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**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-K**

 

**ANNUALREPORT**

**PURSUANTTO SECTION 13 OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

**x         ****ANNUAL REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934**

 

**Forthe fiscal year ended December 31, 2008**

 

**OR**

 

**o****                                ****TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF1934**

 

**Forthe transition period from                                to**

 

**ArgyleSecurity, Inc.**

(Name of issuer asspecified in its charter)

 

| **Delaware**                                                         | ** ** | **20-3101079**                        |
|----------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                                 |       |                                  |
| **12903  Delivery Drive, San Antonio, TX**                           | ** ** | **78247**                             |
| (address of  principal executive offices)                            |       | (Zip Code)                            |

 

Registrant’stelephone number, including area code:   **(210) 828-1700**

 

Securitiesregistered pursuant to Section 12(b) of the Act:**None**

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**CommonStock, $.0001 par value**

(Title of Class)

 

**CommonStock Purchase Warrants**

(Title of Class)

 

**Unitsconsisting of one share of Common Stock and one**

**CommonStock Purchase Warrant**

(Title of Class)

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.

Yeso   Nox

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act.

Yesx  Noo

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.   Yes   x   No   o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of the registrant’sknowledge in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.   o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange.

 

| Large  Accelerated Filero                      |   | Accelerated  Filero         |
|------------------------------------------------|--------|-----------------------------|
|                                           |   |                        |
| Non-Accelerated  Filero                        |   | Smaller  Reporting Companyx |
| (Do not check if  a smaller reporting company) |   |                        |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yeso   Nox

 

State the aggregatemarket value of the voting and non-voting stock held by non-affiliates of theIssuer as of the last business day of the registrant’s most recently completedsecond fiscal quarter: $15,375,187.

 

Indicate the number ofshares outstanding of each of the Registrant’s classes of common stock, as ofthe latest practicable date: 6,267,105 at March 30, 2009.

 

**DOCUMENTSINCORPORATED BY REFERENCE:**

 

**Part IIIof this Annual Report on Form 10-K is incorporated by reference to theproxy statement for the registrant’s annual meeting of stockholders to be heldin 2009.**

 

 

 

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TABLE OF CONTENTS

 
| Part I   |                                                                                                                | 1      |
|---------------|---------------------------------------------------------------------------------------------------------------------|--------|
|          |                                                                                                                |   |
| Item 1.       | Business                                                                                                            | 1      |
| Item 1A.      | Risk Factors                                                                                                        | 16     |
| Item 1B.      | Unresolved  Staff Comments                                                                                          | 23     |
| Item 2.       | Description of  Property                                                                                            | 23     |
| Item 3.       | Legal Proceedings                                                                                                   | 24     |
| Item 4.       | Submission  of Matters to a Vote of Security Holders                                                                | 24     |
|          |                                                                                                                |   |
| Part II  |                                                                                                                | 25     |
|          |                                                                                                                |   |
| Item 5.       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 25     |
| Item 6.       | Selected Financial  Data                                                                                            | 29     |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 31     |
| Item 7A.      | Quantitative  and Qualitative Disclosures About Market Risk                                                         | 54     |
| Item 8.       | Financial  Statements and Supplementary Data                                                                        | 55     |
| Item 9.       | Changes in  and Disagreements with Accountants on Accounting and Financial Disclosure                               | 56     |
| Item 9A(T).   | Controls and  Procedures                                                                                            | 56     |
| Item 9B.      | Other Information                                                                                                   | 57     |
|          |                                                                                                                |   |
| Part III |                                                                                                                | 58     |
|          |                                                                                                                |   |
| Item 10.      | Directors,  Executive Officers and Corporate Governance                                                             | 58     |
| Item 11.      | Executive  Compensation                                                                                             | 58     |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    | 58     |
| Item 13.      | Certain  Relationships and Related Transactions and Director Independence                                           | 58     |
| Item 14.      | Principal  Accounting Fees and Services                                                                             | 58     |
|          |                                                                                                                |   |
| Part IV  |                                                                                                                | 60     |
|          |                                                                                                                |   |
| Item 15.      | Exhibits and  Financial Statement Schedules                                                                         | 60     |

 

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**PART I**

 

**Item1. Business**

 

**Background**

 

Argyle Security, Inc.(formerly Argyle Security Acquisition Corporation) (“Argyle”) was incorporatedin Delaware in June 2005 to acquire, through merger, capital stockexchange, asset acquisition, or other similar business combination, a businessin the security industry. Argyle completed its initial public offering in January 2006. On July 31, 2007, Argyle consummated its initial acquisition through theacquisition of 100% of the outstanding capital stock of ISI Security Group, Inc.(f/k/a ISI Detention Contracting Group, Inc., referred to herein as “ISI”)and its subsidiaries. As a result of the merger, ISI became a wholly ownedsubsidiary of Argyle. When used herein, “Argyle”, the “Company”, “we”, “us”, “our”,refers to the pre-acquisition company until July 31, 2007 and thepost-acquisition company after July 31, 2007.

 

Argyle is acomprehensive security solutions provider to our diverse customer base becauseit addresses the majority of their physical electronic securityrequirements.  Argyle is a detention and commercial equipment contractorthat specializes in designing and integrating security solutions, includingturnkey installations, design, engineering, supply, and installation of variousdetention, surveillance and access control equipment and software solutions forcorrectional facilities and commercial institutions. The work is performedunder fixed-price contracts. The projects are located in various citiesthroughout the United States. The length of the contracts varies but istypically less than two years. Argyle also provides turnkey installationscovering the full spectrum of electronic security and low voltage systems,including fire alarm, access control, closed circuit television, intercom,sound/paging and other custom designed systems.

 

In February 2008,we organized our business under the name of “Argyle Security USA” and then, in January 2009,we eliminated the name “Argyle Security USA” and, for the sole purpose of debtcovenant compliance calculation which only considers the operating business’financial condition, organized the operational business of Argyle under thename “Argyle Security Operations”, or “ASO”, through which we provide securitysolutions to commercial, governmental and correctional customers.  Argylehas two reporting segments or business divisions: “Argyle Corrections” and “ArgyleCommercial Security”.

 

Argyle Correctionsspecializes in the design and installation of turnkey security solutions forpublic and privately-owned/operated detention facilities. Argyle Correctionsdesigns, assembles, supplies, installs, and maintains access control, video andintegrated electronic control systems for correctional and governmentfacilities throughout the United States. Argyle Corrections offers a completearray of electronic security system solutions revolving around access control,including: electronic locking systems and hardware and security doors andframes. Argyle Corrections also includes the sale and design of jail furniture,security glazing and other security-based systems. It provides the above goodsand services to detention market integrators, electrical contractors andcompetitors of Argyle that lack their own in-house electronic solutions.Whether acting as prime contractor or as a subcontractor for projects spanningall levels of security, Argyle Corrections’ product offerings include securitylocking systems, security hollow metal doors and wall panels, security windows,security glass and glazing, security furnishings and accessories, designsupport and full installation capabilities.

 

Argyle Correctionsconsists of all of our businesses in the corrections sector, includingMetroplex Control Systems, Inc. (“MCS”), ISI-Detention, as well as Com-Tecand PDI.  Com-Tec and PDI were acquired in January 2008.  ArgyleCorrections includes:

 

·                  MCS (also referred to asMCS-Detention), which designs, engineers, supplies, installs and maintainscomplex, customized physical and software security solutions, access control,video and electronic security control system solutions at correctional andgovernment facilities;

 

·                  ISI-Detention, which designs,engineers, supplies, installs and maintains a full array of detention systemsand equipment, targeting correctional facilities throughout the United States;

 

·                  PDI, which is a full-service, turnkeysolutions provider that manufactures high-security metal barriers,high-security observation window systems, detention furniture and accessories;and

 

·                  Com-Tec, which is an industry leaderin the custom design and manufacture of electronic security and communicationssystems.

