Secretary             |       |                |
|                   |       | (Principal  Financial and Accounting Officer) |       |                |
|                   |       |                                          |       |                |
| /s/ JAMES F. GERO      |       | Director                                      |       | March 28, 2008 |
| James F. Gero          |       |                                          |       |                |
|                   |       |                                          |       |                |
| /s/ J. FRED BUCY, JR.  |       | Director                                      |       | March 28, 2008 |
| J. Fred Bucy, Jr. |       |                                          |       |                |
|                   |       |                                          |       |                |
| /s/ DONALD M. JOHNSTON |       | Director                                      |       | March 28, 2008 |
| Donald M. Johnston     |       |                                          |       |                |
|                   |       |                                          |       |                |

 

32

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**ANNUAL REPORT ON FORM 10-KSB**

**ITEM 7**

**FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2007 and 2006**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

 

 

33

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

 

TheBoard of Directors and Stockholders

Intrusion Inc.

 

Wehave audited the accompanying consolidated balance sheets ofIntrusion Inc. and subsidiaries (the “Company”) as of December 31,2007 and 2006, and the related consolidated statements of operations, stockholders’equity, and cash flows for the years then ended. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

 

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

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the consolidated financial position ofIntrusion Inc. and subsidiaries as of December 31, 2007 and 2006, andthe consolidated results of their operations and their cash flows for the yearsthen ended in conformity with accounting principles generally accepted in theUnited States of America.

 

Asdiscussed in Note 2 to the consolidated financial statements, effective January 1,2006, the Company adopted Statement of Financial Accounting Standards No. 123(R),Share-Based Payment.

 

/s/KBA Group LLP

Dallas,Texas

March 28,2008

 

 

F-1

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                               | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                               | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Assets**                                                                                                               |       |                  |       |   |   |
| Current  Assets:                                                                                                         |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                |       | $                     | 362        |   | $ | 933 |   |
| Accounts receivable, net of allowance for doubtful  accounts and returns of $40 in 2007 and $90 in 2006                  |       | 110                   |       | 844 |   |
| Inventories, net                                                                                                         |       | 146                   |       | 209 |   |
| Prepaid expenses                                                                                                         |       | 75                    |       | 198 |   |
| Total  current assets                                                                                                    |       | 693                   |       | 2,184 |   |
| Property  and Equipment:                                                                                                 |       |                  |       |   |   |
| Equipment                                                                                                                |       | 438                   |       | 409 |   |
| Furniture and fixtures                                                                                                   |       | 30                    |       | 20 |   |
| Leasehold improvements                                                                                                   |       | 101                   |       | 101 |   |
|                                                                                                                     |       | 569                   |       | 530 |   |
| Accumulated depreciation and amortization                                                                                |       | (425                  | )          | (368 | ) |
|                                                                                                                     |       | 144                   |       | 162 |   |
| Other  assets                                                                                                            |       | 39                    |       | 41 |   |
| **TOTAL  ASSETS**                                                                                                        |       | $                     | 876        |   | $ | 2,387 |   |
| ** **                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Liabilities  and Stockholders’ Equity (Deficit)**                                                                 |       |                  |       |   |   |
| Current  Liabilities:                                                                                                    |       |                  |       |   |   |
| Line of credit                                                                                                           |       | $                     | 100        |   | $ | 200 |   |
| Accounts payable, trade                                                                                                  |       | 261                   |       | 555 |   |
| Accrued vacation expense                                                                                                 |       | 192                   |       | 212 |   |
| Accrued warranty expense                                                                                                 |       | 20                    |       | 49 |   |
| Other accrued expenses                                                                                                   |       | 215                   |       | 283 |   |
| Deferred revenue                                                                                                         |       | 312                   |       | 367 |   |
| Total  current liabilities                                                                                               |       | 1,100                 |       | 1,666 |   |
|                                                                                                                     |       |                  |       |   |   |
| **Commitments  and Contingencies**                                                                                       |       |                  |       |   |   |
|                                                                                                                     |       |                  |       |   |   |
| Stockholders’  Equity (Deficit):                                                                                    |       |                  |       |   |   |
| Preferred stock, $0.01 par value:                                                                                        |       |                  |       |   |   |
| Authorized shares — 5,000                                                                                           |       |                  |       |   |   |
| Series 1 shares issued and outstanding — 260  in 2007 and 2006   Liquidation preference of $1,315 in 2007      |       | 918                   |       | 918 |   |
| Series 2 shares issued and outstanding — 460  in 2007 and 2006   Liquidation preference of $1,155 in 2007      |       | 724                   |       | 724 |   |
| Series 3 shares issued and outstanding — 354  in 2007 and 469 in 2006   Liquidation preference of $776 in 2007 |       | 504                   |       | 667 |   |
| Common stock, $0.01 par value:                                                                                           |       |                  |       |   |   |
| Authorized shares — 80,000                                                                                          |       |                  |       |   |   |
| Issued shares — 11,648 in 2007 and 8,306 in 2006  

Outstanding shares — 11,638 in 2007 and 8,296 in  2006     |       | 116                   |       | 83 |   |
| Common stock held in treasury, at cost—10 shares                                                                    |       | (362                  | )          | (362 | ) |
| Additional paid-in-capital                                                                                               |       | 55,527                |       | 53,947 |   |
| Accumulated deficit                                                                                                      |       | (57,472               | )          | (55,077 | ) |
| Accumulated other comprehensive loss                                                                                     |       | (179                  | )          | (179 | ) |
| Total  stockholders’ equity (deficit)                                                                               |       | (224                  | )          | 721 |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                           |       | $                     | 876        |   | $ | 2,387 |   |

 

See accompanying notes.

