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**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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

 
| **(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, 2009**                     |
| ** **                                                                | ** ** | ** **                                                                                               |
| **OR**                                                                    |
| ** **                                                                | ** ** | ** **                                                                                               |
| **o**                                                                     | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                                      | ** ** | ** **                                                                                               |
| **For the transition period  from      to** |

 

**COMMISSION FILE NUMBER 0-20191**

 

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**Intrusion Inc.**

(Exact name of registrant as specified in itscharter)

 

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

 

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

 

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

 

Securities registered pursuant to Section 12(g) of the Act:

**Common Stock, $0.01 par value**

(Title of class)

 

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Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.

                                                                                                                                                                                      Yes o  No ý

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or 15(d) of the Exchange Act.

                                                                                                                                                                                      Yes o  No ý

 

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

 

Indicate by check mark if disclosure of delinquentfilers in response to Item 405 of Regulation S-K is not contained herein,and will not be contained, to the best of the registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-K or any amendment to this Form 10-K.                                                                                                                                                                                                        o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, a non-accelerated filer, or a smaller reportingcompany.  See definition of “largeaccelerated filer,”  “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

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

 

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

                                                                                                                                                                                      Yes o  No ý

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate website, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files).

                                                                                                                                                                                      Yes o  No o

 

Statethe issuer’s revenues for its most recent fiscal year:  $4,920,000.

 

Statethe aggregate market value of the voting and non-voting common equity held bynon-affiliates computed by reference to the price at which the common equitywas last sold, or the average bid and asked price of such common equity, as of June 30,2009:  $5,300,899.

 

As of March 30,2010, 11,704,535 shares of the issuer’s Common Stock were outstanding.

 

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**DOCUMENTSINCORPORATED BY REFERENCE**

 

Portionsof the Registrant’s definitive Proxy Statement filed in connection with theRegistrant’s 2010 Annual Meeting of Stockholders are incorporated by referenceinto Part III of this Form 10-K.

 

 

**INTRUSION INC.**

**INDEX**

** **
| **PART I**   |   |                                                                                                                |   |
|-------------------|--------|---------------------------------------------------------------------------------------------------------------------|--------|
| Item 1.           |   | Business                                                                                                            | 3      |
| Item 1A.          |   | Risk Factors                                                                                                        | 9      |
| Item 2.           |   | Properties                                                                                                          | 15     |
| Item 3.           |   | Legal Proceedings                                                                                                   | 15     |
| **PART II**  |   |                                                                                                                |   |
| Item 5.           |   | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 16     |
| Item 7.           |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 16     |
| Item 9.           |   | Changes In and  Disagreements with Accountants on Accounting and Financial Disclosure                               | 23     |
| Item 9A(T).       |   | Controls and  Procedures                                                                                            | 23     |
| Item 9B.          |   | Other Information                                                                                                   | 24     |
| **PART III** |   |                                                                                                                |   |
| Item 10.          |   | Directors,  Executive Officers and Corporate Governance                                                             | 24     |
| Item 11.          |   | Executive  Compensation                                                                                             | 25     |
| Item 12.          |   | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 25     |
| Item 13.          |   | Certain  Relationships and Related Transactions, and Director Independence                                          | 25     |
| Item 14.          |   | Principal  Accounting Fees and Services                                                                             | 25     |
| **PART IV**  |   |                                                                                                                |   |
| Item 15.          |   | Exhibits and  Financial Statement Schedules                                                                         | 25     |
| Signatures        |   |                                                                                                                | 29     |

 

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**PART I**

 

**Item 1.**                              Description of Business.

** **

In addition to the historical information contained herein,the discussion in this Form 10-K contains certain forward-lookingstatements, within the meaning of Section 27A of the Securities Act of1933 and Section 21E of the Securities Exchange Act of 1934, that involverisks and uncertainties, such as statements concerning:

 

·                                          growth and anticipated operating results;

·                                          developments in our markets and strategic focus;

·                                          new products and product enhancements;

·                                          potential acquisitions and the integration of acquiredbusinesses, products and technologies;

·                                          strategic relationships and future economic andbusiness conditions.

 

The cautionary statements made in this Form 10-K should be read asbeing applicable to all related forward-looking statements whenever they appearin this Form 10-K. 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-K as well as thosecautionary statements and other factors set forth elsewhere herein.

 

**General**

 

Wedevelop, market and support a family of entity identification, high speed datamining, regulated information compliance, data privacy protection and networkintrusion prevention/detection products. Our product families include:

 

·                                          TraceCopTM for identity discovery and disclosure,

·                                          SavantTM for network data mining,

·                                          Compliance CommanderTM for regulated information anddata privacy protection,

·                                          SecureNetTM for network intrusion prevention anddetection.

 

Wemarket and distribute our products through a direct sales force to:

 

·                                          end-users,

·                                          value-added resellers,

·                                          system integrators,

·                                          managed service providers, and

·                                          distributors.

 

Our end-user customers include:

 

·                                          U.S. federal government entities,

·                                          foreign government entities,

·                                          local government entities,

·                                          banks,

·                                          credit unions,

·                                          other financial institutions,

·                                          hospitals and other healthcare providers, and

·                                          other customers.

 

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.  Our principal executive offices are locatedat 1101 East Arapaho Road, Suite 200, Richardson, Texas 75081, and ourtelephone number is (972) 234-6400. Our website URL is www.intrusion.com. References to the “Company”, “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance Commander, SecureNet, TraceCop and Savantare trademarks of Intrusion Inc.

 

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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, par value $0.01 per share, of Intrusion Inc. (our “Common Stock”) at aninitial conversion price of $3.144 per share.

 

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.

 

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 aninitial conversion price of $2.18 per share, and the warrants may be exercisedat a price of $0.40 per share during the five-year period commencing on June 2,2006.  In connection with 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.

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SiliconValley Bank (“SVB”) to establish a $1.0 million line of credit with SVB (the “2006Credit Line”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to the Amended and Restated Loan andSecurity Agreement (as amended, the “Loan Agreement”) with SVB to replace the2008 Credit Line with a $1.25 million line of credit (the “Current Line ofCredit”).  Our obligations under the LoanAgreement are secured by substantially all of our assets, including all of ourintellectual property.  In addition, G.Ward Paxton, the Company’s Chief Executive Officer, has established a GuarantyAgreement with SVB for all outstanding balances under the Current Line ofCredit.  Borrowings under the CurrentLine of Credit are based on advances (each an “Advance”) against certain of ouraccounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Loan Agreement, or (c) the date on which any “Adjustment”(as defined in the Loan Agreement) is asserted to the Eligible Account.  On June 27, 2010, the Loan Agreementterminates and all outstanding Advances, accrued but unpaid finance charges,outstanding collateral handing fees, and other amounts become due under theLoan Agreement and related documents.  Wehave certain non-financial and financial covenants, including a liquiditycoverage ratio and a rolling EBITDA computation, as defined in the LoanAgreement.  We have no borrowingsoutstanding under the Current Line of Credit as of December 31, 2009 andhad borrowings available of $152,000.

 

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 February 4,2010, the Company extended a revolving promissory note to borrow up to $700,000from G. Ward Paxton, the Company’s Chairman, President and Chief ExecutiveOfficer through March 2011.

 

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OnFebruary 4, 2010, we received a written commitment from our Chief Executive Officer toinvest up to an additional $1,500,000 in the Company until March 2011,should such funding be required by the Company, on terms and conditions similarto the promissory note above.

 

**Government Sales**

 

Sales to U.S. government customers accounted for77.5% of our revenues for the year ended December 31, 2009, compared to86.2% of our revenue in 2008.  We expectto continue to derive a substantial portion of our revenues from sales togovernmental entities in the future as we continue to market our entity identificationproducts, our data mining products, our regulated compliance and data leakageprevention products and our network intrusion prevention products to thegovernment.  Sales to the governmentpresent risks in addition to those involved in sales to commercial customerswhich could adversely affect our revenues, including potential disruption dueto irregularities in or interruptions to appropriation and spending patterns,delays in approving a federal budget and the government’s reservation of theright to cancel contracts and purchase orders for its convenience.

 

Generally, we make our sales under purchase ordersand contracts.  Our customers, includinggovernment customers, may cancel their orders or contracts with little or noprior notice and without penalty.  Althoughwe transact business with various government entities, we believe that thecancellation of any particular order in itself could have a material effect onour financial results.  However, becausewe derive and expect to continue to derive a substantial portion of our revenuefrom sales to government entities, a large number of cancelled or renegotiatedgovernment orders or contracts could have a material adverse effect on ourfinancial results.  Currently, we are notaware of any proposed cancellation or renegotiation of any of our existingarrangements with government entities, and, historically, government entitieshave not cancelled or renegotiated orders which had a material adverse effecton our business.

 

**Industry Background**

 

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

 

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

 

·                                          Control: the ability toaffect network traffic including access to the network or parts thereof inorder to enforce a security policy.

 

·                                          Visibility: the ability tosee and understand the nature of the network and the traffic on the network,which assists in decision making as well as crafting and constantly improvingsecurity policy.

 

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

 

**Products**

 

*TraceCop*

 

Our TraceCop product family includes a database ofworldwide IP addresses which are regularly updated.  In addition, other information and analysisresults, such as geo-location data may also be included.  Customers use the TraceCop data to aid in theidentification and location of individuals involved in cyber crime.  In addition to the IP database, the TraceCopfamily includes analysis software and a GUI interface to assist analysts inlocating the bad guys.  We sell thelicense fee and maintenance for the TraceCop database and either install andservice the database at the Intrusion facility or

 

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installthe TraceCop database on a customer server onsite.

 

# *Savant*

# * *

# *Savant, a new product offering announced in the firstquarter of 2010, is a high-speed network data mining product which organizesthe data into networks of relationships. Savant operates on networks with data flows of up to 20 gigabits (10gigabits at full duplex).  Savant canread and record up to 20 gigabits without dropping packets.  Some of the unique features include analysiswhich determines associations.  Usesinclude building persona and internet habits of the customer’s networkusers.  Savant provides deep inspectionof network traffic recording interesting data and relationships.  Savant is a software product which we licenseto our customers and sell maintenance and upgrades.  We also re-sell the server required toimplement Savant into the customer’s network.*

# * *

# *Compliance Commander*

# * *

ComplianceCommander is our data leak prevention product family.  Compliance Commander is a software productwhich operates on a standard computer or server and connects in-line to thecustomers’ network.  We license theCompliance Commander software to our customers and sell them softwaremaintenance and upgrades.  We also resellstandard computers for implementation of the software.

 

 

# *SecureNet*

# * *

SecureNet is our Network Intrusion/Detection Productfamily.  SecureNet is a software productwhich operates on a standard computer or server and connects inline to thecustomer’s network.  We license theSecureNet software to our customers and additionally sell software maintenanceand upgrades.  We also resell standardcomputers for implementation of the software. SecureNet provides network monitoring and analysis functions with theadded ability to block malicious network traffic for up to two gigabit dataflows.  SecureNet products provide usercustomizable, protocol decode detection technology.  Our SecureNet sensors have their own webbrowser interface for simplified configuration.

 

**Third-Party Products**

 

We currently resell standard commercially availablecomputers and servers from various vendors which we integrate with ourdifferent software products for implementation into our customer networks.  We do not consider any of these third partyrelationships to be material.

 

**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 TraceCop, Savant,Compliance Commander and SecureNet products to meet emerging marketrequirements and are continuously engaged in testing to ensure that ourproducts interoperate with other manufacturers’ products, which comply withindustry standards.

 

During 2009 and 2008, our research and developmentexpenditures were approximately $1.1 million each year. All of our expendituresfor research and development have been expensed as incurred.  At December 31, 2009, we had 17employees 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 standard off-the-shelfproducts, which we OEM or resell from our suppliers.

 

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**Intellectual Property and Licenses**

 

Our success and our ability to compete aredependent, in part, upon our proprietary technology.  We principally rely on a combination ofcontractual rights, trade secrets and copyright laws to establish and protectour proprietary rights in our products. In addition, we have recently appliedfor two patents.  We have also enteredinto non-disclosure agreements with our suppliers, resellers and certaincustomers to limit access to and disclosure of proprietary information. Therecan be no assurance that the steps taken by us to protect our intellectualproperty will be adequate to prevent misappropriation of our technology or thatour competitors will not independently develop technologies that aresubstantially equivalent or superior to our technology.

 

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

 

**Sales, Marketing and Customers**

 

***Field SalesForce.***  Our directsales organization focuses on major account sales, channel partners includingdistributors, Value Added Resellers (VARs) and integrators; promotes ourproducts to current and potential customers; and monitors evolving customerrequirements. The field sales and technical support force provides training andtechnical support to our resellers and end users and assists our customers indesigning secure data networking solutions. We currently conduct sales and marketing efforts from our principaloffice in Richardson (Dallas), Texas.  Inaddition, we have sales personnel, sales engineers or sales representativeslocated in California, Europe and Asia.

 

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

 

***Resellers.***  Resellers such as domestic and internationalsystem integrators and VARs sell our products as stand-alone solutions to endusers and integrate our products with products sold by other vendors intonetwork security systems that are sold to end users. Our field sales force andtechnical support organization provide support to these resellers. Ouragreements with resellers are non-exclusive, and our resellers generally sellother products that may compete with our products. Resellers may place higherpriority on products of other suppliers who are larger than and have more namerecognition than us, and there can be no assurance that resellers will continueto sell and support our products.

 

***Foreign Sales.***  We believe that rapidly evolvinginternational markets are important sources of future net sales. Our exportsales are currently being made through an indirect sales force comprised ofinternational resellers in Europe and Asia. Export sales accounted for approximately 1.0% and 4.7% of total revenuein 2009 and 2008, respectively.  See “Management’sDiscussion and Analysis of Financial Conditions and Results of Operations” includedin this report for a geographic breakdown of our revenue in 2009 and 2008.Sales to foreign customers and resellers generally have been made in UnitedStates dollars.