 

Argyle CommercialSecurity has built a parallel business to Argyle Corrections, targetingcommercial and industrial facilities. Argyle Commercial Security focuses on thecommercial security sector and provides turnkey, electronic security systems tothe commercial market. Currently, MCS Commercial Fire & Security,referred to as MCS-Commercial, operates out of its own San Antonio headquartersand five regional offices in Texas and Colorado. The offices in Austin,Houston, and Denver resulted from acquisitions made by ISI before it wasacquired by Argyle. Its security systems cover access control, video systems,intrusion detection systems, 

 

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proximity andsmart cards, biometric technology, photo identification (ID) printers andsupplies among others. It also secures the community by levering leading edgetechnology through installation of intelligent perimeter security, wirelessvideo, IP video and intelligent video surveillance. Its industry-leading firedetection systems include QuickStart, EST2 & EST3, integrated lifesupport systems, control panels, detectors, and audible and visible signals.Argyle Federal Systems is currently a newly operational business unit whichfocuses on providing security solutions and services targeted at the federalgovernment. In ****November 2008****, Argyle Commercial Securitywas awarded a supply contract through the U.S. General Services Administration(“GSA”) to provide integrated security solutions and products to the variousdepartments in the United States federal government and any other entity thatpurchases off the GSA contract. These solutions and products consist of AccessControl, Video, Perimeter Security and ID Credentials that have been verysuccessful in the commercial marketplace, and now will be available to allgovernmental entities with access to the GSA contracts.

 

The following isan illustration of our business segments and business units.

 

 

On January 1,2008, MCFSA, Ltd. and all of the partnership interests of which are directly orindirectly wholly owned by ISI, acquired substantially all of the businessassets and liabilities of Fire Quest Inc. (“Fire Quest”). Fire Quest is engagedin the business of alarm system sales and service.

 

On January 4,2008, ISI acquired substantially all of the business assets and liabilities ofPeterson Detention, Inc. (“PDI”).  PDI manufactures and fabricatesdetention furniture and accessories, high security metal barriers and highsecurity observation window systems.

 

On January 31,2008, ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI,which in turn is a wholly owned subsidiary of the Company, closed atransaction, pursuant to which ISI-Controls acquired 100% of the outstandinglimited liability company units of Com-Tec Security LLC (“Com-Tec”), resultingin Com-Tec becoming a wholly owned subsidiary of ISI-Controls. Com-Tec isengaged in the business of custom design, manufacture and installation ofelectronic security and communications systems.

 

***MCS-Detention***

 

MCS-Detentionprovides electronic security systems for correctional facilities. MCS-Detentiondevelops electronic security systems for its customers, including doorcontrols, intercoms, closed circuit television and other low voltage electronicsecurity systems that can all be controlled from one location at one console.MCS-Detention does not manufacture any of the hardware that is sold andinstalled as part of its security solutions. Hardware is purchased from thirdparties and installed as required by the plans and specifications for eachproject. MCS-Detention’s expertise lies in designing, engineering, supplying,installing and maintaining complex, customized security, access control, videoand electronic security control system solutions at correctional and governmentfacilities. MCS-Detention also provides fully-integrated, complex electronicand software systems for command center controls and monitoring. Typically,MCS-Detention is a subcontractor to another entity, which entity could be ageneral contractor, ISI-Detention or a competitor of ISI-Detention.

 

Many solutions aresimultaneously provided for the customer, because MCS-Detention determines theneeds of its customer and puts systems together (from many differentmanufacturers) to fit those needs. More importantly, MCS-Detention canintegrate the operation of those varied systems so that they work togetherwithout conflict. Because of the complexity of the systems involved,MCS-Detention regularly designs the security electronic systems and preparesthe drawings for architects and engineers. This complex design work involvescoordination of wiring and conduit on a project, plus developing therequirements for local control and satellite 

 

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control stations.Included in their offerings are access control, closed circuit television (includingcameras, camera management and video image mass storage), detention control,fire alarm, intercom, perimeter protection, sound/paging, video visitation andother custom designed systems. Experience in planning, installation andservice, combined with state-of-the-art equipment, provides MCS-Detention witha distinct advantage in marketing and developing customized solutions forclients.

 

Contracting Structure:Most transactions in which MCS-Detention becomes involved result in a contractwith a customer that is an owner or construction manager (where ISI is a primeor direct contractor), or an agreement with a general contractor or electricalcontractor (where ISI is a subcontractor). MCS-Detention’s customers alsoinclude ISI-Detention and competitors of ISI-Detention that lack the in-housecapability to undertake a security electronics project. MCS-Detention may seekthese projects on its own as a stand-alone vendor or as part of a team that hasbeen assembled to pursue the project. The team approach is more commonlyutilized by ISI-Detention, though it is an important part of MCS-Detention’sbusiness model to act as a stand-alone vendor.

 

Team Contracting: A teamis typically assembled by a general contractor, architect, engineer, developeror a private correctional facility operator to submit a proposal to negotiatewith a customer or submit a competitive bid on a correctional project. In theseteams, MCS-Detention is the ‘‘Electronic Security Solutions Principal’’. Themembers of the team negotiate the amount and terms of the contract for theirrespective parts of the project. This means that MCS-Detention (and the otherconstruction-related members of the team) would enter into a contract with ageneral contractor without having to directly participate in a bid competition.This can occur because the members of the team have previously worked together,and the team members have experience in dealing with most, if not all, of theother team members, and know their capabilities. Once the security and othercomponents of the proposal are completed, the team submits the proposal in acompetition or commences negotiations with the ultimate customer. For purposesof actually submitting the proposal, a ‘‘lead contractor’’ structure isutilized. This means that the principals on the team enter into agreements withthe general contractor, and the construction portion of the team’s proposal issubmitted in the name of the general or lead contractor.

 

Contracts with owners,construction managers, general contractors and electrical are pursued in bothcompetitively-bid situations and negotiated transactions. These constituteapproximately 90% of MCS-Detention’s annual project volume. The processesrelated to competitively bid contracts and negotiated transactions are asfollows:

 
| (i)    | Competitively bid  contract: MCS-Detention, acting alone or as the Electronic Security Solutions  Principal for a team, is asked to submit a proposal with a price to a  customer (owner, general contractor, construction manager or electrical  subcontractor) for a portion of the work on a corrections project. There are  usually other organizations competing with MCS-Detention that are also  submitting proposals with pricing. The customer collects all the bids from  the many vendors or teams, chooses the best one, and then submits a bid or  proposal to its prospective customer in a bid competition. If MCS-Detention’s  customer is an owner or construction manager, and the owner selects  MCS-Detention as the winning bidder, then MCS-Detention enters into an  agreement with the owner or construction manager. If MCS-Detention’s customer  is a general contractor or an electrical engineer and that customer is  selected as the winning bidder, then the customer engages MCS-Detention for  that portion of the project for which MCS-Detention submitted a proposal or  bid. In many bid competitions, the successful bidder is determined by which  the party that has submitted the ‘‘best’’ bid, not necessarily the ‘‘lowest’’  bid. We believe that the relationships we have developed with architects,  engineers, general contractors and others, has occasionally facilitated  MCS-Detention being selected as the ‘‘best’’ bidder (and winning the  contract) in situations where it was not the lowest bidder. However, there  have been other situations where MCS-Detention has not been the successful  bidder when it was, in fact, the lowest bidder. |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (ii)   | Negotiated transaction:  MCS-Detention, acting alone or as the Electronic Security Solutions Principal  for a team, prepares a proposal for a portion of the work on a correctional  project that is to be submitted to a prospective customer for a negotiated  transaction. The parties negotiate the terms of the agreements without  competitive bidding. Many of these negotiated transactions are with repeat  customers. This arrangement allows MCS-Detention to enter into a contract  with a customer without the price pressure and elimination of value-added  services that are common in competitively bid transactions.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (iii)  | Intercompany  Transaction: When MCS-Detention’s customer is ISI-Detention, an intercompany  arrangement for billing and receivables is created.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |

 

MCS-Detention maintainsits sales force in San Antonio, Texas and in Noblesville, Indiana. Sales arepursued nationwide from those locations.