 

 

F-2

----

**INTRUSION INC.AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
| ** **                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                                                        |       |                             |       |   |   |
| Net product revenue                                                         |       | $                                | 2,815      |   | $ | 4,106 |   |
| Net customer support and  maintenance revenue                               |       | 695                              |       | 1,136 |   |
| Total revenue                                                               |       | 3,510                            |       | 5,242 |   |
| Cost of product revenue                                                     |       | 1,304                            |       | 2,002 |   |
| Cost of customer support  and maintenance revenue                           |       | 72                               |       | 202 |   |
| Total cost of revenue                                                       |       | 1,376                            |       | 2,204 |   |
| Gross profit                                                                |       | 2,134                            |       | 3,038 |   |
| Operating expenses:                                                         |       |                             |       |   |   |
| Sales and marketing                                                         |       | 1,933                            |       | 2,714 |   |
| Research and development                                                    |       | 1,655                            |       | 2,067 |   |
| General and administrative                                                  |       | 947                              |       | 1,261 |   |
| Operating loss                                                              |       | (2,401                           | )          | (3,004 | ) |
| Interest income, net                                                        |       | 5                                |       | 45 |   |
| Other income (expense),  net                                                |       | 1                                |       | (65 | ) |
| Loss from operations  before income taxes                                   |       | (2,395                           | )          | (3,024 | ) |
| Income tax provision                                                        |       | —                           |       | — |   |
| Net loss                                                                    |       | (2,395                           | )          | (3,024 | ) |
| Preferred stock dividends  accrued                                          |       | (173                             | )          | (175 | ) |
| Net loss attributable to  common stockholders                               |       | $                                | (2,568     | ) | $ | (3,199 | ) |
|                                                                        |       |                             |       |   |   |
| Net loss per share  attributable to common stockholders (basic and diluted) |       | $                                | (0.26      | ) | $ | (0.45 | ) |
| Weighted average common  shares outstanding (basic and diluted)             |       | 9,929                            |       | 7,043 |   |

 

See accompanying notes.

 

 

F-3

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’ EQUITY**

**(In thousands)**

 
| ** **                                                                                         | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                         | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| **NUMBER OF PREFERRED  SHARES—ISSUED AND OUTSTANDING**                                        | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Balance, beginning of year                                                                         |       | 1,188                            |       | 1,325 |   |
| Issuance of preferred shares pursuant to private placement                                         |       | —                           |       | — |   |
| Conversion of preferred shares to common shares                                                    |       | (114                             | )          | (137 | ) |
| Balance, end of year                                                                               |       | 1,074                            |       | 1,188 |   |
| **PREFERRED STOCK**                                                                                | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Balance, beginning of year                                                                         |       | $                                | 2,309      |   | $ | 2,510 |   |
| Issuance of preferred shares pursuant to private placement, net of  warrants and transaction costs |       | —                           |       | — |   |
| Conversion of preferred shares to common shares                                                    |       | (163                             | )          | (201 | ) |
| Balance, end of year                                                                               |       | $                                | 2,146      |   | $ | 2,309 |   |
| **NUMBER OF COMMON SHARES—ISSUED**                                                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Balance, beginning of year                                                                         |       | 8,306                            |       | 6,919 |   |
| Issuance of common shares under private placements                                                 |       | 3,228                            |       | 1,250 |   |
| Conversion of preferred shares to common shares                                                    |       | 114                              |       | 137 |   |
| Balance, end of year                                                                               |       | 11,638                           |       | 8,306 |   |
| **COMMON STOCK**                                                                                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Balance, beginning of year                                                                         |       | $                                | 83         |   | $ | 69 |   |
| Issuance of common shares under private placement                                                  |       | 32                               |       | 13 |   |
| Conversion of preferred shares to common shares                                                    |       | 1                                |       | 1 |   |
| Balance, end of year                                                                               |       | $                                | 116        |   | $ | 83 |   |
| **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                                                                         |       | $                                | 53,947     |   | $ | 52,994 |   |
| Stock based compensation                                                                           |       | 123                              |       | 441 |   |
| Conversion of preferred shares to common shares                                                    |       | 162                              |       | 200 |   |
| Issuance of common shares under private placement                                                  |       | 1,468                            |       | 488 |   |
| Preferred stock dividends declared                                                                 |       | (173                             | )          | (176 | ) |
| Balance, end of year                                                                               |       | $                                | 55,527     |   | $ | 53,947 |   |
| **ACCUMULATED DEFICIT**                                                                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Balance, beginning of year                                                                         |       | $                                | (55,077    | ) | $ | (52,053 | ) |
| Net loss                                                                                           |       | (2,395                           | )          | (3,024 | ) |
| Balance, end of year                                                                               |       | $                                | (57,472    | ) | $ | (55,077 | ) |
| **ACCUMULATED OTHER COMPREHENSIVE  LOSS**                                                          | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Balance, beginning of year                                                                         |       | $                                | (179       | ) | $ | (179 | ) |
| Balance, end of year                                                                               |       | $                                | (179       | ) | $ | (179 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                |       | $                                | (224       | ) | $ | 721 |   |

 

See accompanying notes.

 

 

F-4

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Operating Activities:                                                        |       |                             |       |   |   |
| Net loss                                                                     |       | $                                | (2,395     | ) | $ | (3,024 | ) |
| Adjustments to reconcile  net loss to net cash used in operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                |       | 56                               |       | 97 |   |
| Provision for doubtful accounts                                              |       | (50                              | )          | (12 | ) |
| Stock based compensation                                                     |       | 123                              |       | 441 |   |
| Changes in operating  assets and liabilities:                                |       |                             |       |   |   |
| Accounts receivable                                                          |       | 784                              |       | (389 | ) |
| Inventories                                                                  |       | 63                               |       | 164 |   |
| Other assets                                                                 |       | 125                              |       | (7 | ) |
| Accounts payable and accrued expenses                                        |       | (410                             | )          | (27 | ) |
| Deferred revenue                                                             |       | (55                              | )          | (160 | ) |
| Net cash used in operating  activities                                       |       | (1,759                           | )          | (2,917 | ) |
| Investing Activities:                                                        |       |                             |       |   |   |
| Maturities of short-term investments                                         |       | —                           |       | 500 |   |
| Purchases of property and equipment                                          |       | (39                              | )          | (3 | ) |
| Net cash provided by (used  in) investing activities                         |       | (39                              | )          | 497 |   |
| Financing Activities:                                                        |       |                             |       |   |   |
| Proceeds from (payments on) line of credit                                   |       | (100                             | )          | 200 |   |
| Proceeds from exercise of employee stock options                             |       | —                           |       | 1 |   |
| Proceeds from issuance of common stock, net                                  |       | 1,500                            |       | 500 |   |
| Dividends paid on preferred stock                                            |       | (173                             | )          | (192 | ) |
| Net cash provided by  financing activities                                   |       | 1,227                            |       | 509 |   |
| Net (decrease) in cash and  cash equivalents                                 |       | (571                             | )          | (1,911 | ) |
| Cash and cash equivalents  at beginning of year                              |       | 933                              |       | 2,844 |   |
| Cash and cash equivalents  at end of year                                    |       | $                                | 362        |   | $ | 933 |   |
|                                                                         |       |                             |       |   |   |
| SUPPLEMENTAL CASHFLOW  INFORMATION:                                          |       |                             |       |   |   |
| Interest paid                                                                |       | $                                | 11         |   | $ | 1 |   |
| Income taxes paid                                                            |       | $                                | —     |   | $ | — |   |
|                                                                         |       |                             |       |   |   |
| SUPPLEMENTAL DISCLOSURE OF  NON CASH FINANCING ACTIVITIES:                   |       |                             |       |   |   |
| Preferred stock dividends  accrued                                           |       | $                                | 173        |   | $ | 176 |   |

 

See accompanying notes.