 

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

 

***Customers.***  Our end-user customers include U.S. federalgovernment entities, foreign government entities, banks, credit unions, otherfinancial institutions, hospitals and other healthcare providers.  Essentially, our customers include any entityrequiring network security solutions for protecting their mission criticaldata.  Sales to certain customers andgroups of customers can be impacted by seasonal capital expenditure approvalcycles, and sales to customers within certain geographic regions can be subjectto seasonal fluctuations in demand.

 

In 2009, 77.5% of our revenue was derived from avariety of U.S. government entities through direct sales and indirectly throughsystem integrators and resellers.  In2009, 76.6% of our total revenues are attributable to three U.S. Governmentcustomers through direct and indirect channels, all of which exceeded 10% oftotal revenue individually in 2009. Comparatively, sales to the U.S. Government through direct and indirectchannels totaled 86.2% of total revenues for 2008 and 73.1% of our totalrevenues in 2008 were attributable to two customers, one of which exceeded 10%of our total revenues individually.  Areduction in our sales to U.S. government entities could have a materialadverse effect on our business and operating results if not replaced.

 

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***Backlog.***  We believe that only a small portion of ourorder backlog is non-cancelable and that the dollar amount associated with thenon-cancelable portion is immaterial. We purchase or contract inventory basedupon our forecast of customer demand and maintain inventories in advance ofreceiving firm orders from customers. Commercial orders are generally fulfilledwithin two days to two weeks following receipt of an order. Certain governmentorders may be scheduled over several months, generally not exceeding one year.

 

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

 

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

 

**Competition**

 

The market for network and data protection securitysolutions is intensely competitive and subject to frequent productintroductions with new technologies, improved price and performancecharacteristics. Industry suppliers compete in areas such as conformity toexisting and emerging industry standards, interoperability with networking andother security products, management and security capabilities, performance,price, ease of use, scalability, reliability, flexibility, product features andtechnical support.

 

There are numerous companies competing in varioussegments of the data security markets. At this time, we do not have directcompetitors for TraceCop.  There areseveral different small start-up companies that perform some of the analysisfunctions that we perform in TraceCop, but these companies don’t have theextensive data-base that we have in TraceCop. In our newest market segment, data mining, we compete with several smallcompanies including Niksun and NetScout. Our competitors in the regulatedinformation compliance market include Vontu (Symantec), Port Authority(Websense), Vericept, Reconnex (McAfee Inc.), Tablus (RSA Security) and a smallnumber of start-up companies that entered the space within the last twoyears.  Our principal competitors in thenetwork intrusion prevention and detection market include Internet SecuritySystems, Inc.(IBM), Cisco Systems, Inc., Symantec, Inc.,Netscreen  (Juniper Networks, Inc.),McAfee Inc., Tipping Point Technologies, a division of 3Com Corporation, andNFR Security (Checkpoint).

 

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, 2009, we employed a total of27 persons, including 6 in sales, marketing and technical support, 17 inresearch, product development and engineering, and 4 in administration andfinance.

 

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

 

Competition in the recruiting of personnel in thenetworking and data security industry is intense. We believe that 

 

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ourfuture success will depend in part on our continued ability to hire, motivateand retain qualified management, sales and marketing, and technical personnel.To date, we have not experienced significant difficulties in attracting orretaining qualified employees.

 

**Item 1A. Risk Factors**

 

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

 

***Our cash, cashequivalents, and investments remained relatively constant at $519,000 at December 31,2009 compared to $554,000 at December 31, 2008.  We may not have sufficient cash to operateour business and may not be able to maintain certain liquidity requirementsunder our existing debt instruments. 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.***

 

Asof December 31, 2009, we had cash and cash equivalents of approximately$519,000, down from approximately $554,000 as of December 31, 2008.  We generated net income of $379,000 in thelast quarter of 2009 and $186,000 net income for the year 2009 compared to anet loss for the year 2008 of $808,000. We are obligated to make payments of accrued dividends on all ouroutstanding shares of preferred stock that will reduce our available cashresources.   As of December 31,2009, in addition to cash and cash equivalents of $519,000, we had $152,000 infunding available under our $1.25 million line of credit at Silicon ValleyBank, and $1.2 million funding available from a written commitment to invest up to $1.5 million from G.Ward Paxton, our CEO.  Based onprojections of growth in revenue and net income in the coming quarters, and theborrowings available previously mentioned, we believe that we will have  sufficient cash resources to finance ouroperations and expected capital expenditures for the next twelve months. We expect to fund our operations through Company profits, our line ofcredit, borrowings from the Company’s CEO, and possibly additional investmentsof private equity and debt, which, if we are able to obtain, will have theeffect of diluting our existing common stockholders, perhaps significantly.  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 upcoming year, 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.

 

***To remain profitable, wemust continue to meet or exceed our current revenue levels.***

 

We had anet income of $186,000 for the fiscal year ended December 31, 2009, buthave incurred large operating losses in previous years.  For the year ended December 31, 2009, wehad net income of $0.2 million and had an accumulated deficit of approximately$58.1 million as of December 31, 2009, compared to a net loss of $0.8million and an accumulated deficit of approximately $58.3 million as of December 31,2008. ** **Weneed to generate and sustain equal to or greater revenues from the sales of ourproducts if we are to remain profitable and grow.  If we are unable to sustain these revenuelevels, net losses may occur and we may never be able to sustain profitabilityor generate positive cash flow from operations in the future.

 

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

 

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

 

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

 

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

 

A large percentage of our revenuesresult from sales to U.S. government entities.  If we were to lose one or more of

 

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these key relationships, our revenues could declineand our business and prospects may be materially harmed. We expect that even ifwe are successful in developing relationships with non-governmental customers,our revenues will continue to be concentrated among government entities. Forthe years ended December 31, 2007, 2008****and2009, sales to U.S. government entities collectively accounted for 73.2%, 86.2%and 77.5% of our total net revenues, respectively. The loss of any of these keyrelationships may send a negative message to other U.S. government entities ornon-governmental customers concerning our product offering.  We cannot assure you that U.S. governmententitieswill be customers of ours in future periods or that we will be able todiversify our customer portfolio to adequately mitigate the risk of loss of anyof these customers.

 

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

 

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

 

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

 

For theyears ended December 31, 2007, 2008 and 2009, we derived 19.2%, 33.9% and65.5% of our revenues from sales through indirect sales channels, such asdistributors, value-added resellers, system integrators, original equipmentmanufacturers and managed service providers. We must expand our sales through these indirect channels in order toincrease our revenues.  We cannot assureyou that our products will gain market acceptance in these indirect saleschannels or that sales through these indirect sales channels will increase ourrevenues.  Further, many of ourcompetitors are also trying to sell their products through these indirect saleschannels, which could result in lower prices and reduced profit margins forsales of our products.

 

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

 

On March 25, 2004, we completed a $5,000,000private placement pursuant to which we issued 1,000,000 shares of our 5%Convertible Preferred Stock (the “Series 1 Preferred Stock”) and warrantsto acquire 556,619 shares of our common stock. The conversion price for the Series 1 Preferred Stock and theexercise price of the warrants is $3.144 per share.  As of February 28, 2010, there were220,000 shares of the Series 1 Preferred Stock outstanding, representingapproximately 349,873 shares of common stock upon conversion.

 

On March 28, 2005, we completed a $2,663,000private placement pursuant to which we issued 1,065,200 shares of our Series 25% Convertible Preferred Stock (the “Series 2 Preferred Stock”) andwarrants to acquire 532,600 shares of our common stock.  The conversion price for the Series 2Preferred Stock is $2.50 per share and the exercise price of the warrants is$2.77 per share.  As of February 28,2010, there were 460,000 shares of the Series 2 Preferred Stockoutstanding, representing 460,000 shares of common stock upon conversion.

 

On December 2, 2005, we completed a $1,230,843private 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 commonstock.  The preferred shares may beconverted into 564,607 shares of common stock at an initial conversion price of$2.18 per share, and the warrants may be exercised at a price of $0.40 pershare during the five-year period commencing on June 2, 2006.  As of February 28, 2010, there were354,056 shares of Series 3 Preferred Stock outstanding, representing354,056 shares of common stock upon conversion.

 

***You will experiencesubstantial dilution upon the conversion or redemption of the shares ofpreferred stock and the exercise of warrants that we issued in our recent privateplacements or in the event we raise additional funds through the issuance ofnew shares of our common stock or securities convertible or exercisable intoshares of common stock.***

 

On March 5, 2010, we had 11,704,535 shares ofcommon stock outstanding.  Uponconversion of all outstanding shares of preferred stock and exercise of theoutstanding warrants, we will have 13,710,902 shares of common stockoutstanding,

 

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approximately a 17.1% increase in the number of shares of our common stockoutstanding.

 

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

 

Further, the occurrence of certainevents could entitle holders of our Series 2 Preferred Stock and Series 3Preferred Stock to require us to redeem their shares for a certain number ofshares of our common stock.  Assuming (i) wehave paid all liquidated damages and other amounts to the holders, (ii) paidall outstanding dividends, (iii) a volume weighted average price of $0.72,which was the ten-day volume weighted average closing price of our common stockon March 5, 2010, and (iv) our 11,704,535shares of common stockoutstanding on March 5, 2010, upon exercise of their redemption right bythe holders of the Series 3 Preferred Stock and the Series 2Preferred Stock, we would be obligated to issue approximately 4,625,878 sharesof our common stock.  This wouldrepresent an increase of approximately 40.0% in the number of shares of ourcommon stock as of March 5, 2010.

 

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

 

Theholders of the shares of our 5% Preferred Stock andwarrants we issued in connection with the sale of our 5% Preferred Stock mayfreely convert their shares of preferred stock and exercise their warrants andsell the underlying shares of common stock pursuant to Rule 144 of theSecurities and Exchange Commission.  Asof February 28, 2010, 780,000 shares of our 5% Preferred Stock had converted into 1,240,457 shares of common stock.

 

Theholders of the shares of Series 2 5% Preferred Stock and warrants we issued in connection with the sale of our Series 2Preferred Stock may freely convert their shares of preferred stock and exercisetheir warrants and sell the underlying shares of common stock pursuant to Rule 144of the Securities and Exchange Commission. As of February 28, 2010, 605,200 shares of Series 2 Preferred Stock had converted into 605,200 shares of common stock.

 

Theholders of the shares of Series 3 5% Preferred Stock and warrants we issued in connection with the sale of our Series 3Preferred Stock, may freely convert their shares of Series 3 Preferred Stock and exercise their warrants and sell the underlying shares of commonstock pursuant to Rule 144 of the Securities and Exchange Commission.  As of February 28, 2010, 210,551 sharesof Series 3 Preferred Stock hadconverted into 210,551 shares of common stock.

 

For thefour weeks ended on March 5, 2010, the average daily trading volume of ourcommon stock on The OTCBB was 6,225 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.

 

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

 

Under the terms of our preferred stock instruments,we cannot issue shares of capital stock with rights senior to those of ourexisting 5% Preferred Stock, Series 2 5% Preferred Stock or Series 35% Preferred Stock without the approval of at least a majority of the holdersof our 5% Preferred Stock, all of the holders of our Series 2 5% PreferredStock, and holders of at least 75% of our Series 3 5% Preferred Stockvoting or acting as separate classes.  Wealso cannot incur certain indebtedness without the approval of at least amajority of 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.

 

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

 

From ourfounding in 1983 until 2000, we derived substantially all of our revenue fromthe design, manufacture and sale of local area networking equipment.  In order to permit us to focus our resourcessolely on developing and marketing our network security products, we sold ourlocal area networking assets and related networking divisions.  We now depend exclusively on revenuesgenerated from the sale of our network security products, which have receivedlimited market acceptance.  We haverecently introduced our regulated information compliance systems, entityidentification and data mining products, and the market for these products hasonly begun to emerge.  We can provide noassurances that 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 

 

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uncertainties:

 

·                                          the need for our network securityproducts, regulated information compliance systems, entity identification anddata mining products to achieve market acceptance and produce a sustainablerevenue 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 businessstrategy may not successfully address these risks.  If we fail to recognize significant revenuesfrom the sales of our network security products, regulated informationcompliance systems, entity identification and data mining products, ourbusiness, financial condition and operating results would be materiallyadversely affected.

 

***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 February 28,2010, our executive officers, directors and preferred stockholders beneficiallyown approximately 26.7% 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 the interests of holders of ourCommon Stock.  Further, we contemplatethe possible issuance of shares of our Common Stock or of securitiesexercisable or convertible into shares of our Common Stock in the future to ourChief Executive Officer and Chief Financial Officer.  Any such issuance will increase thepercentage of stock our Chief Executive Officer, Chief Financial Officer andour management group beneficially 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 data mining marketinclude Niksun and NetScout.  Ourprincipal competitors in the network intrusion prevention and detection marketinclude Internet Security Systems, Inc. (IBM), Cisco Systems, Inc.,Symantec, Inc., Juniper Networks, Inc., McAfee Inc., Tipping PointTechnologies, a division of 3Com Corporation, and NFR Security, Inc.  Our competitors in the regulated informationcompliance market include Vontu (Symantec), Port Authority (Websense),Vericept, Reconnex (McAfee Inc.), Tablus (RSA Security) and a small number ofstart-up companies that entered the space within the last two years. Ourcurrent and potential competitors may have one or more of the followingsignificant advantages over us:

 

·              greaterfinancial, technical and marketing resources;

 

·              bettername recognition;

 

·              morecomprehensive security solutions;

 

·              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 

 

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

 

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

 

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

 

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

 

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

 

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

 

***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 

 

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expenditures, deployingnew technologies within their networks and testing and accepting newtechnologies that affect key operations. As a result, sales and implementation cycles for our products can belengthy, and we may expend significant time and resources before we receive anyrevenues from a customer or potential customer. Our quarterly and annual operating results could be materially harmed iforders forecasted for a specific customer for a particular period are notrealized.

 

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

 

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

 

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

 

We relyprimarily on a combination of patent, copyright, trademark and trade secretlaws, 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 intellectual propertyproves to be inadequate or unenforceable, others may be able to use ourproprietary 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 the infringedor similar technology on commercially reasonable terms could seriously harm ourbusiness.