 

MCS-Detention estimatesthe cost and pricing of a project in a process that is similar to that ofISI-Detention. MCS-Detention will review the design drawings and writtenspecifications to create the same ‘‘take-offs,’’ or lists, of products andmaterials that are required on a project. MCS-Detention will then distributethe lists to vendors, receive the vendors’ bids on their respective portions ofthe project, and then MCS-Detention will calculate the costs to furnish andinstall the products required. MCS-Detention then adds profit and overhead toits calculations and determines the final price for the customer. Indetermining the final price, MCS-Detention uses the same subjective criteriathat ISI-Detention uses.

 

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The contracts thatMCS-Detention secures are subject to similar competitive bidding processes asare the contracts entered into by ISI-Detention. All products supplied byMCS-Detention are purchased from third-party vendors, assembled and prepared byMCS-Detention, and then sold by MCS-Detention to its customer. Typically, allMCS-Detention systems are installed and tested by MCS personnel. The terms ofthe contracts MCS-Detention enters into with its customers are similar to thetypes of contracts entered into by ISI-Detention. The types of customers thatare served by MCS-Detention are the same types of customers that are served byISI-Detention. The electronic security products of MCS-Detention are linkedinto an integrated system using applications software developed and provided byMCS-Detention.

 

***ISI-Detention***

 

ISI-Detention has beeninvolved in furnishing and installing detention equipment in more than 1,900correctional facilities since its inception in 1976. ISI-Detention designs,engineers, supplies, installs, and maintains a full array of detention systemsand equipment, targeting correctional facilities throughout the United States.Its expertise and track record position ISI-Detention favorably among thenation’s leading providers of products and solutions for correctionalfacilities. Its custom-designed systems meet local standards and are in fullcompliance with the applicable standards of the American CorrectionalAssociation, a voluntary organization whose standards for correctional facilitydesign, operation and construction are the recognized industry benchmark forquality and safety.

 

ISI-Detention offers acomplete array of electronic security system solutions revolving aroundelectronic locking systems and hardware, security doors and frames, jailfurniture, security glazing and other security-based systems. ISI-Detentionacts as prime contractor or as a subcontractor for projects spanning all levelsof security. 

 

The contracting structureand the contracts with owners, construction managers, general contractors andelectrical contractors are pursued in both competitively bid situations andnegotiated transactions in a manner similar to MCS-Detention.

 

Product solutions forISI-Detention primarily include detention hardware (prison bars, locks andlocking systems), security glass, security furniture (metal furniture),detention grade hollow metal doors, frames and windows and labor to install theseitems. All of these items are purchased from third-party vendors and soldthrough ISI-Detention to its customer. ISI-Detention does not manufacture thehardware installed as part of its security solutions. Hardware is purchasedfrom third parties and installed as required by the plans and specificationsfor each project. All of these products are sold to general contractors thatare building, expanding or renovating a jail or prison, or they are sold to theowner (governmental or private entity) of a jail or prison that is being built,expanded or renovated. In either situation, these products are installed incity lockups, county jails, state prisons and federal prisons.

 

The security solutioncreated by ISI-Detention for each customer is a unique combination of differentsecurity devices, made by many different manufacturers. These devices includeaccess controls (keypads, card swipe readers, and key fob proximity readers atdoorways), electric locks, closed circuit television equipment, fire alarm systemsand smoke detectors, etc. These many different devices were not originallymanufactured to work together in an integrated system. Each manufacturerdeveloped its product to work in a “typical” environment, and each manufacturerdetermined what ‘‘typical’’ would be.

 

At the beginning of aproject (the design phase), ISI-Detention works with architects, engineers andcontractors to help design the project by writing specifications, developingschedules (detailed lists) of doors, windows, door hardware and glazing for thecustomer. During this stage of development, ISI-Detention writes specificationsfor specific locking systems, analyzes particular conditions and requirementsand recommends products that correspond to the needs of that correctional facility,depending on the type of security that is required and the underlying budget.The design process provides all the vendors and contractors with a clearoutline of what is needed for the project. This provides the customer with adetailed list of the precise items that ISI-Detention will supply to thecustomer, and the cost for those items.

 

To determine the pricingof a project, ISI-Detention will obtain the design drawings of the project inquestion (which are basically the building construction drawings) and determinethe precise quantity of each item needed for the project. ISI-Detentionprovides these lists of required items to the appropriate vendors. Some vendorsperform their own quantity determinations (“takeoffs”), rather than relyingupon the takeoffs prepared by ISI-Detention. The vendor then providesISI-Detention with the price for the items required. Once all the costs arereceived from vendors, and ISI-Detention determines the cost of the servicesthat it will provide, ISI-Detention then adds profit and overhead, depending onmany factors, including but not limited to what other competitors are known tobe bidding on the project, local labor and other conditions, size of theproject, complexity of the project, schedule for completion, etc. ISI-Detentionthen determines a sales price. This price is given to ISI-Detention’s customer.That customer may be a general contractor or the owner of the project — a city,county, state or federal agency.

 

In many cases,ISI-Detention is part of a team that prepares a bid. This team works togetherto create a total construction bid. The head of the team is usually a generalcontractor or private prison operator. Typically, ISI-Detention is invited tobe part of this team because of its repeat customer relationship. The team thencompetes for the contract as a group. This type of repeat customer relationshipallows ISI the ability to negotiate most of the work sold to repeat customers.

 

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Typically, whenISI-Detention creates an initial budget for a project (before the detailedformal estimating of all job costs is completed), ISI-Detention typicallyestimates that 13% of the construction dollars will be allocated toISI-Detention’s scope of work on that project, including the higher-margin,security electronics portion. This is an initial estimate that ISI-Detentionuses in the early stages of a project before final design is completed. Whilethe final amount of the ISI-Detention scope of work changes from project toproject, depending on many factors relating to the design and the intended useof the facility being built or renovated, management has found that an initial budgetof 13% of the estimated total construction amount for a project has proven tobe a reliable basis for estimating the size of ISI-Detention’s portion of theproject.

 

Most governmentalagencies require that their significant contracts be competitively bid.Typically, they utilize the ‘‘Request for Proposal’’ (RFP) method where severalcompetitors submit their sealed proposals for a particular project, or the ‘‘Requestfor Qualifications’’ (RFQ) process where competitors submit theirQualifications for consideration by the customer. Some contracts are let uponthe standard ‘‘Straight Bid’’ process where the detailed plans andspecifications for a project are published and contractors submit a ‘‘Bid’’ orfixed price, for the contract to build the project. Other competitive biddingprocesses may also be utilized, such as the Construction Manager at Risk model,where a Construction Manager is hired for a fee to build the project for afixed price, or ‘‘cost plus profit and overhead’’ basis. When ISI-Detentionresponds to an RFP, RFQ, Straight Bid, or other competitive bidding process, ittypically provides the response to a general contractor (where ISI-Detention isone of several contractors in different disciplines that are part of the totaldesign/bid team providing a proposal with prices) or directly to the owner(governmental agency or private entity) of a correctional project. The qualityof ISI-Detention’s estimating process, knowledge of the industry, knowledge ofits customers and other issues requiring significant judgment and expertise arekey factors in determining whether ISI-Detention will ‘win’ the competitive bidprocess and be offered the contract for the project.

 

When the customer sendsISI-Detention a contract, it contains typical construction contract terms andconditions, such as provision for retainage, certification of completion forprogress payments, fixed markup on change orders, coordination responsibility,and similar provisions. Most contracts allow for progress payments on a monthlybasis, and most contracts are fixed price.

 

ISI-Detention’s customersrequire that ISI-Detention provide not only the detention equipment but thesecurity electronics as well. When this occurs, ISI-Detention usesMCS-Detention (a wholly owned subsidiary of Argyle) to provide the securityelectronics to ISI-Detention. The price for the detention equipment and theprice for the security electronics (closed circuit television, infrared alarms,access control systems, etc.) are combined together and submitted byISI-Detention to its customer as a package price.