 

 

F-5

----

 

**INTRUSION INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

We develop, market and support a family of entityidentification, regulated information compliance, data privacy protection andnetwork intrusion prevention/detection products.  Our product families include:  TraceCop for identity identification,Compliance Commander for regulated information and data privacy protection, andIntrusion SecureNet for network intrusion prevention and detection.  Intrusion’s products help protect criticalinformation assets by quickly detecting, protecting, analyzing and reportingattacks or misuse of classified, private and regulated information forgovernment and enterprise networks.

 

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

 

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

 

Ourprincipal executive offices are located at 1101 East Arapaho Road, Suite 200,Richardson, Texas 75081, and our telephone number is (972) 234-6400.  Our website URL is www.intrusion.com.

 

References to “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM and TraceCopTM areregistered trademarks of Intrusion Inc.

 

As of December 31, 2007, we had cash, cashequivalents and investments of approximately $0.4 million, down fromapproximately $0.9 million as of December 31, 2006.  We expect our net operating losses andoperating cash outflows to continue through at least the first quarter of 2008and possibly throughout the remainder of fiscal year 2008.  In addition, we are obligated to makepayments of accrued dividends on all our outstanding shares of preferred stockthat will reduce our available cash resources  As of February 29, 2008 we had cash and cash equivalents of $40,000and $6,000 available funding under our line of credit at Silicon Valley Bankand $220,000 available from our promissory note to borrow up to $700,000 from G.Ward Paxton, the Company’s Chairman, President and Chief ExecutiveOfficer.  We expect to fund ouroperations through additional amounts of private equity and debt, which, if weare able to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Specifically, we have a March 20,2008 written commitment from our Chief Executive Officer to invest up to anadditional $1,500,000 in the Company until March 2009, should such fundingbe required by the Company, on terms and conditions yet to be determined.  Any equity or debtfinancings, if available at all, may be on terms which are not favorable to usand, in the case of equity financings, may result in dilution to ourstockholders. If our operations do not generate positive cash flow in the nextfew months, or if we are not able to obtain additional debt or equity financingon terms and conditions acceptable to us, if at all, we may be unable toimplement our business plan, fund our liquidity needs or even continue ouroperations.

 

**2. Summary of Significant Accounting Policies**

 

***Principles ofConsolidation***

 

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

 

***Cash and CashEquivalents***

 

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

 

 

F-6

----

 

***Short-termInvestments***

 

Short-terminvestments consist of U.S. government obligations and corporate securitieswith maturities between 90 days and one year as of the balance sheet date.Short-term investments are classified as available for sale.  These investments are valued at market value,which approximates amortized cost. Realized gains and losses from the sale of short-term investments areincluded in other income, net and are derived using the specific identificationmethod for determining the cost of securities.

 

***RiskConcentration***

 

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

 

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

 

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

 

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

 

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

 

***Inventories***

 

Inventoriesare stated at the lower of cost or market. We value our inventories usingaverage cost, which approximates actual cost on a first-in, first-out basis.Our management estimates the allowance required to state inventory at the lowerof cost or market. There is a risk that we will forecast demand for ourproducts 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.

 

***Property andEquipment***

 

Equipmentis stated at cost less accumulated depreciation and is depreciated on astraight-line basis over the estimated useful lives of the assets.  Such lives vary from 1 to 3 years.  Furniture and fixtures are stated at costless accumulated depreciation and are depreciated on a straight-line basis overthe estimated useful lives of the assets. Such lives vary from 1 to 5 years. Leasehold improvements are stated at cost less accumulated amortizationand are amortized on a straight-line basis over the shorter of estimated usefullives of the assets or the remaining terms of the leases.   Such lives vary from 2 to 5 years.  Expenditures for major renewals andbetterments that extend the useful lives of property and equipment arecapitalized.  Repair and maintenancecosts are expensed as incurred. Depreciation and amortization expense totaledapproximately $56,000 and $97,000 for the years ended December 31, 2007and 2006, respectively.

 

F-7

----

 

***Long-Lived Assets***

 

Wefollow the guidance in SFAS 144 “Accounting for the Impairment or Disposal ofLong-Lived Assets” and review long-lived assets, including property andequipment for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.  Recoverability of assets to be held and usedis measured by a comparison of the carrying amount of an asset to futureundiscounted cash flows to be generated by the asset.  If the carrying value exceeds the future undiscountedcash flows, the assets are written down to fair value using discounted cashflows.  As of December 31, 2007 and2006, there was no impairment of long-lived assets.

 

***Foreign CurrencyTranslation***

 

Ourinternational subsidiaries use the United States dollar as their functionalcurrency.  Although, our internationaloffices pay operating expenses in their local currency, they are fully fundedby us in United States dollars, and we exchange the United States dollarslocally to settle operating expenses incurred. As outlined in SFAS 52, assets and liabilities are translated at theexchange rate in effect at the balance sheet date, and income and expenseaccounts at average exchange rates during the month.  We recorded approximately $6,000 as a creditto operating expenses in 2007 and $1,000 in operating expenses in 2006, whichrepresents the total accumulated foreign currency translation adjustmentsrelated to foreign offices.

 

***Accounting forStock Options***

 

Weaccount for stock options using the guidance in SFAS 123 (revised 2004), “Share-BasedPayment” (SFAS 123(R)), which replaces SFAS 123 and supersedes APB Opinion No. 25.  SFAS 123(R) requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values.

 

Weadopted SFAS 123(R) on January 1, 2006 using the modified prospectiveapplication method described in the statement. Stock-based compensation expense recognized in theconsolidated statement of operations during 2007 and 2006 included compensationexpense for stock-based payment awards granted prior to, but not yet vested, asof December 31, 2005 based on the grant date fair value estimated inaccordance with the pro forma provisions of SFAS 148. Stock-based compensationexpense recognized in the statement of operations for the years ended 2007 and2006 is based on awards ultimately expected to vest, reduced by estimatedforfeitures.  SFAS 123(R) requiresforfeitures to be estimated at the time of grant and revised, if necessary, insubsequent periods if actual forfeitures differ from those estimates.