 

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

 

Our operating results have variedsignificantly from quarter to quarter in the past, and we expect our operatingresults to vary from quarter to quarter in the future due to a variety offactors, many of which are outside of our control.  Significant portions of our expenses are notvariable in the short term and we cannot reduce them quickly to respond to unexpecteddecreases in revenues.  Therefore, ifrevenues are below our expectations, this shortfall is likely to adversely anddisproportionately affect our operating results.  Accordingly, we may not attain positiveoperating margins in future quarters.  Any of these factors could cause our operatingresults to be below the expectations of securities analysts and investors,which likely would negatively affect the price of our common stock.

 

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

 

Themarket price of our common stock has been highly volatile in the past and maycontinue to be volatile in the future. For example, in fiscal year 2009, the market price of our common stockon The OTCBB Market fluctuated between $0.13 and $0.84 per share.  The market price of our common stock mayfluctuate significantly in response to a number of factors, many of which areoutside our control, including:

 

·      variationsin our quarterly operating results;

 

·      changes inestimates of our financial performance by securities analysts;

 

·      changes inmarket valuations of our competitors;

 

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

 

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·      product ordesign flaws, product recalls or similar occurrences;

 

·      additionsor departures of key personnel;

 

·      sales ofcommon stock in the future; and

 

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

 

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

 

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

 

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

 

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.

 

**Item 2.          Properties.**

** **

Our headquarters are located in a two-story buildingin Richardson, Texas.  We occupyapproximately 28,000 square feet of floor space in this facility. This facilityincludes our corporate administration, operations, marketing, research anddevelopment, engineering, sales and technical support personnel.  The lease for this facility extends through December 2012.

 

Approximatelythirty percent of our security software research and development andengineering staff are located in two separate small facilities in San Diego,California.  These leases are currentlyset to expire in March 2011. Research and development and engineering personnel occupy thesefacilities.

 

We believe that the existing facilities at December 31,2009 will be adequate to meet our requirements through 2010.  We believe that all facilities are adequatelycovered by appropriate property insurance. See Note 4 of Notes to Consolidated Financial Statements foradditional information regarding our obligations under leases.

 

**Item 3.          Legal Proceedings.**

** **

We are subject to legal proceedings and 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 financial position,operating results or cash flows. However, there can be no assurance such legal proceedings will not havea material impact on future results.

 

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**PART II**

 

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

** **

Our common stock trades on The OTCBB, where it iscurrently listed under the symbol “INTZ.” As of March 5, 2010, there were approximately 125 registeredholders of record of the common stock. The following table sets forth, for theperiods indicated, the high and low closing price per share 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.

 
| ** **     | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
|           |       |     |       |     |       |   |   |   |   |
| First Quarter  |       | $        | .35        |     | $          | .18 |   | $ | .22 |   | $ | .13 |   |
| Second Quarter |       | .75      |       | .19      |       | .24 |   | .14 |   |
| Third Quarter  |       | .74      |       | .35      |       | .41 |   | .17 |   |
| Fourth Quarter |       | .71      |       | .35      |       | .39 |   | .20 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

We have not declared or paid cash dividends on ourcommon stock in our two most recent fiscal years.  We intend to retain any earnings for use inour business and do not anticipate paying any cash dividends on our commonstock in the foreseeable future.  Futuredividends on common stock, if any, will be determined by our Board ofDirectors.  However, shares of our 5%convertible preferred stock accrue cash dividends equal to $0.25 per share perannum, payable in arrears on March 31 and September 30 of each year,and shares of our Series 2 5% and Series 3 5% convertible preferredstock accrue cash dividends equal to $0.125 and $0.109 per share per annum,respectively, payable in arrears on the first business day of March, June, September andDecember of each year.  During thefiscal year ended December 31, 2009, we accrued $58,000 in dividends tothe holders of our 5% Preferred Stock, $57,000 in dividends to the holders ofour Series 2 5% Preferred Stock and $39,000 in dividends to the holders ofour Series 3 5% Preferred Stock.  AtDecember 31, 2009, we have dividends accrued of $140,000 related to our 5%Preferred Stock, $120,000 related to our Series 2 5% Preferred Stock and$81,000 related to our Series 3 5% Preferred Stock.  Delaware law provides that we may only paydividends out of our capital surplus or, if no surplus is available, out of ournet profits for the fiscal year the dividend is declared and/or the precedingfiscal year.  All past due dividends andpenalties were paid in February 2010.

 

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, 2009 forall of our equity compensation plans (in thousands, except per share data). SeeNote 9 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     |       | 1,910                                                                                      | (1)        | $                                                             | 1.31       |                                                                                                                 | 829.5      |   |
| Equity compensation plans  not approved by security holders |       | —                                                                                     |       | —                                                        |       | —                                                                                                               |       |
| Total                                                       |       | 1,910                                                                                      |       | $                                                             | 1.31       |                                                                                                                 | 829.5      |   |

 

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(1)                                  Included in the outstandingoptions are 1,667,499 from the 2005 Plan, 210,000 from the 1995 Plan and 32,500from the 1995 Non-Employee Director Plan.

 

**Item 7.          Management’s Discussion and Analysisof Financial Condition and Results 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

 

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Financial Condition and Results of Operations,” and “Descriptionof Business,” contains forward-looking statements.  These statements relate to future events orto our future financial performance, and involve known and unknown risks,uncertainties and other factors that may cause our actual results, levels ofactivity, performance, or achievements to be materially different from anyfuture results, levels of activity, performance or achievements expressed orimplied by these forward-looking statements. In some cases, you can identifyforward-looking statements by the use of words such as “may,” “could,” “expect,”“intend,” “plan,” “seek,” “anticipate,” “believe,” “estimate,” “predict,” “potential,”“continue,” or the negative of these terms or other comparableterminology.  You should not place unduereliance on forward-looking statements since they involve known and unknownrisks, uncertainties and other factors which are, in some cases, beyond ourcontrol and 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;

 

·                  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 of these orother risks or uncertainties materialize, or if our underlying assumptionsprove to be incorrect, actual results may vary significantly from what weprojected. Any forward-looking statement you read in this filing reflects ourcurrent views with respect to future events and is subject to these and otherrisks, uncertainties and assumptions relating to our operations, results ofoperations, growth strategy and liquidity. We assume no obligation to publiclyupdate or revise these forward-looking statements for any reason, or to updatethe reasons actual results could differ materially from those anticipated inthese forward-looking statements, even if new information becomes available inthe future.

 

The Private SecuritiesLitigation Reform Act of 1995 and Section 27A of the Securities Act, eachof which provide protection in connection with certain forward-lookingstatements, do not directly protect any statements we make in connection withthis Annual Report.

 

**Overview**

 

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

 

·                                          TraceCop for identity identification;

·                                          Savant for data mining;

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

 

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·                                          SecureNet for network intrusionprevention and detection.

 

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

 

Our revenues have decreased over the past 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 bring our operations in line with our new strategic focus, weheld our employee headcount approximately constant in 2009.  At December 31, 2008 we employed 26employees and at December 31, 2009 we employed 27 employees.  As a result of our migration tosoftware-based solutions, our margins have improved from previous years to66.8% in 2008, and 66.2% in 2009.  Wehave also restructured our personnel and operations around the development andsale of our core software products.  As aresult of these efforts, we believe we have reduced operating expenses to alevel that will remain consistent going forward.

 

In order for us to operate and grow our business, wemust continue to sustain operating profits and cash flow positive.  This will require us to counteract reducedsales of our SecureNet products by generating additional revenues from sales ofour entity identification software, data mining and regulated informationcompliance products.  In order to obtainthese sales, our products must gain acceptance in intensely competitive andemerging markets.  We believe our abilityto introduce our TraceCop, Savant and Compliance Commander products into themarketplace in a timely manner and our efforts to maintain our reduced spendinglevels will help us achieve these results.

 

**Critical Accounting Policies and Estimates**

 

Management’s discussion and analysis 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 of whichform the basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

 

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

 

We recognize software revenue from the licensing ofour software products in accordance with FASB ASC Topic 605 whereby revenuefrom the licensing of our products is not recognized until all four of thefollowing criteria have been met: i) execution of a written agreement;ii) delivery of the product has occurred; iii) the fee is fixed anddeterminable; and iv) collectability is probable. Bundled hardware andperpetual software product sales are recognized at time of delivery, as ourlicenses are not sold on a subscription basis. In the case of multiple product and service sales, we perform a VendorSpecific Objective Evidence analysis to appropriately determine the amount ofrevenue derived from each deliverable. If our license strategy changes and we begin to offer licenses on asubscription basis, we would perform this analysis in a similar manner.  Under these circumstances, the revenuerelated to the license would be recognized ratably over the subscriptionperiod.  Market values are easilyobtained for all of our product offerings, as we have historical salesinformation on our product offerings.  Wedefer and recognize maintenance and support revenue over the term of thecontract period, which is generally one year.

 

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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, are recognizedupon delivery of the service and typically are unrelated to product sales.  To date, training and installation revenuehas 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,** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|
| ** **                                        | ** ** | **2009**                         | ** ** | **2008** | ** ** |
|                                              |       |                             |       |   |   |
| Net product revenue                               |       | 94.3                             | %          | 86.1 | % |
| Net customer support and  maintenance revenue     |       | 5.7                              |       | 13.9 |   |
| Total revenue                                     |       | 100.0                            |       | 100.0 |   |
| Cost of product revenue                           |       | 33.5                             |       | 32.6 |   |
| Cost of customer support  and maintenance revenue |       | 0.3                              |       | 0.6 |   |
| Total cost of revenue                             |       | 33.8                             |       | 33.2 |   |
| Gross profit                                      |       | 66.2                             |       | 66.8 |   |
| Operating expenses:                               |       |                             |       |   |   |
| Sales and marketing                               |       | 18.7                             |       | 34.0 |   |
| Research and development                          |       | 22.5                             |       | 27.4 |   |
| General and administrative                        |       | 19.9                             |       | 23.4 |   |
| Operating income (loss)                           |       | 5.1                              |       | (18.0 | ) |
| Interest income (expense),  net                   |       | (1.3                             | )          | (1.5 | ) |
| Other income, net                                 |       | —                           |       | — |   |
| Loss from operations  before income taxes         |       | 3.8                              |       | (19.5 | ) |
| Income tax provision                              |       | —                           |       | — |   |
| Net income (loss)                                 |       | 3.8                              |       | (19.5 | ) |
| Preferred stock dividends  accrued                |       | (3.1                             | )          | (3.9 | ) |
| Beneficial conversion  feature on preferred stock |       | —                           |       | — |   |
| Net loss attributable to  common stockholders     |       | 0.7                              | %          | (23.4 | )% |

 
| ** **         | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------|------------|----------|------------|----------|------------|
|               |       |     |       |     |       |
| Domestic revenue   |       | 99.1     | %          | 95.3     | %          |
| Export revenue to: |       |     |       |     |       |
| Europe             |       | 0.7      |       | 4.2      |       |
| Asia               |       | —   |       | 0.3      |       |
| Latin America      |       | 0.1      |       | 0.2      |       |
| Australia          |       | 0.1      |       | —   |       |
| Net revenue        |       | 100.0    | %          | 100.0    | %          |

 

**2009 compared with 2008**

 

***Net Revenue***

 

Total revenue increased 18.8% to $4.9 millionin 2009 from $4.1 million in 2008.  Theincrease in revenue is related to increased sales from our TraceCop productlines.  Our customer support andmaintenance revenue decreased 51.6% from $0.6 million in 2008 to $0.3 millionin 2009.  This decline is mainly due tothe expiration of maintenance contracts related to our SecureNet product line.  Our product revenues increased 30.2% from$3.6 million in 2008 to $4.6 million in 2009.  We expect our product revenues to increase in the future as the marketacceptance of our TraceCop, Savant and Compliance Commander product linesincrease.

 

Export sales in 2009 decreased to $49 thousand, or1.0% of net revenue, compared to $0.2 million, or 4.7% of net revenue in2008 primarily due to 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.

 

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Historically, due to the timing of our sales cycle, asignificant portion of our monthly sales occurs in the second half of themonth.  Accordingly, our receivablesincrease at the end of each month, which causes a higher accounts receivablebalance at month end. This monthly trend also causes an inflated comparativerelationship between revenue and accounts receivable. We believe that thismonthly trend will continue because monthly sales forecast and planningmeetings are held in the first week of every month, the middle of the month isfocused on sales calls to customers and the later half of the month on closingsales.

 

***Gross Profit***

 

Grossprofit increased 18% to $3.3 million in 2009 from $2.8 million in 2008. Asa percentage of net revenue, gross profit decreased slightly from 66.8% in 2008to 66.2% in 2009.  Gross profit onproducts increased from 62.1% in 2008 to 64.5% in 2009.  Gross profit remained high in 2009 due torevenue growth and product mix that includes an increase in TraceCop sales witha decrease in SecureNet sales.  Grossprofit on customer support and maintenance decreased from 96.0% in 2008 to94.9% in 2009.

 

Grossprofit as a percentage of net revenue is impacted by several factors, includingshifts in product mix, changes in channels of distribution, sales volume,fluctuations in manufacturing costs, pricing strategies, and fluctuations insales of integrated third-party products.

 

***Sales and Marketing***

 

Salesand marketing expenses decreased 34.5% to $0.9 million in 2009 from$1.4 million in 2008, as we continued to reduce expenses to respond tocurrent efforts to become profitable.  Asa percentage of net revenue, sales and marketing expenses decreased from 34.0%in 2008 to 18.7% in 2009. We expect sales and marketing expenses to increase asnet revenue levels increase in 2010.

 

***Research andDevelopment***

 

Researchand development expenses remained constant at $1.1 million, or 22.5% ofnet revenue in 2009 compared to $1.1 million or 27.4% of net revenue in2008.  Our research and development costsare expensed in the period in which they are incurred. We expect research anddevelopment expenses to increase as net revenue levels increase in 2010.