 

Progress payments andretainage provisions control the amount and timing of payments toISI-Detention. For example, upon execution of a contract, an agreed uponmobilization payment may be paid to ISI-Detention. Thereafter, each monthISI-Detention certifies to the customer the percentage of the total work thathas been completed through the preceding month. A third party (typically anarchitect) also provides the owner of the project with a certification of thepercentage of completion. If the third party agrees with ISI-Detention’scertification of its percentage of completion, then ISI-Detention is entitledto receive that percentage of the entire contract amount, less the amount ofretainage (typically 5% to 10%). (For example, if ISI-Detention claims that 60%of its work under its contract has been completed, then ISI-Detention isentitled to be paid 60% of the contract amount, less the retainage amount). Atthe conclusion of the project, assuming no other changes or charges,ISI-Detention should have been paid the full contract amount less theretainage. When the owner of the project, ISI-Detention’s customer and thethird party have all certified that the project is complete and that allsub-contractors of ISI-Detention have been paid or other appropriatedocumentation provided, the retainage amount is paid to ISI-Detention.

 

After a project is soldand ISI-Detention receives a contract, ISI-Detention prepares engineeringdrawings and schedules or lists creating more detail and information than inthe design phase, which takes place early on in the development of a project.During the construction phase of the project, ISI-Detention orders materialsfrom vendors and arranges for those materials to be shipped to the projectsite. Typically, ISI-Detention sends its employees to the job site to installthis equipment. ISI-Detention’s projects usually take 9 to 14 months; somelarger projects may run longer.

 

When competitive bids aresolicited in connection with the construction of a correctional facility,ISI-Detention bids for the detention equipment portion of the overall projectas a direct contractor or as one of the subcontractors for a generalcontractor. The furnished and installed package proposed by ISI-Detentiontypically includes security locking systems and hardware, security hollow metal(doors and frames), detention furniture (tables, bunks, benches, mirrors,etc.), security electronic controls (closed circuit television, intercom, etc.)and security glass and glazing. By providing this complete package furnishedand installed, ISI-Detention is able to provide a warranty program and insurethat all the pieces and components are fully integrated and inter-operatecorrectly.

 

ISI-Detention’s typicalwarranty is a limited warranty of one year and is provided in more than 95% ofthe contracts entered into. This warranty provides for repair or replacement ofdefective materials or workmanship, if a failure occurs within one year ofinstallation of the product. In very limited circumstances, ISI-Detention willprovide an extended warranty of two years (with the same repair and replacementobligations as the one year warranty) when it is demanded by a significantcustomer or is otherwise required to secure a contract. In even more limitedcircumstances, an extended warranty of three years (with the same repair andreplacement obligations as the one year warranty) will be provided.

 

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The aggregate cost offulfilling ISI-Detention’s warranty obligations on completed contracts in 2007and 2008 has been less than $150,000 for those years combined, and there havebeen no claims asserted by customers or users of ISI-Detention’s products thatare outside the normal scope of warranty work required. Additionally, since allof the products sold by ISI-Detention are manufactured by others, the ultimateburden for warranty of those items is passed on to the manufacturers byISI-Detention.

 

***PDI***

 

PDI is a fabricator andfull-scope provider of detention products and furniture. PDI manufactures highsecurity metal barriers, high security observation window systems, detentionfurniture and accessories. PDI was started in 1977 by Mike and LeonardPeterson. Since then, PDI has completed hundreds of successful projects, andits customer list features some of the nation’s most widely recognized andwell-respected owners and contractors. PDI’s product line includes wire mesh,accessories, bar grating, the patented “Steel Block” and detention furniture –both standard and custom, including stainless steel.

 

Most transactions are ona purchase order basis with a customer that is an owner, construction manageror detention contractor (DEC) of a facility. PDI’s customers also includeISI-Detention and competitors of ISI-Detention. In a wide variety of projectsacross the country, architects specify PDI as their steel detention productssupplier. PDI provides in-house drafting and design, pre-sale and post-salesupport teams, a complete product line from coast to coast.

 

As a full-scope provider,PDI offers a range of products that are often manufactured to customers’precise specifications. PDI’s in-house detailers and support staff providedesign and expertise needed to ensure total compliance — regardless of aproject’s size or scope.

 

PDI holds an exclusivelicense from Gregory Holdings, LLC to distribute “Steel Block”, which is ahigh-quality steel masonry block that serves to secure attachments toreinforced concrete masonry walls and can also be used for accessory purposes.Sized to the exact dimensions of a concrete unit and installed by masons, SteelBlocks are grouted and held in place with a vertical and/or horizontalreinforcing bar and become an integral part of the wall. Items are attached tothe Steel Blocks by welding, by using weld nuts or by drilling and tapping thesteel face plate. In addition, Steel Block may be used to provide a secure,flush installation of accessories such as soap dishes, handcuff anchors andintercom blocks, designed for use primarily in detention and institutionalfacilities that cannot be dislodged from a concrete masonry wall. Managementbelieves that the unique nature of Steel Block gives PDI a competitiveadvantage in the market where secured anchoring is highly desired.

 

PDI specifically tailorsits quotes from information received from customers or from plans acquired fromarchitects. Once a project is awarded to PDI, we detail the work for approvalof the customer.

 

The company isheadquartered in Orange, California and has an additional manufacturing plantin Tucson, Arizona.

 

PDI has developed a fullservice website e-Store feature intended to better assist customers byproviding a way to order products online. This feature will allow customers toorder detention furniture, accessories, wire mesh and custom fabrication withmany of the standard products available for delivery the same day. It is expectedthat the e-Store will become fully active during 2009.

 

# ***Com-Tec***

 

Com-Techas been in the business of integrated systems custom design and manufacturingof electronic security and communications systems throughout the United Statessince 2004. Com-Tec’s primary markets include correctional facilities, city andcounty jails, as well as commercial facilities. Com-Tec’s integrated systemscombine a wide range of functions into a single-operated control console. Everyfunction of the system is specifically engineered and integrated to operatesmoothly and efficiently together. Com-Tec’s systems include remote diagnosticsto aid in trouble shooting which dramatically reduces maintenance labor.

 

Com-Tecintegrates the complex components, skills and disciplines needed to createquality electronic security systems for correctional facilities. Com-Tec has expertise in the following correctional-relatedsecurity systems: Touch Screen Based Control Systems, UL 508A Control Panels,Door and Gate Control Systems, Closed Circuit Television Systems, IntegratedIntercom and Paging Systems, Security Management Systems, Access ControlSystems, Perimeter Intrusion Detection Systems, Television DistributionSystems, Facility Upgrades and Retrofits UL 508A Certified Manufacturer. Com-Tecdesigns its systems with future updating and expansion in mind, knowing thatthe needs and requirements of its customers grow and change over time. Com-Tecoffers a package of services and products from the initial stages ofspecification development to preventative maintenance contracts during andafter the sale.

 

Com-Tecassigns experienced managerial personnel to each individual project who takeresponsibility for every major aspect of coordination and integration of thesystem including application and design engineering, factory assembly andtesting, installation, field testing and service and warranty work.

 

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Com-Tec’sfocus in the commercial industry is to provide integrated electronic systemsand service to customers in health care, industrial, commercial, or educationalfacilities. Com-Tec is part of the Argyle National Service Call Center (NSCC)which provides technical assistance, service calls and annual service contractsfor a customer’s security needs. The Argyle NSCC provides on-call, 24-hourassistance from technical specialists and engineers in order to help customersthrough any and all issues they might face.

 

Com-Techas a 35,000-square foot facility in Appleton, Wisconsin.

 

In contrast toISI-Detention and MCS-Detention, Com-Tec typically subcontracts theinstallation of wire and operating system-filed devices in lieu of performingthese tasks with its own labor force.

 

***MCS-Commercial***

 

MCS-Commercial designs,engineers, supplies, installs and maintains professional security, accesscontrol, video and fire alarm system solutions for large commercial customers.Its core market focus creating integrated security solutions related to thesecurity of petro-chemical, healthcare, utilities, education and similarfacilities.