 

F-8

----

 

***Valuation Assumptions***

 

Thefair values of option awards were estimated at the date of grant using a Black-Scholesoption-pricing model with the following assumptions for fiscal years ending December 31,2007 and 2006, respectively:

 
| ** **                              | ** ** | **2007** | ** ** | **2006** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |
| Weighted average grant  date fair value |       | $        | 0.32       |     | $          | 0.32 |   |
| Weighted average  assumptions used:     |       |     |       |     |       |
| Expected dividend yield                 |       | 0.0      | %          | 0.0      | %          |
| Risk-free interest rate                 |       | 4.9      | %          | 4.4      | %          |
| Expected volatility                     |       | 105.1    | %          | 106.0    | %          |
| Expected life (in years)                |       | 4.9      |       | 5.0      |       |
|                                         |            |          |            |          |            |  |  |

 

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becauseour employee stock options have characteristics significantly different fromthose of traded options, and because changes in the subjective inputassumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

 

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

 

***Net Loss PerShare***

 

Wereport two separate earnings per share (“EPS”) numbers, basic EPS and dilutedEPS.  Basic net loss attributable tocommon stockholders per share is computed by dividing net loss attributable tocommon stockholders for the year by the weighted average number of commonshares outstanding for the year.  Dilutednet loss attributable to common stockholders per share is computed by dividingthe net loss attributable to common stockholders for the year by the weightedaverage number of common shares and common stock equivalents outstanding forthe year.  Our common stock equivalents include all common stockissuable upon conversion of convertible preferred stock and the exercise ofoutstanding options and warrants.  Theaggregate number of common stock equivalents excluded from the loss per sharecalculation at December 31, 2007 and 2006 totaled 3,892,293, and3,951,223, respectively.  Common stockequivalents are not included in the diluted loss per share for the years ended December 31,2007 and 2006, as they are anti-dilutive as a result of incurring net lossesduring these years.

 

***RevenueRecognition***

 

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

 

Werecognize software revenue from the licensing of our software products inaccordance with Statement of Position (“SOP”) No. 97-2 “Software RevenueRecognition”, SOP 98-9 “Modification of 97-2, Software Revenue Recognition,with respect to certain transactions” and Staff Accounting Bulletin (“SAB”) No. 104,“Revenue Recognition” 

 

F-9

----

 

wherebyrevenue from the licensing of our products is not recognized until all four ofthe following have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectability is probable. Bundled hardware andsoftware product revenue is recognized at time of delivery, as our licenses arenot sold on a subscription basis.  In thecase of product sales, which include maintenance and customer support, a VendorSpecific Objective Evidence analysis would be performed to appropriatelydetermine the amount of revenue derived from each deliverable.  All of our product offering and serviceoffering market values are readily determined based on current and priorstand-alone sales.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

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

 

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

 

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

 

***Research andDevelopment Costs***

 

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

 

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

 

***Use of Estimates***

 

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

 

***Income Taxes***

 

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

 

We adopted the provisionsof FASB Interpretation No. 48 (FIN 48), *Accountingfor Uncertainty in Income Taxes*, on January 1, 2007.  FIN 48 provides that a tax benefit from anuncertain tax position may be recognized when it is more likely than not thatthe position will be sustained upon examination, including resolutions of anyrelated appeals or litigation processes, based on the technical merits of theposition.  This interpretation also providesguidance on measurement, derecognition, classification, interest and penalties,accounting in interim periods, disclosure and transition.  The adoption of FIN 48 had no impact on ourconsolidated financial statements.

 

F-10

----

*** ***

***Recent Accounting Pronouncements***

 

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

 

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

 

Thepartial adoption of SFAS 157 on January 1, 2008 with respect tofinancial assets and financial liabilities recognized or disclosed at fairvalue in the financial statements on a recurring basis is not expected to havea material impact on our consolidated financial statements. We are in theprocess of analyzing the potential impact of SFAS 157 relating to ourplanned December 31, 2008 adoption of the remainder of the standard.

 

InFebruary 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and FinancialLiabilities—Including an amendment of FASB Statement No. 115* (“SFAS 159”).SFAS 159 permits entities to elect to measure many financial instrumentsand certain other items at fair value. Unrealized gains and losses on items forwhich the fair value option has been elected will be recognized in earnings ateach subsequent reporting date. SFAS 159 is effective for fiscal yearsbeginning after November 15, 2007. We are currently assessing the impactof SFAS 159 on our consolidated financial statements.

 

InDecember 2007, the FASB issued SFAS No. 160, *Non-Controlling Interests in Consolidated Financial Statements anamendment of ARB No. 51* (“SFAS 160”). SFAS 160establishes new standards for the accounting for and reporting ofnon-controlling interests (formerly minority interests) and for the loss ofcontrol of partially owned and consolidated subsidiaries. SFAS 160 doesnot change the criteria for consolidating a partially owned entity.SFAS 160 is effective for fiscal years beginning after December 15,2008. We do not expect the adoption of SFAS 160 will have a materialimpact on our consolidated financial statements.

 

InDecember 2007, the FASB issued SFAS No. 141(revised 2007) (“SFAS 141R”),a revision of SFAS 141, *Business Combinations*.   SFAS 141R establishes requirements forthe recognition and measurement of acquired assets, liabilities, goodwill, andnon-controlling interests. SFAS 141R also provides disclosure requirementsrelated to business combinations. SFAS 141R is effective for fiscal yearsbeginning after December 15, 2008. SFAS 141R will be applied prospectivelyto business combinations with an acquisition date on or after the effectivedate.

 

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

 

**Inventories**

 
| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Finished products               |       | $                     | 185        |   | $ | 180 |   |
| Work in process                 |       | 8                     |       | 8 |   |
| Demonstration systems           |       | 15                    |       | 21 |   |
| Reserve for obsolete  inventory |       | (62                   | )          | — |   |
|                            |       | $                     | 146        |   | $ | 209 |   |

 

**Other Accrued Expenses**

 
| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Accrued sales commissions |       | $                     | 7          |   | $ | 10 |   |
| Accrued payroll           |       | 101                   |       | 115 |   |
| Accrued property taxes    |       | 30                    |       | 26 |   |
| Accrued sales taxes       |       | 35                    |       | 34 |   |
| Other                     |       | 42                    |       | 98 |   |
|                      |       | $                     | 215        |   | $ | 283 |   |

 

 

F-11

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** **

**4. Commitments and Contingencies**

 

***Leases***

 

Welease office space for our corporate headquarters in Richardson, Texas under anoperating lease, the base term of which expires in February 2010.  We lease office space in San Diego,California for a portion of our security software research and developmentstaff under an operating lease that expires in March 2009.