 

***General andAdministrative***

 

Generaland administrative expenses remained relatively flat at $1.0 million, or 19.9%of net revenue in 2009 compared to $1.0 million or 23.4 % of net revenue in2008 as a result of continuing to keep spending under control.  We expect general and administration expensesto increase as net revenue levels increase in 2010.

 

***Interest Expense***

 

Interestexpense remained relatively constant at $64 thousand in 2009 compared to $62thousand in 2008.  Interest expense willvary in the future based on our cash flow and borrowing needs.

 

***Income Taxes***

 

Oureffective income tax rate was 0% in 2009 and 2008 as valuation allowances havebeen recorded for the entire amount of the net deferred tax assets due touncertainty of realization.

 

**Liquidity and Capital Resources**

 

Ourprincipal sources of liquidity at December 31, 2009 were $0.5 millionof cash and cash equivalents. As of December 31, 2009, we do not holdinvestments with a stated maturity beyond one year. Working capital deficiencyat December 31, 2009 was $(0.2) million compared to $(1.3) million atDecember 31, 2008.

 

Netcash used in operations in 2009 was $469 thousand, primarily due to a $998thousand decrease in deferred revenue for the year and the following uses ofcash: a $12 thousand increase in prepaid expenses and other assets, and a $10thousand increase in accounts receivable. This was partially offset by thefollowing sources of cash and non-cash items: net income of $186 thousand forthe year, a $164 thousand increase in accounts payable, $107 thousand instock-based compensation, a $13 thousand decrease in inventories, and $81thousand in depreciation expense. Net cash used in operations in 2008 was $112thousand, primarily due to a net loss of $808 thousand for the year and thefollowing uses of cash: a $191 

 

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thousandincrease in accounts receivable, a $40 thousand decrease in the provision fordoubtful accounts, and a decrease in accounts payable, accrued expenses andother current liabilities totaling $122 thousand.  This was partially offset by the followingsources of cash and non-cash items: a $778 thousand increase in deferredrevenue, a $127 thousand decrease in inventories, a $19 thousand decrease inprepaid expenses and other assets, $75 thousand in stock-based compensation,and $50 thousand in depreciation expense. Future fluctuations in accountsreceivable, inventory balances and accounts payable will be dependent uponseveral factors, including quarterly sales, timely collection of accountsreceivable, and the accuracy of our forecasts of product demand and componentrequirements.

 

Netcash used in investing activities in 2009 was $57 thousand for net purchases ofproperty and equipment.  Net cash used ininvesting activities in 2008 was $76 thousand for net purchases of property andequipment.

 

Cash provided byfinancing activities in 2009 was $491 thousand, primarily consisting of netfinancing proceeds from a loan by an officer of $490 thousand; compared to cashprovided by financing activities in 2008 was $380 thousand, primarilyconsisting of net financing proceeds from a loan by an officer of $480 thousandand a net reduction in the line of credit of $100 thousand.

 

AtDecember 31, 2009, we did not have any material commitments for capitalexpenditures. Operating lease commitments of $1.1 million are detailed inthe Contractual Obligations section below. During 2009, we funded ouroperations through the use of available cash, cash equivalents and investments,our line of credit and loans from our Company’s CEO.

 

Asof December 31, 2009, we had cash, cash equivalents and investments in theamount of approximately $0.5 million, down from approximately$0.6 million as of December 31, 2008. Throughout 2009, we continued to reduce expenses and realize the benefitof cost-cutting actions taken in previous years.

 

On February 4, 2010,the Company extended a revolving promissory note to borrow up to $700,000 fromG. Ward Paxton, the Company’s Chairman, President and Chief Executive Officerthrough March 2011.

 

OnFebruary 4, 2010, we received a written commitment from our Chief Executive Officer toinvest up to an additional $1,500,000 in the Company until March 2011,should such funding be required by the Company, on terms and conditions similarto the promissory note above.

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SiliconValley Bank (“SVB”) to establish a $1.0 million line of credit with SVB (the “2006Credit Line”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to the Amended and Restated Loan andSecurity Agreement (as amended, the “Loan Agreement”) with SVB to replace the2008 Credit Line with a $1.25 million line of credit (the “Current Line ofCredit”).  Our obligations under the LoanAgreement are secured by substantially all of our assets, including all of ourintellectual property.  In addition, G.Ward Paxton, the Company’s Chief Executive Officer, has established a GuarantyAgreement with SVB for all outstanding balances under the Current Line ofCredit.  Borrowings under the CurrentLine of Credit are based on advances (each an “Advance”) against certain of ouraccounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus2.0%.  Finance charges are payable at thesame time its related Advance is due. Each Advance is also subject to a monthly collateral handling fee of0.5% of all outstanding Advances, depending on certain qualifying financialfactors specified in the Loan Agreement. The collateral handling fee is payable at the same time its relatedAdvance is due.  Each Advance must berepaid at the earliest of (a) the date that the Eligible Account relatedto the Advance is paid, (b) the date the Eligible Account is no longereligible under the Loan Agreement, or (c) the date on which any “Adjustment”(as defined in the Loan Agreement) is asserted to the Eligible Account.  On June 27, 2010, the Loan Agreement terminatesand all outstanding Advances, accrued but unpaid finance charges, outstandingcollateral handing fees, and other amounts become due under the Loan Agreementand related documents.  We have certainnon-financial and financial covenants, including a liquidity coverage ratio anda rolling EBITDA computation, as defined in the Loan Agreement.  We have no borrowings outstanding under theCurrent Line of Credit as of December 31, 2009 and had borrowingsavailable of $152,000.

 

Asof December 31, 2009, we had cash and cash equivalents of approximately$519,000, down from approximately $554,000 as of December 31, 2008.  We generated net income of $379,000 in thelast quarter of 2009 and $186,000 net income for the year 2009 compared to anet loss for the year 2008 of $808,000. We used $469,000 of cash in operations in 2009 and operating cashoutflows may continue in 2010.  We areobligated to make payments of accrued dividends on all our outstanding sharesof preferred stock that will reduce our available cash resources.   As of December 31, 2009, in addition tocash and cash equivalents of $519,000, we had $152,000 in funding availableunder our $1.25 million line of credit at Silicon 

 

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ValleyBank, and $1.2 million funding available from a written commitment to invest up to $1.5 million from G.Ward Paxton, our CEO.  Based onprojections for continued growth in revenue and net income in the comingquarters, a commitment from the Company’s CEO to advance the Company up to anadditional $1.2 million in funding should it be necessary and $1.25 millionline of credit with borrowings available of $152,000 at December 31, 2009,we believe that our available credit line and available cash resources willprovide sufficient cash resources to finance our operations and expectedcapital expenditures for the next twelve months.  We expect tofund our operations through Company profits, our line of credit, borrowingsfrom the Company’s CEO, and possibly additional investments of private equityand debt, which, if we are able to obtain, will have the effect of diluting ourexisting common stockholders, perhaps significantly.  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.

 

Weintend to explore the possible acquisitions of businesses, products and technologiesthat are complementary to our existing business. We are continuing to identifyand prioritize additional security technologies, which we may wish to develop,either internally or through the licensing or acquisition of products fromthird parties. While we engage from time to time in discussions with respect topotential acquisitions, there can be no assurances that any such acquisitionswill be made or that we will be able to successfully integrate any acquiredbusiness. In order to finance such acquisitions, it may be necessary for us toraise additional funds through public or private financings. 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.

 

### **Contractual Obligations**

### ** **

Thefollowing table sets forth certain information concerning the futurecontractual obligations under our operating leases at December 31,2009.  We have no other significantcontractual obligations at December 31, 2009.

 

**Future minimum lease payments consisted of the following at December 31,2009 (in thousands):**

 
| 2010   |   | $      | 349    |   |
|--------|--------|--------|--------|--------|
| 2011   |   | 354    |   |
| 2012   |   | 368    |   |
|   |   |   |   |   |
|   |   | $      | 1,071  |   |

 

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

### ** **

Asof December 31, 2009, we did not have any significant off-balance sheetarrangements, as defined in Item 303(a)(4)(ii) of Regulation S-K.

 

**Item 9.****         ****Changes Inand Disagreements with Accountants on Accounting and Financial Disclosure.**

 

None.

 

**Item 9A(T).     ****Controls and Procedures**

 

Evaluation of Effectiveness of Disclosure Controlsand Procedures

 

TheCompany’s management, under the supervision and with the participation of theChief Executive Officer and Chief Financial Officer, conducted an evaluation ofthe effectiveness of the design and operation of the Company’s disclosurecontrols and procedures, as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based on this evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of the end of the periodcovered by this report, the Company’s disclosure controls and procedures areeffective to provide reasonable assurance that information required to bedisclosed by the Company in reports that it files or submits under the ExchangeAct is recorded, processed, summarized, and reported within the time periodsspecified in SEC rules and forms, and is accumulated and communicated tomanagement, including the Company’s principal executive officer and principalfinancial officer, as appropriate, to allow timely decisions regarding requireddisclosure.

 

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Management Report on Internal Control over FinancialReporting

 

TheCompany’s management is responsible for establishing and maintaining adequateinternal control over financial reporting (as defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) to provide reasonable assuranceregarding the reliability of the Company’s financial reporting and thepreparation of consolidated financial statements for external purposes inaccordance with U.S. generally accepted accounting principles.

 

TheCompany’s management, under the supervision and with the participation of theChief Executive Officer and Chief Financial Officer, conducted an evaluation ofthe effectiveness of the Company’s internal control over financial reportingbased on criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission.  Management’sevaluation included an assessment of elements such as the design and operatingeffectiveness of key financial reporting controls, process documentation,accounting policies, and the Company’s overall control environment.  Based on its evaluation, management concludedthat the Company’s internal control over financial reporting was effective asof the year ended December 31, 2009 to provide reasonable assuranceregarding the reliability of the Company’s financial reporting and thepreparation of consolidated financial statements for external reportingpurposes in accordance with U.S. generally accepted accounting principles.  The Company reviewed the results ofmanagement’s assessment with the Audit Committee of the Board of Directors.

 

ThisAnnual Report does not include an attestation report of the Company’sregistered public accounting firm regarding internal control over financialreporting.  Management’s report was notsubject to attestation by the Company’s registered public accounting firmpursuant to temporary rules of the Securities and Exchange Commission thatpermit the Company to provide only management’s report in this AnnualReport.  This report shall not be deemedto be filed for purposes of Section 18 of the Exchange Act or otherwisesubject to the liabilities of that section, and is not incorporated byreference into any filing of the Company, whether made before or after the datehereof, regardless of any general incorporation language in such filing.

 

Inherent Limitations on Effectiveness of Controls

 

TheCompany’s management, including the Chief Executive Officer and Chief FinancialOfficer, does not expect that the Company’s disclosure controls or internalcontrol over financial reporting will prevent or detect all error and allfraud.  A control system, no matter howwell designed and operated, can provide only reasonable, not absolute, assurancethat the control system’s objectives will be met.  The design of a control system must reflectthe fact that there are resource constraints, and the benefits of controls mustbe considered relative to their costs.  Further,because of the inherent limitations in all control systems, no evaluation ofcontrols can provide absolute assurance that misstatements due to error orfraud will not occur or that all control issues and instances of fraud, if any,have been detected.  The design of anysystem of controls is based in part on certain assumptions about the likelihoodof future events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions.  Projections of any evaluation of the effectivenessof controls to future periods are subject to risks.  Over time, controls may become inadequatebecause of changes in conditions or deterioration in the degree of compliancewith policies or procedures.

 

Changes in Internal Controlover Financial Reporting

 

During the year ended December 31, 2009, therewere no changes in our internal control over financial reporting (as defined inRules 13a-15(f) and 15d-15(f) under the Exchange Act) that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Item 9B.****      ****OtherInformation**

 

Notapplicable.

 

**PART III**

 

Certaininformation required by Part III is omitted from this Form 10-Kbecause we will file a definitive Proxy Statement for our 2010 annualmeeting of stockholders pursuant to Regulation 14A (the “Proxy Statement”)no later than 120 days after the end of the fiscal year covered by this Form 10-K,and certain information to be included therein is incorporated herein byreference.

 

**Item 10.****       ****Directors,Executive Officers and Corporate Governance.**

 

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

 

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**Item 11.****       ****ExecutiveCompensation.**

 

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

 

**Item 12.****       ****SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.**

 

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

 

**Item 13.****       ****CertainRelationships and Related Transactions, and Director Independence.**

 

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

 

**Item 14.****       ****PrincipalAccounting Fees and Services.**

 

The information called for by this item isincorporated herein by reference to the Proxy Statement.