 

MCS-Commercial suppliessecurity electronic products to end-users and contractors. A total solution issold to the end-user whereby MCS-Commercial utilizes the most appropriateproducts and configurations for a particular need. In addition, it alsoprovides the ongoing service needs of the customers. These products include:access control systems, fire alarms, video, CCTV, sound paging systems andstructured cabling. In contrast to ISI-Detention and MCS-Detention, which selltheir products to the corrections industry for jails and prisons,MCS-Commercial typically sells its products to contractors that are building orrenovating commercial projects, or to owners of commercial properties.MCS-Commercial does not manufacture any of the hardware that is sold andinstalled as part of its security solutions. Hardware is purchased from thirdparties and installed as required by the plans and specifications for eachproject. Although the products of MCS-Commercial and MCS-Detention are similarin many respects (i.e. access control systems, CCTV, etc.), MCS-Commercialsells products only to commercial customers for commercial projects.

 

Contracting Structure:Approximately 34% of the work of MCS-Commercial is negotiated service work,which is not subject to competitive bidding and is billed on an hourly basisfor time and materials. The remaining 66% of MCS-Commercial’s work is generallyequally divided between negotiated contracts and competitively bid transactionson commercial (not correctional) projects. Most non-service work transactionsresult in a contract with a customer that is an owner or construction managerof a project (where MCS-Commercial is a prime or direct contractor) or anagreement with a general contractor or electrical contractor on a project(where MCS-Commercial is a subcontractor).

 

MCS-Commercial hasfocused upon relationship selling and negotiated contracts, because in thecommercial (non-governmental) arena, competitive bidding is not mandated bylaw, and the parties have the option of negotiating a contract should theychoose to do so. MCS-Commercial will continue to focus upon the negotiatedtransaction sector of its business, by aggressively seeking out and courtingrelationships with owner/customers.

 

MCS-Commercial pursuesthe majority of its work on its own as a stand-alone vendor, though a smallerportion is pursued as part of a team that has been assembled to pursue theproject. The team approach is more commonly utilized by ISI Detention, thoughit is an important part of MCS-Commercial’s business model.

 

 MCS-Commercialmaintains sales/service offices in Dallas, San Antonio, Austin and Houston,Texas as well as in Denver, Colorado. Each office is responsible for sellingand servicing MCS-Commercial products in its respective geographical area.

 

The process of estimatingand pricing projects for MCS-Commercial is substantially the same process usedby ISI-Detention and MCS-Detention. Additionally, MCS-Commercial enters intocontracts that are similar, if not identical, in terms and conditions to thecontracts entered into by ISI-Detention and MCS-Detention. MCS-Commercial buysand resells all of its products to its customers. Installation is performed byMCS-Commercial employees and also by subcontractors.

 

As used above, the term ‘hardware’is intended to mean hard goods generally related to all facets of modernsecurity systems. Therefore, this term includes not only operational computerterminals (with software loaded upon them), computer monitors and networkingdevices, but it also includes security grade doors, windows, locks, hinges,door closers, door handles, cameras, sensors, intercoms, fire alarms, smokealarms, access controls, installation hardware (screws, nuts, bolts, cables,etc.) and similar goods involved in modern correctional, governmental andcommercial security systems.

 

**General**

 

Other than PDI, none ofthe business units manufactures the hardware that it sells. Hardware ispurchased from third parties and 

 

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resold. None of thebusiness units have long-term agreements with their third-party hardwarevendors. Most of the hardware that the business units typically recommend beused in any particular customized security solution for a customer is availableto them from more than one hardware vendor. Accordingly, we do not believe thatsuch long-term agreements are necessary. MCS-Commercial has distributionagreements in place with some of its third-party vendors to distribute certainproduct lines. Computers are included in the hardware that the divisions sellto their customers. Those computers require software, and that software ispurchased from third parties. None of our proprietary software is soldseparately to our customers. The divisions load the third-party software on thecomputers (or it is installed by the manufacturer of the computer) and insurethat the computers are working properly before they are sold and shipped to thecustomer.

 

We have made a concertedeffort to become a total solutions provider of security and detention solutionsfor the corrections design/build market. In the security industry, a ‘‘totalsolutions provider’’ means that a vendor has the ability to design customizedsolutions for a wide range of security needs, and provide all of the hardwareand software for those solutions, rather than designing a wide array ofsolutions, but only actually fulfilling the design in one or two areas. If acustomer selects a series of security vendors, each providing a separate andindependent system that addresses only a limited security need, then thenumerous systems required to provide overall security can cause manyunanticipated problems in operations, maintenance, and upgrades. ISI, as a ‘‘totalsolutions provider,’’ can provide its customers with one source for a widerange of security solutions that are tested and proven to work together.

 

Our operating unitsprovide a range of products, as well as value-added services, such as designassistance to architects, engineers and owners through writing specifications,providing CAD documents, equipment selection and vendor recommendation. Thebreadth of our offerings has enabled us to establish a leadership position inthe design/build corrections market; in turn, this recognized expertise inproviding customized, high-level solutions to the most demanding of customershas allowed us to acquire projects in other security-sensitive sectors, such asthe healthcare industry, water treatment plants, utilities, federal courthousesand upscale private commercial buildings.

 

Through our designassistance and performance, we develop relationships that make repeat businesswith customers more likely. For example, more than 60% of the revenues during2006, 2007 and 2008 has been the result of contracts with repeat customers.These repeat customers typically allow us to negotiate the work, especially ondesign-build projects. Design-build projects are contracts where we providesubstantial design assistance to its customers.

 

Hardware re-sales are notimpacted by whether we act as a contractor or subcontractor on a particularproject. In either instance, whether as a subcontractor or a contractor, wepurchase hardware, pre-assemble and test it, and once approved, ship the goodsto the jobsite, where the hardware is installed. Whether we are a subcontractorto a general contractor, or a party to a direct contract with an owner of aproject, these internal processes at Argyle do not change. The key relevantdifference in Argyle acting as a general/prime contractor or a subcontractorwith regard to hardware re-sales is merely the identity of the party with whomArgyle contracts and the party to whom Argyle looks for initial payment.

 

Whether we are acting asa general/prime contractor or a subcontractor, the cost of the hardware isincluded in Cost of Revenues/Contract Costs in our financial statements, andthe revenues generated by the sale of that hardware is reflected in ContractRevenues in our financial statements. The profit from the sale of hardware isfirst reflected in Gross Profit in our financial statements, which is thenreduced by general, sales and administrative costs, etc. In either situation,the results of the resale of the hardware are reflected in the internalfinancial results of each project, and ultimately in our financial results, asany other component of a project such as labor, utilities, or supplies.

 

Each project presents uswith a unique combination of a one-of-a-kind array of security related devicesin a unique geographic configuration and utilization, and security deploymentenvironment. Examples of those disparate environments include a city jail in ahumid coastal area with hundreds of prisoners being booked in and out each day,the searing heat of a desert prison with long-term inmates where classroomeducation is the key activity, or a downtown high-rise with residents andbusiness tenants demanding comprehensive 24/7 personal safety that does notintrude upon their private or business lives. Making these systems worktogether is a key value-added service that the business units provide.

 

The communication andoperational interaction between systems presented to us in each projectrequires project-specific programming to resolve. The cost of suchproject-dedicated programming is charged to each individual project. Theprogramming solution is stored for use at a later time should a similarrequirement arise. Over time, we have developed a library or warehouse of theseunique software solutions, which helps us solve the communications conflictsamong disparate systems quickly and accurately.

 

This library of uniquesoftware solutions, created on a project-by-project basis, is the foundation ofthe proprietary TotalWerks suite of software programs that we use to solvecommunications conflicts among security devices. This suite of software is adevelopment tool used by us, and it is not sold to any customer. The TotalWerkssuite allows the fabrication and engineering personnel of MCS-Detention andMCS-Commercial to quickly create the software solutions that are needed for aspecific project.

 

Before any system isshipped to a customer, it is first assembled at our offices in a simulatedreal-world environment. The 

 

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TotalWerks software isused during this intensive testing, and allows the engineering and fabricationstaff to test every input/output device (door switch, card swipe reader,security keyboard, night watchman guard tour signal device, etc.) in theexpected real-world environment for that project in order to insure that eachdevice works properly with all the other required systems, before the system isshipped to the customer.