 

  The Company’s lease for the headquartersfacility contains escalation provisions. In accordance with SFAS 13 “Accounting for Leases,” FASB TechnicalBulletin 88-1 “Issues Relating to Accounting for Leases,” and FASB TechnicalBulletin 85-3 “Accounting for Operational Leases with Scheduled Rent Increases,”the Company records rent expense on facility leases on a straight-linebasis.  Real estate taxes, insurance andmaintenance expenses are the obligations of the Company.  Rent expense totaled approximately $435,000and $486,000 for the years ended December 31, 2007 and 2006, respectively.

 

Futureminimum lease payments consisted of the following on December 31, 2007 (inthousands):

 
| 2008   |   | $   | 393    |   |
|--------|--------|-----|--------|--------|
| 2009   |   | 409 |   |
| 2010   |   | 68  |   |
|   |   | $   | 870    |   |

 

***Legal Proceedings***

 

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

 

Weare not aware of any material claims outstanding or pending against IntrusionInc. at December 31, 2007.

 

**5. Employee Benefit Plans**

*** ***

***Employee StockPurchase Plan***

 

OnApril 24, 1997, we adopted an Employee Stock Purchase Plan (the “PurchasePlan”) under which 125,000 shares of common stock were reserved for issuance.On April 24, 2007, the Purchase Plan was terminated pursuant to its 10year term. No shares were purchased under the Purchase Plan in the years ended December 31,2007 and December 31, 2006.  A totalof 45,702 shares were issued under the Purchase Plan since inception.  No shares are available for purchase underthe Purchase Plan as of December 31, 2007 due to the termination.

 

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

 

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

 

Employeesmay contribute from 1% to 25% of their annual compensation to the Plan, limitedto a maximum amount as set by the Internal Revenue Service.  Participants who are over the age of 50 maycontribute an additional amount of their salary per year, as defined annuallyby the Internal Revenue Service.  We matchemployee contributions at the rate of $0.25

 

 

F-12

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pereach $1.00 of contribution on the first 4% of compensation.  Matching contributions to the Plan wereapproximately $23,000 for both years ended December 31, 2007 and 2006.

 

**6. Line of Credit**

 

**               **On March 29,2006, we established a $1,000,000 line of credit with Silicon Valley Bank whichmay increase to $2,000,000 if we have EBITDA of at least $200,000 for twoconsecutive quarters.  Under the terms ofthis agreement, we may borrow an amount equal up to 80% of eligible accountsreceivable balances.  In addition, we mayobtain inventory advances equal to 35% of finished goods inventory, capped atthe lesser of the inventory availability, $300,000 or 35% of our totalborrowing base.  The line includes aliquidity coverage ratio of unrestricted cash on deposit with Silicon ValleyBank plus the amount equal to 80% of our eligible accounts receivable to theamount of the obligations of not less than 1.25:1.00. We have $100,000outstanding under this credit line at December 31, 2007.  Also, we had no additional borrowing capacityunder our credit line at December 31, 2007.  Amounts we borrow under the credit lineaccrue interest at an annual rate of prime plus 1% and are secured by a lien onall of our assets.  As described in Note12, the line of credit was extended on March 28, 2008, until June 28,2008.  Accrued interest on alloutstanding amounts is payable monthly in arrears and all outstanding principaland accrued but unpaid interest on the amounts we borrow are due on June 28,2008.   At or before June 28, 2008,it is anticipated that we will put a new credit facility in place with SiliconValley Bank.

 

**7. Income Taxes**

 

Deferredincome taxes reflect the net tax effects of temporary differences between thecarrying amounts of assets and liabilities for financial reporting purposes andthe amounts used for income tax purposes. There are no deferred tax liabilitiesas of December 31, 2007 and 2006. Significant components of our deferred tax assets as of December 31,2007 and 2006 are as follows (in thousands):

 
| ** **                                                | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **2007**             | ** ** | **2006** | ** ** |
| ** **                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net operating loss  carryforwards                         |       | $                    | 29,122     |   | $ | 30,462 |   |
| Net operating loss  carryforwards of foreign subsidiaries |       | 374                  |       | 374 |   |
| Book over tax depreciation                                |       | 88                   |       | 94 |   |
| Intangibles                                               |       | 759                  |       | 939 |   |
| Stock-based compensation  expense                         |       | 207                  |       | 162 |   |
| Vacation accrual                                          |       | 70                   |       | 78 |   |
| Allowance for doubtful  accounts and returns              |       | 7                    |       | 24 |   |
| Warranty accrual                                          |       | 7                    |       | 18 |   |
| Inventory allowance                                       |       | 82                   |       | 69 |   |
| Foreign tax credit                                        |       | 1,083                |       | 1,083 |   |
| Other                                                     |       | 3                    |       | 470 |   |
| Deferred tax assets                                       |       | 31,802               |       | 33,773 |   |
| Valuation allowance for deferred tax assets               |       | (31,802              | )          | (33,773 | ) |
| Deferred tax assets, net of allowance                     |       | $                    | —     |   | $ | — |   |

 

Deferredtax assets are required to be reduced by a valuation allowance if it is morelikely than not that some portion or all of the deferred tax assets will not berealized.  Realization of the futurebenefits related to the deferred tax assets is dependent on many factors,including the Company’s ability to generate taxable income within the near tomedium term.  Management has consideredthese factors in determining the valuation allowance for 2007 and 2006.

 

 

F-13

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Thedifferences between the provision for income taxes and income taxes computedusing the federal statutory rate for the years ended December 31, 2007 and2006 are as follows (in thousands):

 
| ** **                                               | ** ** | **2007** | ** ** | **2006** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Reconciliation of income  tax benefit to statutory rate: |       |     |       |     |       |
| Income tax benefit at statutory rate                     |       | $        | (814       | )        | $          | (1,028 | ) |
| State income taxes, net of federal income tax benefit    |       | (63      | )          | (80      | )          |
| Expiration of state net operating loss carryforwards     |       | 2,841    |       | —   |       |
| Change in valuation allowance                            |       | (1,971   | )          | 1,060    |       |
| Other                                                    |       | 7        |       | 48       |       |
|                                                     |       | $        | —     |     | $          | — |   |

 

AtDecember 31, 2007, we had federal net operating loss carryforwards of approximately$85.9 million for income tax purposes that begin to expire in 2008 and aresubject to the ownership change limitations under Internal Revenue Code Section 382.We also had approximately $10.5 million of state net operating losscarryforwards that begin to expire to in 2017. Net operating loss carryforwards of the foreign subsidiaries of approximately$1.0 million at December 31, 2007 are available indefinitely for offsetonly against taxable income generated by the foreign subsidiaries.