 

**Item 15.****       ****Exhibitsand Financial Statement Schedules.**

 

(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 |
|-----------------------------------------------------------------------------------------------------------------------|-----|
| Report  of Independent Registered Public Accounting Firm                                                              | F-2 |
| Consolidated  Balance Sheets at December 31, 2009 and 2008                                                       | F-3 |
| Consolidated  Statements of Operations for the years ended December 31, 2009 and 2008                            | F-4 |
| Consolidated Statements of Changes in Stockholders’  Deficit for the years ended December 31, 2009 and 2008 | F-5 |
| Consolidated Statements of Cash Flows for the years  ended December 31, 2009 and 2008                            | F-6 |
| Notes to Consolidated Financial Statements                                                                            | F-7 |

 

(b)**          ****Exhibits**

 

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

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

 

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|      |   | Stonegate Securities, Inc.  on December 2, 2005                                                                                                                                                       |
|-----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.2(24)  |   | 1995  Stock Option Plan of the Registrant, as amended                                                                                                                                                           |
| 10.3(1)   |   | Form of  Indemnification Agreement                                                                                                                                                                         |
| 10.4(2)   |   | 1995  Non-Employee Directors Stock Option Plan of the Registrant (amended and  restated as of January 10, 2002)                                                                                            |
| 10.5(9)   |   | Lease  Agreement between CalWest Industrial Holdings Texas, L.P. and Intrusion Inc.                                                                                                                             |
| 10.6(8)   |   | Securities  Purchase Agreement dated as of March 25, 2004, by and among the  Registrant and the purchasers listed on Exhibit A thereto                                                                |
| 10.7(4)   |   | Amended  and Restated 401(k) Savings Plan of the Registrant                                                                                                                                                |
| 10.8(4)   |   | 1997  Employee Stock Purchase Plan of the Registrant, as amended January 17,  2001                                                                                                                         |
| 10.9(6)   |   | Intrusion  Inc. 401(k) Savings Plan Summary of Material Modifications                                                                                                                                      |
| 10.10(12) |   | 2005 Stock Incentive Plan of the  Registrant (amended and restated as of May 30, 2007)                                                                                                                     |
| 10.10(23) |   | Amended 2005 Stock Incentive Plan  of the Registrant                                                                                                                                                            |
| 10.11(12) |   | Form of Notice of Grant of  Stock Option                                                                                                                                                                   |
| 10.12(12) |   | Form of Stock Option  Agreement                                                                                                                                                                            |
| 10.13(12) |   | Form of Stock Issuance  Agreement                                                                                                                                                                          |
| 10.14(12) |   | Form of Notice of Grant of  Non-Employee Director Automatic Stock Option (Initial Grant)                                                                                                                   |
| 10.15(12) |   | Form of Notice of Grant of  Non-Employee Director Automatic Stock Option (Annual Grant)                                                                                                                    |
| 10.16(12) |   | Form of Automatic Stock  Option Agreement                                                                                                                                                                  |
| 10.17(10) |   | Securities  Purchase Agreement dated as of March 28, 2005, by and among the  Registrant and the investors listed on Exhibit A thereto                                                                 |
| 10.18(11) |   | Securities  Purchase Agreement dated as of December 2, 2005, by and among the  Registrant and the investors listed on Exhibit A thereto                                                               |
| 10.19(14) |   | Loan and Security Agreement dated  as of March 29, 2006, by and between the Registrant and Silicon Valley  Bank (extended on March 28, 2008)                                                          |
| 10.20(14) |   | Intellectual Property Security  Agreement dated as of March 29, 2006, by and between the Registrant and  Silicon Valley Bank                                                                               |
| 10.21(15) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated December 28, 2006.                                                                          |
| 10.21(15) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and Michael L. Paxton,  dated December 28, 2006.                                                                       |
| 10.21(16) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated March 15, 2007.                                                                             |
| 10.21(16) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and Michael L. Paxton,  dated March 15, 2007.                                                                          |
| 10.21(17) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated June 27, 2007.                                                                              |
| 10.21(17) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and Michael L. Paxton,  dated June 27, 2007.                                                                           |
| 10.21(18) |   | Subscription and Investment  Representation Agreement by and between Intrusion Inc. and G. Ward Paxton,  dated September 26, 2007.                                                                         |
| 10.21(19) |   | Promissory Note dated as of  January 30, 2008, by and between the Registrant and G. Ward Paxton                                                                                                            |
| 10.22(20) |   | Amended and Restated Loan and  Security Agreement dated as of June 30, 2008, by and between the  Registrant and Silicon Valley Bank                                                                        |
| 10.23(21) |   | Intellectual Property Security Agreement dated as of  June 30, 2008, by and between the Registrant and Silicon Valley Bank                                                                                 |
| 10.24(26) |   | First Amendment to  Lease, executed on September 11, 2009, by and between Intrusion Inc. and  Walton CWTX Corporate Place 87, LP                                                                           |
| 10.25(27) |   | Promissory Note dated as of  February 4, 2010, by and between the Registrant and G. Ward Paxton                                                                                                            |
| 10.26(27) |   | Capital Contribution  Agreement by G. Ward Paxton dated February 4, 2010                                                                                                                                   |
| 16.1(25)  |   | Letter of KBA Group LLP  dated June 5, 2009                                                                                                                                                                |
| 21(5)     |   | List of Subsidiaries of  Registrant                                                                                                                                                                             |
| 23.1(27)  |   | Consent  of KBA Group LLP, Independent Registered Public Accounting Firm                                                                                                                                        |
| 23.2(27)  |   | Consent  of Whitley Penn LLP, Independent Registered Public Accounting Firm                                                                                                                                     |
| 31.1(27)  |   | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) of the  Exchange Act                                                                                                             |
| 31.2(27)  |   | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) of the  Exchange Act                                                                                                             |
| 32.1(27)  |   | 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(27)  |   | 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 |

 

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----

(1)           Filed as an Exhibit in the Registrant’sRegistration Statement on Form S-1, as amended (File No. 33-6899),which was declared effective on May 21, 1992, by the Securities andExchange Commission, which Exhibit is incorporated herein by reference.

 

(2)           Filed as an Exhibit to the Registrant’sDefinitive Proxy Statement on Schedule 14A in connection with thesolicitation of proxies for its 2002 Annual Meeting of Stockholders, which Exhibit isincorporated herein by reference.

 

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

 

(4)           Filed as an Exhibit to the Registrant’s AnnualReport on Form 10-K, for the fiscal year ended December 31, 2000.

 

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

 

(6)           Filed as an Exhibit to the Registrant’sQuarterly Report on Form 10-Q for the quarter ended March 31, 2002,which Exhibit is incorporated herein by reference.

 

(7)           Filed as an Exhibit to the Registrant’sDefinitive Proxy Statement on Schedule 14A in connection with thesolicitation of proxies for its Special Meeting of Stockholders held March 18,2004, which Exhibit is incorporated herein by reference.

 

(8)           Filed as an Exhibit to the Registrant’s CurrentReport on Form 8-K dated March 26, 2004 (as amended), which Exhibit isincorporated by reference.

 

(9)           Filed as an Exhibit to the Registrant’s AnnualReport on Form 10-K for the fiscal year ended December 31, 2003 (asamended), which Exhibit is incorporated herein by reference.

 

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

 

(11)         Filed as an Exhibit to the Registrant’s CurrentReport on Form 8-K dated December 6, 2005, which Exhibit isincorporated herein by reference.

 

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

 

(13)         Filed asan Exhibit to the Registrant’s Quarterly Report on Form 10-Q for thequarter ended September 30, 2004, which Exhibit is incorporatedherein by reference.

 

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

 

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

 

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

 

(17)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated June 28,2007, which Exhibit is incorporated herein by reference.

 

(18)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated September 27,2007, which Exhibit is incorporated herein by reference.

 

(19)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated January 31,2008, which Exhibit is incorporated herein by reference.

 

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(20)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated July 1,2008, which Exhibit is incorporated herein by reference.

 

(21)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated November 13,2008, which Exhibit is incorporated herein by reference.

 

(22)         Filed asan Exhibit to the Registrant’s Annual Report on Form 10-K for thefiscal year ended December 31, 2008, which Exhibit is incorporatedherein by reference.

 

(23)         Filed asAppendix A to the Registrant’s Definitive Proxy Statement on Schedule 14Ain connection with the solicitation of proxies for its 2009 Annual Meeting ofStockholders, which Appendix is incorporated herein by reference.

 

(24)         Filed as an Exhibit to the Registrant’sDefinitive Proxy Statement on Schedule 14A in connection with thesolicitation of proxies for its 1995 Annual Meeting of Stockholders, which Exhibit isincorporated herein by reference.

 

(25)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated June 5,2009, which Exhibit is incorporated herein by reference.

 

(26)         Filed asan Exhibit to the Registrant’s Current Report on Form 8-K dated September 16,2009, which Exhibit is incorporated herein by reference.

 

(27)         Filed herewith.

 

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 
| Dated:  March 29, 2010 | INTRUSION INC. |
|-----------------------------|---------------------|
|                        | (Registrant)        |
|                        |                |
|                        | By:                 | /s/ G. WARD PAXTON |   |
|                        |                | G. Ward Paxton |   |
|                        |                | *Chairman, President, and Chief Executive Officer* |   |
|                        |                | *(Principal Executive Officer)* |   |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.

 
| **Signature**          | ** ** | **Title**                                    | ** ** | **Date**            |
|------------------------|------------|----------------------------------------------|------------|---------------------|
|                   |       |                                         |       |                |
| /s/ G. WARD PAXTON     |       | Chairman, President,                         |       | March 29, 2010 |
| G. Ward Paxton         |       | Chief Executive Officer, and Director        |       |
|                   |       |                                         |       |                |
| /s/ T. JOE HEAD        |       | Vice Chairman, Vice President                |       | March 29, 2010 |
| T. Joe Head            |       | and Director                                 |       |
|                   |       |                                         |       |                |
| /s/ MICHAEL L. PAXTON  |       | Vice President, Chief Financial              |       | March 29, 2010 |
| Michael L. Paxton      |       | Officer, Treasurer and Secretary             |       |
|                   |       | (Principal Financial and Accounting Officer) |       |
|                   |       |                                         |       |                |
| /s/ JAMES F. GERO      |       | Director                                     |       | March 29, 2010 |
| James F. Gero          |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ J. FRED BUCY, JR.  |       | Director                                     |       | March 29, 2010 |
| J. Fred Bucy, Jr.      |       |                                         |       |                |
|                   |       |                                         |       |                |
| /s/ DONALD M. JOHNSTON |       | Director                                     |       | March 29, 2010 |
| Donald M. Johnston     |       |                                         |       |                |

 

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**ANNUAL REPORT ON FORM 10-K**

**ITEM 7**

**FINANCIAL STATEMENTS**

**YEARS ENDED DECEMBER 31, 2009 and 2008**

**INTRUSION INC.**

**RICHARDSON, TEXAS**

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

Tothe Board of Directors and Stockholders of

Intrusion Inc.

 

Wehave audited the accompanying consolidated balance sheet of Intrusion Inc.and subsidiaries, as of December 31, 2009, and the related consolidatedstatements of operations, changes in stockholders’ deficit, and cash flows forthe year then ended. These consolidated financial statements are the responsibilityof the Company’s management. Our responsibility is to express an opinion onthese consolidated financial statements based on our audit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit 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, an audit of its internal control over financialreporting.  An audit includesconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides 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, 2009, and theconsolidated results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates of America.

 

/s/Whitley Penn LLP

Dallas,Texas

March 29,2010

 

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

TheBoard of Directors and Stockholders of

Intrusion Inc.

 

Wehave audited the accompanying consolidated balance sheet of Intrusion Inc.and subsidiaries (the “Company”), as of December 31, 2008, and the relatedconsolidated statements of operations, changes in stockholders’ deficit, andcash flows for the year then ended. These consolidated financial statements arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these consolidated financial statements based on ouraudit.

 

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit 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 an audit of their internal control over financialreporting.  Our audit includedconsideration of internal control over financial reporting as a basis fordesigning audit procedures that are appropriate in the circumstances, but notfor the purpose of expressing an opinion on the effectiveness of the Company’sinternal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audit provides 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, 2008, and theconsolidated results of their operations and their cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates of America.

 

/s/KBA Group LLP

Dallas,Texas

March 27,2009

 

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**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

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

 
| ** **                                                                                                                 | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                 | ** ** | **2009**              | ** ** | **2008** | ** ** |
| **Assets**                                                                                                                 |       |                  |       |   |   |
| Current Assets:                                                                                                            |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                  |       | $                     | 519        |   | $ | 554 |   |
| Accounts receivable                                                                                                        |       | 351                   |       | 341 |   |
| Inventories, net                                                                                                           |       | 7                     |       | 20 |   |
| Prepaid expenses                                                                                                           |       | 68                    |       | 56 |   |
| Total current assets                                                                                                       |       | 945                   |       | 971 |   |
| Property and Equipment:                                                                                                    |       |                  |       |   |   |
| Equipment                                                                                                                  |       | 566                   |       | 509 |   |
| Furniture and fixtures                                                                                                     |       | 34                    |       | 34 |   |
| Leasehold improvements                                                                                                     |       | 101                   |       | 101 |   |
|                                                                                                                       |       | 701                   |       | 644 |   |
| Accumulated depreciation  and amortization                                                                                 |       | (555                  | )          | (475 | ) |
|                                                                                                                       |       | 146                   |       | 169 |   |
| Other assets                                                                                                               |       | 39                    |       | 39 |   |
| **TOTAL ASSETS**                                                                                                           |       | $                     | 1,130      |   | $ | 1,179 |   |
| ** **                                                                                                                 |       |                  |       |   |   |
| **Liabilities and  Stockholders’ Deficit**                                                                            |       |                  |       |   |   |
| Current Liabilities:                                                                                                       |       |                  |       |   |   |
| Loan payable to officer                                                                                                    |       | $                     | —     |   | $ | 480 |   |
| Accounts payable, trade                                                                                                    |       | 202                   |       | 204 |   |
| Accrued expenses                                                                                                           |       | 472                   |       | 334 |   |
| Dividends payable                                                                                                          |       | 360                   |       | 187 |   |
| Deferred revenue                                                                                                           |       | 93                    |       | 1,090 |   |
| Total current liabilities                                                                                                  |       | 1,127                 |       | 2,295 |   |
|                                                                                                                       |       |                  |       |   |   |
| Loan payable to officer                                                                                                    |       | 970                   |       | — |   |
|                                                                                                                       |       |                  |       |   |   |
| Commitments and  Contingencies                                                                                             |       |                  |       |   |   |
|                                                                                                                       |       |                  |       |   |   |
| Stockholders’ Deficit:                                                                                                |       |                  |       |   |   |
| Preferred stock, $0.01 par value:                                                                                          |       |                  |       |   |   |
| Authorized shares — 5,000                                                                                             |       |                  |       |   |   |
| Series 1 shares  issued and outstanding — 220 in 2009 and 260 in 2008   Liquidation preference of $1,240 in 2009 |       | 778                   |       | 918 |   |
| Series 2 shares  issued and outstanding — 460  Liquidation preference of $1,270 in 2009                          |       | 724                   |       | 724 |   |
| Series 3 shares  issued and outstanding — 354  Liquidation preference of $853 in 2009                            |       | 504                   |       | 504 |   |
| Common stock, $0.01 par value:                                                                                             |       |                  |       |   |   |
| Authorized shares — 80,000                                                                                            |       |                  |       |   |   |
| Issued shares — 11,715 in 2009 and 11,648 in 2008  Outstanding shares — 11,705 in 2009 and 11,638 in 2008        |       | 117                   |       | 116 |   |
| Common stock held in  treasury, at cost—10 shares                                                                     |       | (362                  | )          | (362 | ) |
| Additional paid-in-capital                                                                                                 |       | 55,545                |       | 55,443 |   |
| Accumulated deficit                                                                                                        |       | (58,094               | )          | (58,280 | ) |
| Accumulated other  comprehensive loss                                                                                      |       | (179                  | )          | (179 | ) |
| Total stockholders’  deficit                                                                                          |       | (967                  | )          | (1,116 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ DEFICIT**                                                                      |       | $                     | 1,130      |   | $ | 1,179 |   |