 

The TotalWerks suite ofsoftware is essentially a combination of the adaptations and tools that we havecreated for individual projects, and the cost of developing almost all of thecomponent pieces of the Suite was charged to individual projects for whicheach separate adaptation or tool was created. The cost of the additional workcompleted on the TotalWerks suite to streamline its operation has been minimal.Therefore, we do not maintain a separate research and development program or “costcenter”.

 

There are two softwarepackages that are loaded on these computers, including Microsoft Windows XP andWonderware that require licensing, and the transfer of the license to ourcustomer is handled differently for each of the packages.

 

**Bonding**

 

Bid, performance andpayment bonds are an important component of our business. Many owners orcontractors will require that we submit a bid bond when we place a bid for newprojects. Many owners or contractors require that performance and payment bondsbe delivered to the customer before we can enter into a contract. Approximately30% of contract revenues and 20% of overall company revenues for 2008 weregenerated by “bonded” contracts (contracts that require performance and paymentbonds), and approximately 28% of Argyle’s revenues in the past three years havebeen derived from bonded contracts.

 

A bidbond guarantees the owner or a general contractor that the bidding contractorwill honor its bid and will sign all contract documents if awarded thecontract. The owner or general contractor may sue the bidding contractor andits surety to enforce the bond. If the bidding contractor refused to honor thebid, it and its surety are liable on the bond for any additional costs theowner or general contractor may incur in reletting the contract. This usuallyis the difference in dollar amount between the low bid and the second low bid.A performance bond guarantees the owner or general contractor that the workingcontractor will complete the contract according to its terms including priceand time. A payment bond guarantees the owner that subcontractors and supplierswill be paid the monies that they are due from the principal.

 

 From 2004 throughthe ISI merger in July 2007, bonding capacity had been made available tous through ISI*MCS, an entity created and owned by the Chief Executive Officerand President of ISI, Sam Youngblood and Don Carr, respectively. Since theconsummation of the acquisition of ISI, ISI*MCS has not provided any new bondedcontracts for Argyle. We have secured adequate bonding capacity that we believewill address the total expected business in 2009.

 

The bonding company thatissues performance and payment bonds is an interested party in all mattersregarding the bonded contracts. A bonding company is obligated to complete aproject for which it has issued bonds and will typically seek recovery of itscosts to complete the contract from all available parties. The result is that adispute with an owner or general contractor arising from a bonded contract mustalso include consideration of the interests of the bonding company, typically awell-financed and highly sophisticated party. The addition of thissophisticated party to disputes regarding bonded contracts increases the riskthat a default or breach of a bonded contract by Argyle will result in a lossto Argyle. Even if Argyle is able to resolve or avoid a dispute with an owneror general contractor, resolving a dispute with a bonding company that has paida claim to complete a project will increase the potential risk of loss.

 

**Acquisitions**

 

On July 31, 2007,Argyle consummated a business combination, acquiring 100% of the outstandingcapital stock of ISI Detention Contracting Group, Inc. (which became ISISecurity Group, Inc. upon the close of the transaction) and itssubsidiaries, the value of which the Board of Directors determined was greaterthan 80% of Argyle’s assets at the time of the merger. Prior to theacquisition, we had no operations and we were considered a developmental stageenterprise. ISI is deemed to be a ‘‘predecessor’’ to the combined company. Theaccompanying consolidated balance sheet includes the assets and liabilitiesrelated to the acquisition of ISI, adjusted to fair value pursuant to Statementof Financial Accounting Standards (SFAS) No. 141,*Business Combinations* .

 

Argyle used an estimated$20.5 million (excluding Argyle and ISI transaction costs) of the net proceedsof the initial public offering to acquire ISI.  At the closing of themerger, the consideration paid by the Company to the stockholders and debtholders of ISI was $18.6 million in cash; 1,180,000 shares of common stock ofArgyle (valued at approximately $9.2 million); and $1.9 million of unsecuredpromissory notes which were convertible or redeemable by the Company intoshares of our common stock at a price of $10.00 per share.

 

On January 1, 2008,MCFSA, Ltd. (“MCFSA”), all of the partnership interests of which are directlyor indirectly wholly owned by ISI, acquired substantially all of the businessassets and liabilities of Fire Quest. Fire Quest is engaged in the business ofalarm system sales and service.  In consideration for the sale of itsassets to MCFSA, Fire Quest received cash in the amount of $0.75 million and apromissory note in the aggregate principal amount of $0.25 million (“Fire QuestPromissory Note”). The Promissory 

 

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Notes will bear interestat the rate of 7.25% per year and will become due and payable on January 1,2009.

 

On January 4, 2008,ISI acquired substantially all of the business assets and liabilities ofPeterson Detention for cash in the amount of $1.5 million and convertiblepromissory notes (the “PDI Promissory Notes”) in the aggregate principal amountof $3.0 million. The aggregate principal amount of the PDI Promissory Notes maybe reduced depending on the occurrence of certain events described in the AssetPurchase Agreement. The payment of the PDI Promissory Notes is guaranteed byand secured by the assets of ISI and the Company; bears interest at 6% per yearand will become due and payable on December 31, 2012. As of February 28,2008, the holders of the PDI Promissory Notes may convert up to $1,500,000 ofthe outstanding balance of the PDI Promissory Notes into shares of Argyle’scommon stock at the average closing price of Argyle’s common stock for the 20trading days preceding the conversion date, provided that the conversion pricemay be no less than $8.00 per share.

 

On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI, closeda transaction, pursuant to which ISI-Controls acquired 100% of the outstandingunits of Com-Tec Security, LLC (“Com-Tec”), resulting in Com-Tec becoming awholly owned subsidiary of ISI-Controls. Com-Tec is engaged in the business ofcustom design, manufacture and installation of electronic security andcommunication systems.  In consideration for the sale of the units toISI-Controls, the holders of units in Com-Tec (the “Seller”) received cash inthe amount of $3.0 million and a secured subordinated promissory note in theaggregate principal amount of $3.515 million (the “Com-Tec Promissory Note”).The aggregate principal amount of the Com-Tec Promissory Note may be reduceddepending on the occurrence of certain events described in the Unit PurchaseAgreement by and among ISI-Controls, the Seller and Jeffrey E. Corcoran as theSeller Representative (the “Unit Purchase Agreement”). The Com-Tec PromissoryNote is guaranteed by and secured by the assets of ISI and the Company; bearsinterest at 7% per year and will become due and payable on April 1, 2011. OnMarch 2, 2009, the principal of the Promissory Note was reduced to$3,491,290.80 as a result of adjustments made because of uncollected accountsreceivable.

 

**Customers**

 

Our company is customerfocused and takes pride in its customer retention. More than 60% of therevenues for ISI-Detention and MCS-Detention in 2006, 2007 and 2008 has beenthe result of contracts with repeat customers. We continuously focus on findingways to better serve our clients. Our diverse customer base consists primarilyof contractors, construction companies and architects catering to publicly andprivately run detention facilities and commercial construction. Our top threecustomers in 2006 amounted to 33% of total revenues. For fiscal year 2007, wegenerated 8% of total revenues from our top customer, 15% from the top two and20% from the top three. For fiscal year 2008, we generated 9% of total revenuesfrom our top customer, 19% from the top two and 27% from the top three. Ourlargest customer represented $12.7 million of total revenues in 2008.

 

**Competition**

 

The security servicesindustry is a large and competitive market. We compete for contracts based onour strong client relationships, successful past performance record,significant technical expertise and specialized knowledge.

 

The Argyle Correctionsbusiness segment often competes against detention systems integrators, as wellas specialized information technology consulting and outsourcing firms. Ourcompetitors include Norment Security Group, Cornerstone Detention Products, SierraSteel, CCC Group, G-S Company, and Pauly Jail Building Company. Our competitorsfor our hardware/software solutions include Norment Security Group, StanleyIntegrator (part of Stanley Works), Simplex Grinnell (part of Tyco), ESiCompanies, Southwest Communications, and Accurate Controls.  PDI, principally competes against prisonfurniture fabricators such as PSI, LLC, Mustang Metal and Cornerstone Detentionand Com-Tec competes against TremTech (part of Norment), Accurate Controls andMTI.