 

**8. Stock Options**

 

AtDecember 31, 2007, we had three stock-based compensation plans, which aredescribed below. These plans were developed to retain and attract key employeesand directors.

 

In1995, we adopted our 1995 Stock Option Plan (the “1995 Plan”), which providesfor the issuance of up to 400,000 shares of common stock upon exercise ofoptions granted pursuant to the 1995 Plan. On April 26, 2001, ourstockholders increased the overall number of shares available for issuancepursuant to the plan to 825,000 shares of common stock. The 1995 Plan providesfor the issuance of both non-qualified and incentive stock options to ouremployees, officers, and employee-directors. The 1995 Plan expired by its termson March 21, 2005 and no options were available for future issuance afterthe expiration.  At December 31,2007, 67,365 employee options have been exercised and employee options topurchase a total of 277,380 shares of common stock are outstanding.  A total of 2,290,295 options have beengranted pursuant to the 1995 Plan, of which, 1,945,550 have been cancelled.

 

                In 1995, we adopted the 1995 Non-EmployeeDirector Stock Option Plan (the “1995 Non-Employee Director Plan”).  The 1995 Non-Employee Director Plan providedfor the issuance of non-qualified stock options to non-employee directors. The1995 Non-Employee Director Plan was amended in April 2002 to increase thenumber of shares available for issuance to 65,000 from 40,000 shares. The1995 Non-Employee Director Plan expired by its terms on March 21, 2005 andno options were available for future issuance after the expiration.  No options have been exercised under the 1995Non-Employee Director Plan.  Non-employeeoptions to purchase a total of 32,500 shares of common stock areoutstanding at December 31, 2007. A total of 62,500 options have beengranted to directors pursuant to the 1995 Non-Employee Director Plan, of which,30,000 have been cancelled.

 

                On March 17, 2005, theBoard approved the 2005 Stock Incentive Plan (the “2005 Plan”), which wasapproved by the stockholders on June 14, 2005.  The 2005 Plan serves as a replacement for the1995 Non-Employee Director Plan and the 1995 Option Plan which expired by theirterms on March 21, 2005.  Theapproval of the 2005 Plan had no effect on the 1995 Plans or any optionsgranted pursuant to either plan.  Alloptions will continue with their existing terms and will be subject to the 1995Non-Employee Director Plan or the 1995 Plan, as applicable.  Further, the Company will not be able tore-issue any option which is cancelled or terminated under the 1995Non-Employee Director Plan or the 1995 Option Plan.  The 2005 Plan provided for the issuance of upto 750,000 shares of common stock upon exercise of options granted pursuant tothe 2005 Plan.  On May 30, 2007, theStockholders approved an Amendment to the 2005 Plan that increased this amountby 750,000 for a total of 1,500,000 shares of common stock that may be issuedupon the exercise of options granted pursuant to the 2005 Plan.

 

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

 

F-14

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Board.  Each non-employee Board member will receivean option grant for 10,000 shares of Common Stock upon initial election orappointment to the Board, provided that individual has not previously beenemployed by the Company in the preceding six (6) months.  In addition, on the date of each annual stockholdersmeeting, each Board member will automatically be granted an option to purchase5,000 shares of Common Stock, provided he or she has served as a non-employeeBoard member for at least six (6) months. At December 31, 2007, no 2005 Plan options have been exercised andemployee and non-employee Board member options to purchase a total of831,500 shares of common stock are outstanding.  A total of 1,072,500 options have beengranted under the 2005 Plan, of which 241,000 have been cancelled and optionsfor 668,500 shares remain available for future grant.  No shares have been issued pursuant to theStock Issuance Program.

 

Commonshares reserved for future issuance, including conversions of preferred stock,warrants, outstanding options and options available for future grant under allof the stock option plans and employee stock purchase plans total approximately4,560,793 million shares at December 31, 2007 as follows, inthousands:

 
| **(In thousands)**               | ** ** | **Outstanding** | ** ** | **Available for  Future Grant** | ** ** |
|----------------------------------|------------|-----------------|------------|---------------------------------|------------|
|                             |       |            |       |                            |       |
| Preferred Stock                  |       | 1,227           |       | —                          |       |
| Warrants                         |       | 1,524           |       | —                          |       |
| 1995 Plan                        |       | 277             |       | —                          |       |
| 1995 Non-Employee Director  Plan |       | 32              |       | —                          |       |
| 2005 Plan                        |       | 832             |       | 669                             |       |
| Total                            |       | 3,892           |       | 669                             |       |

 

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

 

***Stock Incentive Plan Summary***

 

Asummary of our stock option activity and related information for the yearsended December 31, 2007 and 2006 is as follows:

 
| ** **                          | ** ** | **2007**                               | ** ** | **2006**                               | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | ** **                             | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at beginning  of year   |       | 1,086                                  |       | $                                      | 3.23       |   | 891 |   | $ | 5.48 |   |
| Granted at price = market  value    |       | 246                                    |       | .41                                    |       | 367 |   | .44 |   |
| Granted at price >  market value |       | 100                                    |       | .44                                    |       | 60 |   | .33 |   |
| Exercised                           |       | —                                 |       | —                                 |       | (1 | ) | .76 |   |
| Forfeited                           |       | (137                                   | )          | .69                                    |       | (69 | ) | 2.75 |   |
| Expired                             |       | (153                                   | )          | 6.12                                   |       | (162 | ) | 8.42 |   |
|                                |       |                                   |       |                                   |       |   |   |   |   |
| Outstanding at end of year          |       | 1,141                                  |       | $                                      | 2.30       |   | 1,086 |   | $ | 3.23 |   |
| Options exercisable at end  of year |       | 575                                    |       | $                                      | 3.99       |   | 554 |   | $ | 5.47 |   |

 

F-15

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***Stock Options Outstanding and Exercisable***

 

Informationrelated to stock options outstanding at December 31, 2007, is summarizedbelow:

 
| ** **                   | ** ** | **Options Outstanding**                      | ** ** | **Options Exercisable**                             | ** ** |
|------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------------|------------|
| **Range of Exercise Prices** | ** ** | **Outstanding at  12/31/07 (in  thousands)** | ** ** | **Weighted  Average  Remaining   Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable at  12/31/07 (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| $ 0.30-$1.00            |       | 626                                          |       | 7.79  years                                         |       | $ | 0.37 |   | 117 |   | $ | .34 |   |
| $ 1.01-$5.00            |       | 473                                          |       | 6.71  years                                         |       | $ | 2.76 |   | 416 |   | $ | 2.80 |   |
| $ 5.01-$10.00           |       | 20                                           |       | 3.33  years                                         |       | $ | 6.14 |   | 20 |   | $ | 6.14 |   |
| $ 10.01-$20.00          |       | 8                                            |       | 2.43  years                                         |       | $ | 19.03 |   | 8 |   | $ | 19.03 |   |
| $ 20.01-$63.00          |       | 14                                           |       | 2.20  years                                         |       | $ | 57.79 |   | 14 |   | $ | 57.79 |   |
|                         |       | 1,141                                        |       | 7.16  years                                         |       | $ | 2.30 |   | 575 |   | $ | 3.99 |   |