 

See accompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

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

 
| ** **                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                          | ** ** | **2009**                         | ** ** | **2008** | ** ** |
|                                                                                |       |                             |       |   |   |
| Net product revenue                                                                 |       | $                                | 4,642      |   | $ | 3,566 |   |
| Net customer support and  maintenance revenue                                       |       | 278                              |       | 574 |   |
| Total revenue                                                                       |       | 4,920                            |       | 4,140 |   |
| Cost of product revenue                                                             |       | 1,648                            |       | 1,352 |   |
| Cost of customer support  and maintenance revenue                                   |       | 14                               |       | 23 |   |
| Total cost of revenue                                                               |       | 1,662                            |       | 1,375 |   |
| Gross profit                                                                        |       | 3,258                            |       | 2,765 |   |
| Operating expenses:                                                                 |       |                             |       |   |   |
| Sales and marketing                                                                 |       | 922                              |       | 1,407 |   |
| Research and development                                                            |       | 1,106                            |       | 1,136 |   |
| General and administrative                                                          |       | 980                              |       | 968 |   |
| Operating income (loss)                                                             |       | 250                              |       | (746 | ) |
| Interest income (expense),  net                                                     |       | (64                              | )          | (62 | ) |
| Income (loss) from  operations before income taxes                                  |       | 186                              |       | (808 | ) |
| Income tax provision                                                                |       | —                           |       | — |   |
| Net income (loss)                                                                   |       | 186                              |       | (808 | ) |
| Preferred stock dividends  accrued                                                  |       | (154                             | )          | (161 | ) |
| Net income (loss)  attributable to common stockholders                              |       | $                                | 32         |   | $ | (969 | ) |
|                                                                                |       |                             |       |   |   |
| Net income (loss) per  share attributable to common stockholders, basic and diluted |       | $                                | 0.00       |   | $ | (0.08 | ) |
|                                                                                |       |                             |       |   |   |
| Weighted average common  shares outstanding:  Basic                                 |       | 11,678                           |       | 11,638 |   |
| Diluted                                                                             |       | 12,873                           |       | 11,638 |   |

 

See accompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CHANGES IN STOCKHOLDERS’ DEFICIT**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                   | ** ** | **2009**                         | ** ** | **2008** | ** ** |
| **NUMBER OF PREFERRED  SHARES—ISSUED AND OUTSTANDING**                  |       |                             |       |   |   |
| Balance, beginning of year                                                   |       | 1,074                            |       | 1,074 |   |
| Conversion of preferred  shares to common shares                             |       | (40                              | )          | — |   |
| Balance, end of year                                                         |       | 1,034                            |       | 1,074 |   |
| **PREFERRED STOCK**                                                          |       |                             |       |   |   |
| Balance, beginning of year                                                   |       | $                                | 2,146      |   | $ | 2,146 |   |
| Conversion of preferred  shares to common shares                             |       | (140                             | )          | — |   |
| Balance, end of year                                                         |       | $                                | 2,006      |   | $ | 2,146 |   |
| **NUMBER OF COMMON SHARES—ISSUED**                                      |       |                             |       |   |   |
| Balance, beginning of year                                                   |       | 11,638                           |       | 11,638 |   |
| Issuance of common shares  under private placements                          |       | 3                                |       | — |   |
| Conversion of preferred  shares to common shares                             |       | 63                               |       | — |   |
| Balance, end of year                                                         |       | 11,704                           |       | 11,638 |   |
| **COMMON STOCK**                                                             |       |                             |       |   |   |
| Balance, beginning of year                                                   |       | $                                | 116        |   | $ | 116 |   |
| Issuance of common shares  under private placement                           |       | 1                                |       | — |   |
| Balance, end of year                                                         |       | $                                | 117        |   | $ | 116 |   |
| **TREASURY SHARES**                                                          |       |                             |       |   |   |
| Balance, beginning of year  and end of year                                  |       | $                                | (362       | ) | $ | (362 | ) |
| **ADDITIONAL PAID-IN-CAPITAL**                                               |       |                             |       |   |   |
| Balance, beginning of year                                                   |       | $                                | 55,443     |   | $ | 55,527 |   |
| Stock-based compensation                                                     |       | 107                              |       | 75 |   |
| Conversion of preferred  shares to common shares                             |       | 140                              |       | — |   |
| Issuance of common shares  under private placement                           |       | 1                                |       | — |   |
| Preferred stock dividends  declared, net of waived penalties by shareholders |       | (146                             | )          | (159 | ) |
| Balance, end of year                                                         |       | $                                | 55,545     |   | $ | 55,443 |   |
| **ACCUMULATED DEFICIT**                                                      |       |                             |       |   |   |
| Balance, beginning of year                                                   |       | $                                | (58,280    | ) | $ | (57,472 | ) |
| Net income (loss)                                                            |       | 186                              |       | (808 | ) |
| Balance, end of year                                                         |       | $                                | (58,094    | ) | $ | (58,280 | ) |
| **ACCUMULATED OTHER COMPREHENSIVE  LOSS**                                    |       |                             |       |   |   |
| Balance, beginning of year  and end of year                                  |       | $                                | (179       | ) | $ | (179 | ) |
| **TOTAL STOCKHOLDERS’ DEFICIT**                                         |       | $                                | (967       | ) | $ | (1,116 | ) |

 

See accompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                            | ** ** | **Year  Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                            | ** ** | **2009**                          | ** ** | **2008** | ** ** |
| Operating Activities:                                                                 |       |                              |       |   |   |
| Net income (loss)                                                                     |       | $                                 | 186        |   | $ | (808 | ) |
| Adjustments  to reconcile net income (loss) to net cash used in operating activities: |       |                              |       |   |   |
| Depreciation and  amortization                                                        |       | 81                                |       | 50 |   |
| Provision for doubtful  accounts                                                      |       | —                            |       | (40 | ) |
| Stock-based compensation                                                              |       | 107                               |       | 75 |   |
| Changes  in operating assets and liabilities:                                         |       |                              |       |   |   |
| Accounts receivable                                                                   |       | (10                               | )          | (191 | ) |
| Inventories                                                                           |       | 13                                |       | 127 |   |
| Prepaid expenses and other  assets                                                    |       | (12                               | )          | 19 |   |
| Accounts payable, accrued  expenses and other current liabilities                     |       | 164                               |       | (122 | ) |
| Deferred revenue                                                                      |       | (998                              | )          | 778 |   |
| Net cash used in operating  activities                                                |       | (469                              | )          | (112 | ) |
| Investing Activities:                                                                 |       |                              |       |   |   |
| Purchases of property and  equipment                                                  |       | (57                               | )          | (76 | ) |
| Financing Activities:                                                                 |       |                              |       |   |   |
| Net payments on line of  credit                                                       |       | —                            |       | (100 | ) |
| Borrowings from officer                                                               |       | 490                               |       | 1,180 |   |
| Payments on loans from  officer                                                       |       | —                            |       | (700 | ) |
| Proceeds from issuance of  common stock, net                                          |       | 1                                 |       | — |   |
| Net cash provided by  financing activities                                            |       | 491                               |       | 380 |   |
| Net increase (decrease) in  cash and cash equivalents                                 |       | (35                               | )          | 192 |   |
| Cash and cash equivalents  at beginning of year                                       |       | 554                               |       | 362 |   |
| Cash and cash equivalents  at end of year                                             |       | $                                 | 519        |   | $ | 554 |   |
|                                                                                  |       |                              |       |   |   |
| SUPPLEMENTAL  CASH FLOW INFORMATION:                                                  |       |                              |       |   |   |
| Interest paid                                                                         |       | $                                 | 25         |   | $ | 62 |   |
| Income taxes paid                                                                     |       | $                                 | —     |   | $ | — |   |
|                                                                                  |       |                              |       |   |   |
| SUPPLEMENTAL  DISCLOSURE OF NON CASH FINANCING ACTIVITIES:                            |       |                              |       |   |   |
| Preferred stock dividends  accrued                                                    |       | $                                 | 154        |   | $ | 161 |   |

 

See accompanying notes.

 

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**INTRUSION INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

We develop, market, and support a family of entityidentification, data mining, regulated information compliance, data privacyprotection and network intrusion prevention/detection products.  Our product families include:  TraceCop for identity identification, Savantfor data mining, Compliance Commander for regulated information and dataprivacy protection, and 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.

 

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-user customersinclude banks, credit unions, other financial institutions, U.S. federalgovernment entities, foreign government entities, hospitals and otherhealthcare providers. Essentially, our end-user can be defined as ‘any end-userrequiring network 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 sold, or otherwise disposed of, our networkingdivisions, which included our Essential Communications division and our localarea networking assets. On June 1, 2000, we changed our name from ODSNetworks, Inc. to Intrusion.com, Inc., and our ticker symbol fromODSI to INTZ to reflect our focus on intrusion prevention and detectionsolutions, along with information compliance and data privacy protectionproducts. On November 1, 2001, we changed our name 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 the “Company”, “we”, “us”, “our” or “Intrusion Inc.”refer to Intrusion Inc. and its subsidiaries.  Compliance CommanderTM, SecureNetTM and TraceCopTM areregistered trademarks of Intrusion Inc.

 

Asof December 31, 2009, we had cash and cash equivalents of approximately$519,000, down from approximately $554,000 as of December 31, 2008.  We generated net income of $379,000 in thelast quarter of 2009 and $186,000 net income for the year 2009 compared to anet loss for the year 2008 of $808,000. We used $469,000 of cash in operations in 2009 and operating cashoutflows may continue in 2010.  We areobligated to make payments of accrued dividends on all our outstanding sharesof preferred stock that will reduce our available cash resources.   As of December 31, 2009, in addition tocash and cash equivalents of $519,000, we had $152,000 in funding available underour $1.25 million line of credit at Silicon Valley Bank, and $1.2 millionfunding available from a written commitment to invest up to $1.5 million from G. Ward Paxton, ourCEO.  Based on projections forcontinued growth in revenue and net income in the coming quarters, a commitmentfrom the Company’s CEO to advance the Company up to an additional $1.2 millionin funding should it be necessary and $1.25 million line of credit withborrowings available of $152,000 at December 31, 2009, 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 throughCompany profits, our line of credit, borrowings from the Company’s CEO, andpossibly additional investments of private equity and debt, which, if we areable to obtain, will have the effect of diluting our existing commonstockholders, perhaps significantly.  Anyequity or debt financings, if available at all, may be on terms which are notfavorable to us and, in the case of equity financings, may result in dilutionto our stockholders.

 

**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.

 

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***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.

 

***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.  We do notbelieve that we are subject to any unusual financial risk with our bankingarrangements.  We have not experiencedany significant losses on our cash and cash equivalents.

 

Wesell our products to customers in diversified industries worldwide andperiodically have receivables from customers, primarily in North America,Europe and Asia. Fluctuations in currency exchange rates and adverse economicdevelopments in foreign countries could adversely affect the Company’soperating results.  We perform ongoingcredit evaluations of our customers’ financial condition and generally requireno collateral.  We maintain reserves forpotential credit losses, and such losses, in the aggregate, have historicallybeen minimal and have not exceeded management’s expectations.

 

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

 

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

 

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 an increase to a valuation allowance.  Balances that remain outstanding after wehave used reasonable collection efforts are written off through a charge to thevaluation allowance.

 

***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***

 

Equipmentand furniture and fixtures are stated at cost less accumulated depreciation anddepreciated on a straight-line basis over the estimated useful lives of theassets.  Such lives vary from 1 to 5years.  Leasehold improvements are statedat cost less accumulated amortization and are amortized on a straight-linebasis over the shorter of estimated useful lives of the assets or the remainingterms of the leases.   Such lives varyfrom 2 to 5 years.  Expenditures formajor renewals and betterments that extend the useful lives of property and equipmentare capitalized.  Repair and maintenancecosts are expensed as incurred. Depreciation and amortization expense totaledapproximately $81,000 and $50,000 for the years ended December 31, 2009and 2008, respectively.

 

***Long-Lived Assets***

 

Wereview long-lived assets, including property and equipment for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be held and 

 

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usedis measured by a comparison of the carrying amount of an asset to futureundiscounted cash flows to be generated by the asset.  If the carrying value exceeds the futureundiscounted cash flows, the assets are written down to fair value.  During the years ended December 31, 2009and 2008, there was no impairment of long-lived assets.

 

***Foreign Currency***

 

All assets andliabilities in the balance sheet of foreign subsidiaries whose functionalcurrency is other than the U.S. dollar are translated at year-end exchangerates.  All revenues and expenses in thestatement of operations, of these foreign subsidiaries, are translated ataverage exchange rates for the year. Translation gains and losses are not included in determining net lossbut are shown in accumulated other comprehensive loss in the stockholders’deficit section of the consolidated balance sheet.  Foreign currency transaction gains and lossesare included in determining net loss and were not significant.

 

***Accounting forStock Options***

 

Weaccount for stock options using the guidance in FASB ASC Topic 718, whichreplaces SFAS 123(R) and supersedes APB Opinion No. 25.  FASB ASC Topic 718 requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the financial statements based on their fair values.