 

The Argyle CommercialSecurity business segment faces a much broader array of competitors such as:Koetter, Siemens, DSS, Fire Alarm Services, Fire Alarm Control Services, Tyco,Chubb and Lone Star. There are also several smaller regional companies thatcompete with us.

 

Some of the companies wecompete with are much larger than Argyle, and such companies have significantlygreater resources than us. However, the larger conglomerates that compete inthe detention sector offer only the electronic portion of our detentionsecurity solution. There are very few companies that provide both electronicand physical security solutions, Norment being the most prominent, allowinggeneral contractors to deal with a single supplier for all of theircorrectional security needs. The commercial security sector has always had afew very large competitors and many moderate-size competitors. The lattercompanies continue to thrive on the basis of their sales capability, projectexecution performance and their after-project service. The commercial securitymarket has proven to be large enough in prior years to support growth for bothlarge and moderate size security companies. Management does not expectcompetition in any of the sectors to decline in the foreseeable future.

 

**Employees**

 

As of December 31,2008, we had approximately 592 full-time employees. Future success dependssignificantly on our ability to attract, retain and motivate qualifiedpersonnel. We are not a party to any collective bargaining agreement, have notexperienced any strikes or work stoppages and consider our relationshipwith our employees to be satisfactory.

 

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**Market**

 

The Company’s primaryfocus markets include the corrections and detention market and the criticalinfrastructure segments of the commercial security market in attractivegeographic areas.

 

*Correctionsand Detention Market. *TheUnited States has the largest prison population in the world and incarceratesits citizens at a greater rate than any other country and the detention markethas been expanding in recent years. The number of inmates housed in U.S.prisons and jails reached a record high of 2.3 million during 2007. As a resultof this situation, some states have had to move their excess prisoners to otherstates where detention facilities have some excess capacity to absorbadditional prisoners. Management believes that we are well positioned to takeadvantage of the continued growth in population in detention facilities. Thestatistics presented above were obtained from publicly available U.S. Departmentof Justice Bureau of Justice Statistics Bulletins.

 

The current prisonconstruction programs of various federal agencies, states, counties and citiesare driven by many different factors pertaining to inmate populations. Inaddition to annual increases in inmate population, these factors include theincrease in the rate of juvenile and female incarceration, the segmenting ofviolent sexual predators, the segmenting of aging inmates, the recent rapidincrease in the rate of illegal alien incarceration, plus the significanttransient movement of the population, which also causes an increase inincarceration rates in different locations. According to the American Instituteof Architects semi-annual forecast, the public safety construction sector willperform relatively well compared to other nonresidential sectors and will avoidthe worst of the declines in project activity for the next two years.

 

Private prison operatorsare growing at a much faster rate than the 2.5%-to-3.0% increase in inmategrowth (Bureau of Justice Statistics Bulletin). One of the reasons for thisaccelerated growth is the increasing acceptance of the financing plans thathave been developed by the private operators.

 

*CommercialSecurity Market.*The North American electronic security marketreached $27.1 billion by the end of 2007, of which 67% was in thecommercial/industrial sector — MCS-Commercial’s market. The fastest growingsectors within that market are video (10% per year) and access control (8 - 9%per year), both areas in which MCS-Commercial competes. MCS-Commercial alsocompetes in the fire protection area. MCS-Commercial is also able to design andprovide fire alarm products and services. The fire alarm market is a potentialcatalyst for garnering video and access control business because of the uniquelicensing requirements mandated by state and local authorities which oversee anindustry that is focused more on life-safety than on property protection. Manyof the organizations vying for commercial/industrial business lack the firealarm certification licensing needed to provide a total system solution.

 

Note: The statisticspresented above were obtained from documents originally published by JP Freeman &Co., IMS Research, and The Freedonia Group, market research organizationsserving the physical security industry.

 

**BusinessStrategy**

 

 Our Company is acomprehensive security solutions provider to our diverse customer base, becausewe address the majority of their physical electronic securityrequirements.  We meet these requirements with a broad range of specificbut custom integrated, security solutions delivered on a turnkey basis. Our goal is to become a trusted resource to our customers and, in doing so, todevelop long standing relationships, through which we then become an ongoingprovider of recurring maintenance and support services for both systemsinstalled by us as well as legacy systems.  We view our most importantasset, as well as our ongoing and continuous focus, to be the value and trustthat we have developed with our customers by meeting or exceeding theirexpectations.  In both our corrections and commercial markets, ourlong-term customer relationships represent a growing source of predictablefuture installation revenues as well as recurring services — at growth ratesthat well exceed that of our competitors.  Currently, our primary businessis the delivery of these solutions as a systems integrator, though we currentlyproduce some of our own proprietary software and hardware for the correctionsmarket, which we will also sell to other system integrators.  We mayconsider acquisitions if we determine that our ownership of such technologieswill not compromise the best possible products and services to our customerbase.

 

The graphic below depictsour current comprehensive focus areas as well as our desired future serviceofferings.

 

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*SolutionsFocus.*As the industry continues to grow, we are focusing ourefforts in a manner that will allow us to respond to the needs of ourcustomers.  In order to accomplish the goals of our clients, we haveimplemented a business strategy that is client-oriented and solutions focused*.*The key elements of the strategyinclude:

 

·Capitalize on the opportunities emerging from digital convergence, newtechnologies and growing markets to offer customers total security solutions:

 

PRODUCTS+ SOFTWARE + SERVICE = SOLUTIONS

 

·Employ both organic growth and strategic acquisitions to create a publicly heldglobal security company that operates in the areas of our focus markets andchannels.

 

·Capitalize on acquisition targets in a globally fragmented market.

 

·Move expeditiously to reach critical mass — a size sufficient to attract globalcustomers, larger acquisition candidates, exceptional people and efficientcapital.

 

·Leverage technology, products, channels and skill sets.

 

·Enhance and leverage valuable brands and relationships across new geographicregions and channels.

 

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**KeyAlliances**

 

At Argyle Corrections,creating, maintaining and enhancing key alliances with architects, security consultantsand general contractors involved in the development and construction ofdetention facilities is critical for the development of a steady and recurringrevenue stream in a market that is steadily growing.

 

At Argyle CommercialSecurity the focus is to develop alliances with very large and multi-siteregional or national organizations that will then utilize our capabilities fortheir security needs in growth/expansion projects and/or in many locations, soas to provide a steady and profitable revenue stream for us.  Thetechnology partners that are critical to our success are in the primary areasof access control, video, biometrics, fire detection, printers, intercom andperimeter security.  We have established relationships with companies ineach of those fields.

 
| ******Access Control**         | ** ** | **Video**            | ** ** | **Fire Detection /   Printers / Intercom** | ** ** | ******Biometrics** | ** ** | **Perimeter Security** |
|--------------------------------|------------|----------------------|------------|--------------------------------------------|------------|--------------------|------------|------------------------|
|                           |       |                 |       |                                       |       |               |       |                   |
| GE Security                    |       | American  Dynamics   |       | EST                                        |       | Sagem Morpho       |       | RSSI                   |
|                           |       |                 |       |                                       |       |               |       |                   |
| Info Graphic Systems           |       | DVTEL                |       | FARGO                                      |       | LG IRIS            |       | Fiber Patrol           |
|                           |       |                 |       |                                       |       |               |       |                   |
| AMAG Technology                |       | NICE                 |       | AIPHONE                                    |       | RFL OGICS          |       |                   |
|                           |       |                 |       |                                       |       |               |       |                   |
| DSX                            |       | KALATEL              |       | Zenitel                                    |       |               |       |                   |
|                           |       |                 |       |                                       |       |               |       |                   |
| Access  Specialists, Inc. |       | SONY                 |       | Siemens                                    |       |               |       |                   |
|                           |       |                 |       |                                       |       |               |       |                   |
| Software House                 |       | Panasonic            |       | Code Blue                                  |       |               |       |                   |
|                           |       | Bosch                |       | Viking                                     |       |               |       |                   |
|                           |       | Pelco                |       |                                       |       |               |       |                   |
|                           |       | Axis  Communications |       |                                       |       |               |       |                   |

 

**GeographicExpansion and Strategic Acquisitions**

 

We believe that theacquisition of comprehensive manufacturing and product integration capabilitythat can be tightly integrated with Argyle’s other products and will greatlyenhance our competitive posture in capturing business and will also result inmore of the project revenue remaining in-house for enhanced margin.  Inaddition, through our strategic acquisitions, we have added office locationsthroughout the U.S., resulting in our detention sector having the ability tobetter service our customers.