 

Summarizedinformation about outstanding stock options as of December 31, 2007, thatare fully vested and those that are expected to vest in the future as well asstock options that are fully vested and currently exercisable, are as follows:

 
| ** **                                   | ** ** | **Outstanding Stock**

**Options (Fully Vested**

**and Expected to Vest)*** | ** ** | **Options that are Exercisable** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| **As of December 31, 2007**             | ** ** | ** **                                                                   | ** ** | ** **                       | ** ** |
| Number of outstanding  options               |       | 946                                                                          |       | 575                              |       |
| Weighted average remaining  contractual life |       | 7.03                                                                         |       | 6.57                             |       |
| Weighted average exercise  price per share   |       | $                                                                            | 2.66       |                             | $          | 3.99 |   |
| Intrinsic value                              |       | $                                                                            | 0          |                             | $          | 0 |   |

----

*  Includes effects of expectedforfeitures 

 

                The exercisable options detailedin the table above have a $0 intrinsic value as the fair market value on December 31,2007 is less than the exercise prices of all of the exercisable options. As of December 31,2007, the total unrecognized compensation cost related to non-vested optionsnot yet recognized in the statement of operations totaled approximately $76thousand (including expected forfeitures) and the weighted period over whichthese awards are expected to vest was 1.27 years.

 

**9. Preferred Stock**

 

***Series 1 5% Preferred Stock***

 

                On March 25, 2004, wecompleted a $5.0 million private placement of our 5% convertible preferredstock and warrants.  In the privateplacement, we sold 1,000,000 shares of our 5% preferred stock at a price of$5.00 per share for gross proceeds of $5.0 million, less $275,000 of issuancecosts.  The 5% preferred shares wereinitially convertible into 1,590,331 shares of common stock at a conversionprice of $3.144 per share.  Holders of the 5% convertible preferred stockinclude 140,000 shares purchased by our CEO and 60,000 shares purchased by adirector of the Company.

 

The5% dividends related to the 5% preferred stock are paid semi-annually on thelast business day in March and September of each year, beginning withSeptember 2004.  Preferredstockholders vote together with common stockholders on an as converted tocommon stock basis.  Based on theconversion rate of the preferred stock, holders of our 5% preferred stock willreceive 1.5903 votes per share rounded to the nearest whole number.  The liquidation preference for the 5%preferred stock is an amount equal to $5.00 per share plus any accrued andunpaid dividends.  Holders of our 5%preferred stock have liquidation preference rights over common stockholders.

 

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

 

F-16

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$0.9million.  In accordance with EITF 98-5, the beneficial conversion feature wasfully amortized in the first quarter of 2004, as the preferred stock does nothave a stated maturity and is immediately convertible into common stock.

 

The5% preferred stock was recorded as the financing proceeds of $5.0 million less$275,000 issuance costs and the fair value of the warrants issued inconjunction with the 5% preferred stock of $1.2 million.

 

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

 

During2005, 580,304 shares of our 5% preferred stock were converted into 922,875 sharesof our common stock.  There were noconversions of our 5% preferred stock during 2006 and 2007.  At December 31, 2007 there are 259,696shares of our 5% preferred stock outstanding.

 

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

 

                On March 28, 2005, we completed a $2.7 million private placement ofSeries 2 5% convertible preferred stock and warrants.  In the private placement, we sold 1,065,200shares of preferred stock at a price of $2.50 per share for gross proceeds of$2.7 million, less $173,000 of issuance costs. The shares of Series 2 5% preferred stock are convertible into1,065,200 shares of common stock at an initial conversion price of $2.50 pershare.  Holders of the Series 2 5%preferred stock include 160,000 shares purchased by our CEO and 60,000 sharespurchased by a director of the Company.

 

                The5% dividends accruing on the Series 2 5% preferred stock are required tobe paid quarterly on the first business day in March, June, September and December ofeach year, beginning with June 2005. The liquidation preference for the preferred stock is an amount equal to$2.50 per share plus any accrued and unpaid dividends.  Holders of our Series 2 5% preferredstock have liquidation preference rights over our 5% preferred stock holders aswell as our common stockholders.  Theholders of the Series 2 5% preferred stock are not entitled to vote on anymatter, except as otherwise required by law or with respect to certain limitedmatters specified in the Certificate of Designations creating the Series 25% preferred stock.

 

                Includedin this transaction were warrants to purchase 532,600 shares of common stock atan exercise price of $2.77 per share. Warrant holders include 80,000 held by our CEO and 30,000 held by adirector of the Company.  The relativefair value of these warrants was valued at $0.7 million using the Black-Scholesmodel and has been recorded as a discount to the Series 2 5% preferredstock and an increase in additional paid-in capital.  The issuance of these warrants also resultedin a beneficial conversion feature to the Series 2 5% preferred stockvalued at $0.9 million.  In accordancewith EITF 98-5, the beneficial conversion feature was fully amortized in thefirst quarter of 2005, as the preferred stock does not have a stated maturity andis immediately convertible into common stock. In connection with the closing of this private placement, we issuedwarrants to purchase 60,390 shares of our common stock at an exercise price of$2.77 per share to two affiliates of our financial advisor for assistance withthe private placement.  These warrantswere valued at $0.1 million using the Black-Scholes model and have beenrecorded as a reduction to the Series 2 5% preferred stock and an increaseto additional paid-in capital.

 

                The Series 25% preferred stock was recorded as the net of the proceeds of $2.7 million less$173,000 issuance costs and the fair value of the warrants issued inconjunction with the Series 2 5% preferred stock totaling $0.8 million.

 

                Holders of Series 2 5%preferred stock have the right to require us to redeem any or all of the theirshares upon the occurrence of certain events within the Company’s control thatare defined in Certificate of Designation at a price equal the sum of (1) thegreater of $3.25****and the productof the volume weighted average price of our common stock on the trading dayimmediately preceding the event multiplied by $2.50 divided by the conversionprice then in effect plus (2) any accrued but unpaid dividends on the Series 25% preferred stock plus (3) all liquidated damages or other amountspayable to the holders of Series 2 5% preferred stock.