 

Stock-based compensationexpense recognized in the statements of operations for the years ended 2009 and2008 is based on awards ultimately expected to vest, reduced by estimatedforfeitures.  FASB ASC Topic 718 requires forfeitures to be estimated atthe time of grant and revised, if necessary, in subsequent periods if actualforfeitures differ from those estimates.

 

**Valuation Assumptions**

 

Thefair values of option awards were estimated at the date of grant using aBlack-Scholes option-pricing model with the following assumptions for fiscalyears ending December 31, 2009 and 2008, respectively:

 
| ** **                              | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------------------|------------|----------|------------|----------|------------|
|                                    |       |     |       |     |       |
| Weighted average grant  date fair value |       | $0.26    |       | $0.17    |       |
| Weighted average  assumptions used:     |       |     |       |     |       |
| Expected dividend yield                 |       | 0.00     | %          | 0.00     | %          |
| Risk-free interest rate                 |       | 1.89     | %          | 2.64     | %          |
| Expected volatility                     |       | 163.80   | %          | 107.10   | %          |
| Expected life (in years)                |       | 4.90     |       | 5.00     |       |

 

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-free interestrate is based on the rates in effect on the grant date for U.S. Treasuryinstruments with maturities matching the relevant expected term of the award.

 

***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 dilutive common stock equivalentsoutstanding for the year.  Our common stock equivalents include allcommon stock issuable upon conversion of convertible preferred stock and theexercise of outstanding options and warrants. The aggregate number of common stock equivalents excluded from the lossper share calculation at December 31, 2009 and 2008 totaled 1,624,309 and4,219,138, respectively.  Common stockequivalents are included in the diluted loss per share for the years ended December 31,2009 and 2008 except in cases where the issuance would be anti-dilutive.

 

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***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.

 

Werecognize software revenue from the licensing of our software products inaccordance with FASB ASC Topic 605 whereby revenue from the licensing of ourproducts is not recognized until all four of the following have been met:i) execution of a written agreement; ii) delivery of the product hasoccurred; iii) the fee is fixed and determinable; andiv) collectability is probable. Bundled hardware and software productrevenue is recognized at time of delivery, as our licenses are not sold on asubscription basis.  In the case ofproduct sales, which include maintenance and customer support, a Vendor SpecificObjective Evidence analysis would be performed to appropriately determine theamount of revenue derived from each deliverable.  All of our product offering and serviceoffering market values are readily determined based on current and priorstand-alone sales.  We defer andrecognize maintenance and support revenue over the term of the contract period,which is generally one year.

 

Servicerevenue, primarily including maintenance, training and installation arerecognized upon delivery of the service and typically are unrelated to productsales.  To date, training andinstallation revenue has not been material. These revenues are included in net customer support and maintenancerevenues 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 and development costsare comprised primarily of salaries and related benefits expenses, contractlabor and prototype and other related expenses.

 

Softwaredevelopment costs are included in research and development and are expensed asincurred. FASB ASC Topic 350 requires that software development costs incurredsubsequent to reaching technological feasibility be capitalized, if material.If the process of developing a new product or major enhancement does notinclude a detailed program design, technological feasibility is determined onlyafter 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 andincome taxes. Actual results could differ from these estimates.

 

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***Income Taxes***

 

Deferred income taxes aredetermined using the liability method in accordance with FASB ASC 740, *Accounting for Income Taxes*. Deferred taxassets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases. Deferred taxassets and liabilities are measured using enacted tax rates expected to applyto taxable income in the years in which those temporary differences are expectedto be recovered or settled. The effect on deferred tax assets and liabilitiesof a change in tax rates is recognized in income in the period that includesthe enactment date. In addition, a valuation allowance is established to reduceany deferred tax asset for which it is determined that it is more likely thannot that some portion of the deferred tax asset will not be realized.

 

FASB ASC 740 creates asingle model to address accounting for uncertainty in tax positions byprescribing a minimum recognition threshold a tax position is required to meetbefore being recognized in the financial statements. FASB ASC 740 also providesguidance on derecognition, measurement, classification, interest and penalties,accounting in interim periods, disclosure and transition. There are nounrecognized tax benefits to disclose in the notes to the consolidatedfinancial statements.

 

***Reclassifications***

 

Certain 2008 amounts havebeen reclassified to conform to 2009 presentation.

 

***Recent Accounting Pronouncements***

 

In June 2009, theFASB issued SFAS 168, “The FASB Accounting Standards Codification and theHierarchy of Generally Accepted Accounting Principles,” currently within thescope of ASC 105-10. ASC 105-10 identifies the FASB Accounting StandardsCodification (the “Codification”) as the authoritative source of generallyaccepted accounting principles (“GAAP”) in the United States.  TheCodification did not change GAAP but reorganizes the literature.  Rules and interpretive releases of theSecurities and Exchange Commission under federal securities laws are alsosources of authoritative GAAP for Securities and Exchange Commissionregistrants. This guidance is effective for financial statements issued forinterim and annual periods ending after September 15, 2009 and the Companyadopted the provisions of this guidance as of September 30, 2009.  The Company’s adoption of this guidance didnot have a material impact on its financial statements.

 

In October 2009, theFASB issued Topic 605—Revenue Recognition (EITF 08-1,  *Multiple-Deliverable Revenue Arrangements,*(amendments to FASB Topic 605, *RevenueRecognition*)) and Topic 985—Software (EITF 09-3, *Certain Arrangements That Include Software Elements*,(amendments to FASB Topic 985, *Software*)).Topic 605—Revenue Recognition requires entities to allocate revenue in anarrangement using estimated selling prices of the delivered goods and servicesbased on a selling price hierarchy. The amendments eliminate the residualmethod of revenue allocation and require revenue to be allocated using therelative selling price method. Topic 985—Software removes tangible productsfrom the scope of software revenue guidance and provides guidance ondetermining whether software deliverables in an arrangement that includes atangible product are covered by the scope of the software revenue guidance.Topic 605—Revenue Recognition and Topic 985—Software should be applied on aprospective basis for revenue arrangements entered into or materially modifiedin fiscal years beginning on or after June 15, 2010, with early adoptionpermitted. The Company is currently evaluating the impact of Topic 605—RevenueRecognition and Topic 985—Software on its consolidated financial statements.

 

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

 

**Inventories**

 
| ** **                      | ** ** | **December 31,** | ** ** |
|---------------------------------|------------|-----------------------|------------|
| ** **                      | ** ** | **2009**              | ** ** | **2008** | ** ** |
| Finished products               |       | $                     | 5          |   | $ | 67 |   |
| Demonstration systems           |       | 2                     |       | 5 |   |
| Reserve for obsolete  inventory |       | —                |       | (52 | ) |
|                            |       | $                     | 7          |   | $ | 20 |   |

 

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**Accrued Expenses**

 
| ** **               | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2009**              | ** ** | **2008** | ** ** |
|                     |       |                  |       |   |   |
| Accrued payroll          |       | $                     | 132        |   | $ | 111 |   |
| Accrued vacation         |       | 177                   |       | 172 |   |
| Accrued property taxes   |       | —                |       | 12 |   |
| Accrued warranty expense |       | 3                     |       | 3 |   |
| Accrued sales taxes      |       | 2                     |       | 1 |   |
| Accrued interest         |       | 39                    |       | — |   |
| Deferred rent            |       | 89                    |       | — |   |
| Other                    |       | 30                    |       | 35 |   |
|                     |       | $                     | 472        |   | $ | 334 |   |
|                          |            |                       |            |  |  |  |  |  |  |

 

**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 December 2012.  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 2011.

 

TheCompany’s lease for the headquarters facility contains escalationprovisions.  The Company records rentexpense on facility leases on a straight-line basis.  Real estate taxes, insurance and maintenanceexpenses are the obligations of the Company. Rent expense totaled approximately $354,000 and $458,000 for the yearsended December 31, 2009 and 2008, respectively.

 

Futureminimum lease payments consisted of the following at December 31, 2009 (inthousands):

 
| 2010   |   | $      | 349    |   |
|--------|--------|--------|--------|--------|
| 2011   |   | 354    |   |
| 2012   |   | 368    |   |
|   |   |   |   |
|   |   | $      | 1,071  |   |

 

***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, 2009.

 

**5. Employee Benefit Plan**

 

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

 

Wehave 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.  Wematch employee contributions at the rate of $0.25 

 

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pereach $1.00 of contribution on the first 4% of compensation.  Matching contributions to the Plan wereapproximately $19,000 for each of the years ended December 31, 2009 and2008.

 

**6. Line of Credit**

 

OnMarch 29, 2006, we entered into a Loan and Security Agreement with SiliconValley Bank (“SVB”) to establish a $1.0 million line of credit with SVB (the “2006Credit Line”).  On June 30, 2008, weentered into an Amended and Restated Loan and Security Agreement with SVB to,among other things, replace the 2006 Credit Line with a $2.5 million line ofcredit (the “2008 Credit Line”).  On June 28,2009, we entered into the First Amendment to the Amended and Restated Loan andSecurity Agreement (as amended, the “Loan Agreement”) with SVB to replace the2008 Credit Line with a $1.25 million line of credit (the “Current Line ofCredit”).  Our obligations under the LoanAgreement are secured by substantially all of our assets, including all of ourintellectual property.  In addition, G.Ward Paxton, the Company’s Chief Executive Officer, has established a GuarantyAgreement with SVB for all outstanding balances under the Current Line ofCredit.  Borrowings under the CurrentLine of Credit are based on advances (each an “Advance”) against certain of ouraccounts receivable that are approved by SVB (each an “Eligible Account”).  SVB may make an Advance of up to eightypercent (80%) of each Eligible Account, or such other percentage SVB maydetermine in its sole discretion.  EachAdvance is subject to a finance charge calculated as a daily rate that is basedon a 360-day annual rate of the greater of the prime rate or 5.25%, plus 2.0%.  Finance charges are payable at the same timeits related Advance is due.  Each Advanceis also subject to a monthly collateral handling fee of 0.5% of all outstandingAdvances, depending on certain qualifying financial factors specified in theLoan Agreement.  The collateral handlingfee is payable at the same time its related Advance is due.  Each Advance must be repaid at the earliestof (a) the date that the Eligible Account related to the Advance is paid, (b) thedate the Eligible Account is no longer eligible under the Loan Agreement, or (c) thedate on which any “Adjustment” (as defined in the Loan Agreement) is assertedto the Eligible Account.  On June 27,2010, the Loan Agreement terminates and all outstanding Advances, accrued butunpaid finance charges, outstanding collateral handing fees, and other amountsbecome due under the Loan Agreement and related documents.  We have certain non-financial and financialcovenants, including a liquidity coverage ratio and a rolling EBITDAcomputation, as defined in the Loan Agreement. We have no borrowings outstanding under the Current Line of Credit as ofDecember 31, 2009 and had borrowings available of $152,000.

 

**7. Borrowings from Officer**

 

On January 30,2008, and extended on October 24, 2008, March 19, 2009 and February 4,2010, the Company entered into an unsecured revolving promissory note to borrowup to $700,000 from G. Ward Paxton, the Company’s Chairman, President and ChiefExecutive Officer.  Under the terms ofthe note, the Company may borrow, repay and reborrow on the loan as needed upto an outstanding principal balance due of $700,000 at any given time.

 

OnMarch 20, 2008 and extended on November 7, 2008 and February 4,2010, we received a writtencommitment from our Chief Executive Officer to invest up to an additional$1,500,000 in the Company until March 2011, should such funding berequired by the Company, on terms and conditions identical to those describedabove on the $700,000 note.

 

Amountsborrowed from this officer accrue interest at a floating rate per annum equalto SVB’s prime rate plus 1% (5% at December 31, 2009).  All outstanding borrowings and accrued butunpaid interest is due on March 31, 2011. As of December 31, 2009 the borrowings outstanding totaled $970,000and accrued interest totaled $39,000. The Company paid approximately $52,000 in interest to the officer during2008 and none during 2009.

 

**8. 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, 2009 and 2008. Significant components of our deferred tax assets as of December 31,2009 and 2008 are as follows (in thousands):

 

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| ** **                                                | ** ** | **December 31** | ** ** |
|-----------------------------------------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **2009**             | ** ** | **2008** | ** ** |
| ** **                                                | ** ** | ** **           | ** ** | ** ** | ** ** |
| Net operating loss  carryforwards                         |       | $                    | 29,650     |   | $ | 29,510 |   |
| Net operating loss  carryforwards of foreign subsidiaries |       | 374                  |       | 374 |   |
| Book over tax depreciation                                |       | 4                    |       | 84 |   |
| Intangible assets                                         |       | 400                  |       | 579 |   |
| Stock-based compensation  expense                         |       | 273                  |       | 234 |   |
| Other                                                     |       | 132                  |       | 131 |   |
| Deferred tax assets                                       |       | 30,833               |       | 30,912 |   |
| Valuation allowance for  deferred tax assets              |       | (30,833              | )          | (30,912 | ) |
| 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 future benefitsrelated to the deferred tax assets is dependent on many factors, including theCompany’s ability to generate taxable income within the near to mediumterm.  Management has considered thesefactors in determining the valuation allowance for 2009 and 2008.

 

Thedifferences between the provision for income taxes and income taxes computedusing the federal statutory rate for the years ended December 31, 2009 and2008 are as follows (in thousands):

 

| ** **                                               | ** ** | **2009** | ** ** | **2008** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                     |       |     |       |     |       |
| Reconciliation of income tax benefit to statutory  rate: |       |     |       |     |       |
| Income tax benefit at  statutory rate                    |       | $        | 63         |     | $          | (275 | ) |
| State income taxes, net of  federal income tax benefit   |       | (6       | )          | (21      | )          |
| Expiration of foreign tax  credits                       |       | —   |       | 1,083    |       |
| Changes in state net  operating loss carryforwards       |       | 12       |       | 98       |       |
| Permanent differences                                    |       | 3        |       | —   |       |
| Change in valuation  allowance                           |       | (79      | )     | (890     | )          |
| Other                                                    |       | 7        |       | 5        |       |
|                                                     |       | $        | —     |     | $          | — |   |

 

AtDecember 31, 2009, we had federal net operating loss carryforwards ofapproximately $85.7 million for income tax purposes that began to expire in2009 and are subject to the ownership change limitations under Internal RevenueCode Section 382. We also had approximately $6 million of state netoperating loss carryforwards that begin to expire in 2017.