 

During2005, 565,200 shares of Series 2 5% preferred stock were converted into565,200 shares of our common stock. During 2006, 40,000 shares of Series 2 5% preferred stock wereconverted into 40,000 shares of our common stock.  During 2007, no shares of Series 2 5%preferred stock were converted into shares of our common stock. At December 31,2007 there are 460,000 shares of Series 2 5% preferred stock outstanding.

 

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

 

                On December 2, 2005, we completed a $1.2 million private placementof Series 3 5% convertible preferred stock and warrants.  In the private placement, we sold 564,607shares of preferred stock at a price of $2.18 per share for gross proceeds of$1.2 million, less $100,000 of issuance costs. The shares of Series 3 5% preferred stock are convertible into564,607 shares of 

 

F-17

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common stock at an initial conversion price of $2.18 pershare.  Holders of the Series 3 5%preferred stock include 55,046 shares purchased by our CEO and 27,523 sharespurchased by a director of the Company.

 

                The5% dividends accruing on the Series 3 5% preferred stock are required tobe paid quarterly on the first business day in March, June, September and December ofeach year, beginning with March 1, 2006. The liquidation preference for the preferred stock is an amount equal to$2.18 per share plus any accrued and unpaid dividends.  Holders of our Series 3 5% preferredstock have liquidation preference rights over holders of our 5% preferred, Series 25% preferred stock and common stock.  Theholders of the Series 3 5% preferred stock are not entitled to vote on anymatter, except as otherwise required by law or with respect to certain limitedmatters specified in the Certificate of Designations creating the Series 35% preferred stock.

 

                Includedin this transaction were warrants to purchase 282,306 shares of common stock atan exercise price of $0.40(repriced on December 28, 2006 from aninitial exercise price of $2.58) pershare.  Warrant holders include 27,523held by our CEO and 13,762 held by a director of the Company.  The relative fair value of these warrants wasvalued at $0.3 million using the Black-Scholes model and has been recorded as adiscount to the Series 3 5% preferred stock and an increase in additionalpaid-in capital.  The issuance of thesewarrants also resulted in a beneficial conversion feature to the Series 35% preferred stock valued at $0.5 million. In accordance with EITF 98-5, the beneficial conversion feature wasfully amortized on the grant date, as the preferred stock does not have astated maturity and is immediately convertible into common stock.  In connection with the closing of thisprivate placement, we issued warrants to purchase 27,531 shares of our commonstock at an exercise price of $2.58 per share to an affiliate of our financialadvisor for assistance with the private placement.  These warrants were valued at $37,000 usingthe Black-Scholes model and have been recorded as a reduction to the Series 35% preferred stock and an increase to additional paid-in capital.

 

                The Series 35% preferred stock was recorded as the net of the proceeds of $1.2 million less$100,000 issuance costs and the fair value of the warrants issued inconjunction with the Series 3 5% preferred stock totaling $0.3 million.

 

                Holders of Series 3 5%preferred stock have the right to require us to redeem any or all of the theirshares upon the occurrence of certain events within the Company’s control thatare defined in Certificate of Designation at a price equal the sum of (1) thegreater of $2.834****and the productof the volume weighted average price of our common stock on the trading dayimmediately preceding the event multiplied by $2.18 divided by the conversionprice then in effect plus (2) any accrued but unpaid dividends on the Series 35% preferred stock plus (3) all liquidated damages or other amountspayable to the holders of Series 3 5% preferred stock.

 

During2006, 95,872 shares of Series 3 5% preferred stock were converted into95,872 shares of our common stock. During 2007, 114,679 shares of Series 3 5% preferred stock wereconverted into 114,679 shares of our common stock.  At December 31, 2007 there are 354,056shares of Series 3 5% preferred stock outstanding.

 

**10. Common Stock Private Placement**

 

On December 28, 2006, we completed a privateplacement of 1,250,000 shares of our Common Stock for gross proceeds of$500,000.  G. Ward Paxton, our Chairman, President and ChiefExecutive Officer purchased 1,000,000 shares for a total of $400,000.  Michael L. Paxton, our Vice President andChief Financial Officer purchased 250,000 shares for a total of $100,000.

 

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

 

                On June 27, 2007, we completed aprivate placement of 1,111,111 shares of our Common Stock for gross proceeds of$500,000.  G. Ward Paxton, our Chairman,President and Chief Executive Officer purchased 1,000,000 shares for a total of$450,000.  Michael L. Paxton, our VicePresident and Chief Financial Officer purchased 111,111 shares for a total of$50,000.

 

                On September 26, 2007, wecompleted a private placement of 1,190,476 shares of our Common Stock for grossproceeds of $500,000 with G. Ward Paxton, our Chairman, President and ChiefExecutive Officer.

 

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

 

Ouroperations are concentrated in one area—security software and appliances.  Sales to the U.S. Government through directand indirect channels totaled 73.2% of total revenues for 2007 and 73.6% oftotal revenues for 2006.  During 2007approximately 66.5% of total revenues are attributable to two governmentcustomers.  During 2006 approximately65.6% of total revenues are attributable to three government customers.  There were no individual commercial customersin 2007 or 2006 that exceeded 10% of total revenues for that year.  Our similar product and service offerings arenot viewed as individual segments, as our management analyzes the business as awhole and expenses are not allocated to each product offering.

 

Exportsales (based on our customers location), primarily to Europe, Asia and Canada,were $0.3 million in 2007 and $0.5 million in 2006. No significantlong-lived assets are deployed outside of the United States.  Our foreign operations act only as salessupport offices in those regions.

 

**12. Subsequent Events**

 

**               **On March 20,2008, we received a writtencommitment from our Chief Executive Officer to invest up to an additional$1,500,000 in the Company until March 2009, should such funding berequired by the Company, on terms and conditions yet to be determined.

 

# *                On March 28, 2008, weextended our existing $1,000,000 line of credit with Silicon Valley Bank until June 28,2008.  On or before June 28, 2008,it is anticipated that we will enter into a new credit facility with SiliconValley Bank.*

 

On January 30, 2008, we entered into a revolvingpromissory note to borrow up to $700,000 from G. Ward Paxton, the Company’sChairman, President and Chief Executive Officer.  Under the terms of the note, the Company mayborrow, repay and reborrow on the loan as needed up to an outstanding principalamount of $700,000 at any date.  Amountsthe Company borrows under the note accrue interest at a floating rate per annumequal to the announced prime rate of Silicon Valley Bank plus 1% and are unsecured.  As of February 29, 2008 we had $220,000available to borrow under the promissory note. All outstanding principaland accrued but unpaid interest are due on December 31, 2008.

 

 

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