 

**9. Stock Options**

 

AtDecember 31, 2009, 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. In 2000 and 2001, our stockholdersapproved to increase the overall number of shares available for issuancepursuant to the plan to a total of 825,000 shares of common stock. The 1995Plan provides for the issuance of both non-qualified and incentive stockoptions to our employees, officers, and employee-directors. The 1995 Planexpired by its terms on March 21, 2005 and no options were available forfuture issuance after the expiration.  AtDecember 31, 2009, 67,365 employee options have been exercised andemployee options to purchase a total of 210,000 shares of common stock areoutstanding.

 

In 1995, we adopted the 1995 Non-Employee DirectorStock Option Plan (the “1995 Non-Employee Director Plan”).  The 1995 Non-Employee Director Plan providedfor the issuance of non-qualified stock options to non-employee directors. The1995 Non-Employee Director Plan was amended in April 2002 to increase thenumber of shares available for issuance to 65,000 from 40,000 shares. The1995 Non-Employee Director Plan expired by its terms on March 21, 2005 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, 2009. A total of 62,500 options have beengranted to directors pursuant to the 1995 Non-Employee Director Plan, of which,30,000 have been

 

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cancelled.

 

On March 17, 2005, the Board approved the 2005Stock Incentive Plan (the “2005 Plan”), which was approved by the stockholderson June 14, 2005.  The 2005 Planserves as a replacement for the 1995 Non-Employee Director Plan and the 1995Option Plan which expired by their terms on March 21, 2005.  The approval of the 2005 Plan had no effect onthe 1995 Plans or any options granted pursuant to either plan.  All options will continue with their existingterms and will be subject to the 1995 Non-Employee Director Plan or the 1995Plan, as applicable.  Further, theCompany will not be able to re-issue any option which is cancelled orterminated under the 1995 Non-Employee Director Plan or the 1995 OptionPlan.  The 2005 Plan provided for theissuance of up to 750,000 shares of common stock upon exercise of optionsgranted pursuant to the 2005 Plan.  On May 30,2007, the Stockholders approved an Amendment to the 2005 Plan that increasedthis amount by 750,000 for a total of 1,500,000 shares of common stock that maybe issued upon the exercise of options granted pursuant to the 2005 Plan. On May 29,2008 and May 21, 2009, the Stockholders approved an increase of 500,000shares respectively of common stock that may be issued pursuant to the 2005Plan for a total of 2,500,000 shares.

 

The 2005 Plan consists of three (3) separateequity incentive programs: the Discretionary Option Grant Program; the StockIssuance Program; and the Automatic Option Grant Program for non-employee Boardmembers.  Officers and employees,non-employee Board members and independent contractors are eligible toparticipate in the Discretionary Option Grant and Stock Issuance Programs.  Participation in the Automatic Option GrantProgram is limited to non-employee members of the Board.  Each non-employee Board member will receivean option grant for 10,000 shares of common stock upon initial election orappointment to the Board, provided that individual has not previously beenemployed by the Company in the preceding six (6) months.  In addition, on the date of each annualstockholders meeting, each Board member will automatically be granted an optionto purchase 5,000 shares of common stock, provided he or she has served as anon-employee Board member for at least six (6) months.  At December 31, 2009, 3,001 options havebeen exercised and options to purchase a total of 1,667,499 shares ofcommon stock are outstanding.  A total of2,013,500 options have been granted under the 2005 Plan, of which 343,000 havebeen cancelled and options for 829,500 shares remain available for futuregrant.  No shares have been issuedpursuant to the Stock 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 total 4,810,604 shares at December 31, 2009 asfollows, in thousands:

 
| **(In  thousands)**              | ** ** | **Common  Shares  Reserved for FutureIssuance** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|
|                             |       |                                            |       |
| Preferred Stock                  |       | 1,164                                           |       |
| Warrants                         |       | 903                                             |       |
| 1995 Plan                        |       | 210                                             |       |
| 1995 Non-Employee Director  Plan |       | 33                                              |       |
| 2005 Plan                        |       | 2,497                                           |       |
| Total                            |       | 4,807                                           |       |

 

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, 2009 and 2008 is as follows:

 

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| ** **                          | ** ** | **2009**                                | ** ** | **2008**                               | ** ** |
|-------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **Number  of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  of  Options (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                          | ** ** | ** **                              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Outstanding at beginning  of year   |       | 1,468                                   |       | $                                      | 1.66       |   | 1,141 |   | $ | 2.30 |   |
| Granted at price = market  value    |       | 346                                     |       | .29                                    |       | 345 |   | .22 |   |
| Granted at price >  market value |       | 150                                     |       | .31                                    |       | 100    |    | .24 |   |
| Exercised                           |       | (3                                      | )          | .26                                    |       | — |   | — |   |
| Forfeited                           |       | (10                                     | )          | .25                                    |       | (60 | ) | .69 |   |
| Expired                             |       | (38                                     | )          | 1.83                                   |       | (58 | ) | 4.15 |   |
|                                |       |                                    |       |                                   |       |   |   |   |   |
| Outstanding at end of year          |       | 1,913                                   |       | $                                      | 1.31       |   | 1,468 |   | $ | 1.66 |   |
| Options exercisable at end  of year |       | 1,055                                   |       | $                                      | 2.15       |   | 749 |   | $ | 2.98 |   |
|                                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |

 

***Stock Options Outstanding and Exercisable***

 

Informationrelated to stock options outstanding at December 31, 2009, is summarizedbelow:

 
| ** **                    | ** ** | **Options  Outstanding**                      | ** ** | **Options  Exercisable**                            | ** ** |
|-------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Outstanding  at  12/31/09 (in  thousands)** | ** ** | **Weighted  Average  Remaining   Contractual Life** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Exercisable  at  12/31/09 (in  thousands)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                          |       |                                          |       |                                                |       |   |   |   |   |   |   |
| $ 0.20-$1.00             |       | 1,492                                         |       | 6.61 years                                          |       | $ | 0.30 |   | 634 |   | $ | .33 |   |
| $ 1.01-$5.00             |       | 390                                           |       | 5.08 years                                          |       | $ | 2.88 |   | 390 |   | $ | 2.88 |   |
| $ 5.01-$10.00            |       | 13                                            |       | 2.16 years                                          |       | $ | 5.29 |   | 13 |   | $ | 5.29 |   |
| $ 10.01-$20.00           |       | 5                                             |       | 1.16 years                                          |       | $ | 19.19 |   | 5 |   | $ | 19.19 |   |
| $ 20.01-$63.00           |       | 13                                            |       | 0.24 years                                          |       | $ | 58.77 |   | 13 |   | $ | 58.77 |   |
|                          |       | 1,913                                         |       | 6.21 years                                          |       | $ | 1.31 |   | 1,055 |   | $ | 2.15 |   |

 

Summarizedinformation about outstanding stock options as of December 31, 2009, 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, 2009**                        | ** ** | ** **                                                            | ** ** | ** **                         |
| Number  of outstanding options                          |       | 1,733                                                                 |       | 1,055                              |
| Weighted  average remaining contractual life            |       | 6.12                                                                  |       | 5.45                               |
| Weighted  average exercise price per share              |       | $                                                                     | 1.42       |                               | $ | 2.15 |
| Intrinsic  value (in thousands)                         |       | $                                                                     | 133        |                               | $ | 53 |
|                                                    |       |                                                                  |       |                               |
| *  Includes effects of expected  forfeitures  |       |                                                                  |       |                               |

 

Asof December 31, 2009, the total unrecognized compensation cost related tonon-vested options not yet recognized in the statement of operations totaledapproximately $56 thousand (including expected forfeitures) and the weightedaverage period over which these awards are expected to vest was .89 years.

 

**10. Preferred Stock**

 

***5% Preferred Stock***

 

On March 25, 2004, we completed a $5.0 million private placementof our 5% convertible preferred stock and warrants.  In the private placement, we sold 1,000,000shares of our 5% preferred stock at a price of $5.00 per share for grossproceeds of $5.0 million, less $275,000 of issuance costs.  The 5% preferred shares were initiallyconvertible into 1,590,331

 

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sharesof common stock at a conversion price of $3.144 per share.  Holders of the 5% convertible preferred stockinclude 140,000 shares purchased by our CEO and 60,000 shares purchased by adirector of the Company.

 

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.

 

Allwarrants previously issued to 5% convertible preferred stock holders haveexpired.

 

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 if certain conditions are met.

 

Therewere 39,696 shares of 5% preferred stock converted into 63,129 shares of commonstock during 2009.  At December 31,2009 there are 220,000 shares of our 5% preferred stock outstanding.

 

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

 

On March 28, 2005, we completed a $2.7 million private placementof Series 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 260,000 shares by our CEO,  100,000 shares by our CFO and 60,000 sharesby a director of the Company.

 

The 5% dividends accruing on the Series 2 5% preferred stock arerequired to be paid quarterly on the first business day in March, June, September andDecember of each year, beginning with June 2005.  The liquidation preference for the preferredstock is an amount equal to $2.50 per share plus any accrued and unpaiddividends.  Holders of our Series 25% preferred stock have liquidation preference rights over our 5% preferredstock holders as well as our common stockholders.  The holders of the Series 2 5% preferredstock are not entitled to vote on any matter, except as otherwise required bylaw or with respect to certain limited matters specified in the certificate ofdesignations.

 

Included in this transaction were warrants to purchase 532,600 sharesof common stock at an exercise price of $2.77 per share.  Warrant holders include 80,000 held by ourCEO and 30,000 held by a director of the Company.  In connection with the closing of thisprivate placement, we issued warrants to purchase 60,390 shares of our commonstock at an exercise price of $2.77 per share to two affiliates of ourfinancial advisor for assistance with the private placement.

 

Holdersof Series 2 5% preferred stock have the right to require us to redeem anyor all of the their shares upon the occurrence of certain events within theCompany’s control that are defined in Certificate of Designation at a priceequal the sum of (1) the greater of $3.25****and the product of the volume weighted average price of our commonstock on the trading day immediately preceding the event multiplied by $2.50divided by the conversion price then in effect plus (2) any accrued butunpaid dividends on the Series 2 5% preferred stock plus (3) allliquidated damages or other amounts payable to the holders of Series 2 5%preferred stock.

 

AtDecember 31, 2009 there are 460,000 shares of Series 2 5% preferredstock 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 common stock at an initial conversion price of $2.18 pershare.  Holders of the Series 3 5%preferred stock include 123,853 shares by our CEO, 68,808 shares by our CFO and27,523 shares purchased by a director of the Company.

 

The 5% dividends accruing on the Series 3 5% preferred stock are requiredto be paid quarterly on the first business day in March, June, September andDecember of each year, beginning with March 1, 2006.  The liquidation preference for the preferredstock is an amount equal to $2.18 per share plus any accrued and unpaid dividends.  Holders of our Series 3 5%

 

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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.

 

Included in this transaction were warrants to purchase 282,306 sharesof common stock at an exercise price of $0.40 (repriced on December 28,2006 from an initial exercise price of $2.58) per share.  Warrant holders include 27,523 held by ourCEO and 13,762 held by a director of the Company.  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.

 

Holdersof Series 3 5% preferred stock have the right to require us to redeem anyor all of their shares upon the occurrence of certain events within the Company’scontrol that are defined in the certificate of designation at a price equal thesum of (1) the greater of $2.834****andthe product of the volume weighted average price of our common stock on thetrading day immediately preceding the event multiplied by $2.18 divided by theconversion price then in effect plus (2) any accrued but unpaid dividendson the Series 3 5% preferred stock plus (3) all liquidated damages orother amounts payable to the holders of Series 3 5% preferred stock.

 

AtDecember 31, 2009 there are 354,056 shares of Series 3 5% preferredstock outstanding.

 

***Dividends Payable***

 

Duringthe fiscal year ended December 31, 2009, we accrued $58,000 in dividendsto the holders of our 5% Preferred Stock, $57,000 in dividends to the holdersof our Series 2 5% Preferred Stock and $39,000 in dividends to the holdersof our Series 3 5% Preferred Stock. As of December 31, 2009, we have $360,000 in accrued and unpaiddividends included in other current liabilities.  Delaware law provides that we may only paydividends out of our capital surplus or, if no surplus is available, out of ournet profits for the fiscal year the dividend is declared and/or the precedingfiscal year.  All past due dividends and penalties were paid in February 2010.

 

**11. Concentrations**

 

Ouroperations are concentrated in one area—security software/entityidentification.  Sales to the U.S.Government through direct and indirect channels totaled 77.5% of total revenuesfor 2009 and 86.2% of total revenues for 2008. During 2009 approximately 62.5% of total revenues are attributable totwo government customers.  During 2008approximately 73.1% of total revenues are attributable to two governmentcustomers. One individual commercial customer in 2009 exceeded 10% of totalrevenues for the year; while 2008 had none. Our similar product and service offerings are not viewed as individualsegments, as our management analyzes the business as a whole and expenses arenot allocated to each product offering.

 

**12.  Subsequent Events**

 

On February 4,2010, the Company extended a revolving promissory note to borrow up to $700,000from G. Ward Paxton, the Company’s Chairman, President and Chief ExecutiveOfficer through March 2011.

 

OnFebruary 4, 2010, we received a written commitment from our Chief Executive Officer toinvest up to an additional $1,500,000 in the Company until March 2011,should such funding be required by the Company, on terms and conditions yet tobe determined.

 

OnFebruary 26, 2010, theCompany paid all past due dividends and penalties payable to 5% PreferredStock, Series 2 5% Preferred Stock and Series 3 5% Preferred Stock inthe amount of $334,000.

 

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