 

We believe that in ArgyleCommercial Security, either acquisition of existing solution providers in someof the larger metropolitan markets in the U.S., or internal expansion toaddress those markets, will enlarge our national footprint and better enable usto service the multi-site organizations that are being sought as customers.External acquisitions will give us access to new customers in the regions thatare of interest and would give us a running start as opposed to the slowerbuild-up that would ensue from internal expansion.

 

**Sales**

 

Our sales goals are tofocus on sales and marketing to niche target markets and those marketsoperating in regions of the market that are not currently addressed today. We wantto maintain a dedicated, highly motivated and organized national account salesteam with the necessary credentials to capture larger scale and multi-sitecommercial security opportunities.

 

**Marketing**

 

Successfully brandingourselves and each of our business units to create greater visibility in theindustry and across the nation is the central goal of our marketingefforts.  We want to coordinate media and public relations campaigns forall Argyle products and services and establish new ideas regarding ways topromote the “Argyle” brand, service, Company, and industry experts throughresearching news and daily events. We want to continue to develop and improve acentralized database system where all sales and marketing staff can track salesleads and customer information, continue to enhance project bid spreadsheet forcost code and pricing structure, facilitate and refine “smarts andparts” bidding requirements and roll out revised project “turn-over”procedures. We also plan to develop a risk analysis format and developenterprise risk management systems to monitor internal and external risks.

 

**CompetitiveStrengths**

 

Our management teambelieves that Argyle is competitively well positioned and believes that it hasa number of strengths versus the competition:

 

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·                  Asolid reputation in both the detention and the commercial market sectors withits customers for on-time project execution, security solution performance andcustomer service that results in a significant amount of repeat business beinggarnered. For example, more than 60% of the revenues for ISI-Detention andMCS-Detention during 2006, 2007, and 2008 have been the result of contractswith repeat customers.

 

·                  Abilityto react to changing technological needs.

 

·                  Asoftware platform that lends itself to very rapid adaptation to the specificrequirements of individual facilities and to the use of the two major operatingsystems in the market-Windows and Linux, with minimal effort.

 

·                  Abroad array of software drivers that allow our solutions to utilize a widevariety of security system peripherals from many different third-partysuppliers.

 

Many of our competitorsdo not have the in-house capability for electronic system solutions. We providethese solutions to our customers thereby further enhancing our value toclients.  Furthermore, we believe that we have leading edge solutions,including touch screen and PDA wireless control for the detention industry,plus a software development process that provides timely and efficient securitysolutions for customers.

 

**Researchand Development**

 

We do not currently havea research and development department or “cost center”. A software developmentteam within MCS-Detention provides our operating arms with new features andcapabilities in developing security solutions. Software development allows newtechnologies to be reviewed and incorporated into our product lines.  Thedevelopment team not only looks at software advances but also hardwarebreakthroughs.  The development team has projects in various stages ofdevelopment which, when completed, will provide us with technology andintegration advantages over our competition.  For example, technology isbeing developed to allow our customers to have a more active role inmodifications to their own products.  Technologies using RFID, Bluetooth,Multi-Touch, RSS, Pod casting, Ultra-wideband and VoIP will bring enhancementsand new feature sets to an already technologically well positioned productline.  Product lines acquired during recent acquisitions are beingresearched.  New hardware and software feature sets for these products arebeing developed which will again set standards in the marketplace but alsoreduce the fabrication time allowing quicker jobsite deployments.

 

**GovernmentRegulations**

 

Various states within theUnited States require companies performing the type of work performed by us indetention facilities to be licensed. We maintain active licenses in every statein which we do business that requires licensing. Outside of detentionfacilities, many states and local municipalities require companies that provideturnkey electronic security systems for commercial facilities to obtain andmaintain special security licenses.

 

The process of obtainingspecialty security licenses is bureaucratic. We have designated personnel tooversee the process for maintaining all of our licenses. Obtaining new licensestypically requires that a test be taken in that state, if it requires a statelicense. If a state license expires or is revoked for any reason, it couldprevent us from being authorized to enter into a contract in that state. If alocal license expires or is revoked for any reason, we may be assessed a fine,depending on the delinquency in regard to that license.

 

The following is a listof the specialty licenses that we have secured as of December 31, 2008:

 

Alabama — Detention &Security Equipment

Arkansas — Sound &Intercom Systems, Fire Detection Systems, Signal & Burglar AlarmSystems, Computer Cabling

Arizona — Low VoltageCommunication Systems

California — Low VoltageSystems

Florida — Alarm SystemContractor

Georgia — UnrestrictedLow Voltage

Iowa — Subcontractor

Idaho — ElectricalLimited Energy Specialty Contractor

Illinois — Private alarmcontractor

Louisiana — ElectricalControls, Prison, Penitentiary, Jail Confinement Institutional Equipment

Minnesota — TechnologySystems Contractor

Mississippi — Security,Burglar & Fire Alarms, Detention Equipment

Montana — Subcontractor(Bid Only Certificate)

North Carolina — LowVoltage Electrical and Alarm

North Dakota —Subcontractor

Nebraska — Subcontractor

 

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New Mexico — Sound,Intercommunication, Alarm System, Installation of Detention Furnishings,Automatic Fire Detection & Alarm Systems

Nevada — Low VoltageSystems, Detention Equipment

Oklahoma — AccessControl, CCTV, Nurse Call, Locksmith

Oregon — Subcontractor

South Carolina — GeneralContractor

Tennessee - ElectricalControls

Texas — Private SecurityAlarm License and Fire Alarm License

Utah — Contractor

Virginia — ElectronicCommunications

Washington — Contractor

City of Arvada — BuildingSubcontractor

City of Aurora — FireAlarm Contractor and Fire Alarm Supervisor

City of Boulder — FireAlarm Systems

City of Broomfield —Contractor

City of Centennial —Business license and Access Control and Security

City of Colorado Springs —Fire Alarm

City of Denver — AccessControl System and Electrical Signal

City of Lakewood —Contractor

City of Littleton —Miscellaneous

City of Loveland — FireAlarm

City of Thornton —Contractor — Fire Alarm

City of Westminster —General Building Contractor

City of Wheat Ridge —Electrical Signal

 

**AvailableInformation**

 

Weelectronically file our annual reports on Form 10-K, quarterly reports on Form 10-Qand current reports on Form 8-K with the Securities and ExchangeCommission (SEC) pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934. Any materials we file with the SEC areaccessible to the public at the SEC’s Public Reference Room at 100 F.Street, N.E., Washington, DC 20549. You may obtain information on the operationof the SEC’s Public Reference Room by calling the SEC at(800) SEC-0330. The public may also utilize the SEC’s Internet website,which contains reports, proxy and information statements, and other informationregarding issuers that file electronically with the SEC. The address of the SECwebsite is http://www.sec.gov.

 

Youmay obtain free copies of our annual reports on Form 10-K, quarterlyreports on Form 10-Q and current reports on Form 8-K and amendmentsto those reports on our website at http://www.argylesecurity.com, or bycontacting our corporate office by calling (210) 828-1700, or by sendingan e-mail message to dneville@argylesecurity.com.

 

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**Item1A. Risk Factors**

 

In addition to theother information in this annual report, the following factors should beconsidered carefully in evaluating the Company’s business and prospects. THEFOLLOWING MATTERS, AMONG OTHERS, MAY HAVE A MATERIAL ADVERSE EFFECT ON THEBUSINESS, FINANCIAL CONDITION, LIQUIDITY, RESULTS OF OPERATIONS OR PROSPECTS,FINANCIAL OR OTHERWISE, OF THE COMPANY. REFERENCE TO THIS CAUTIONARY STATEMENTIN THE CONTEXT OF A FORWARD-LOOKING STATEMENT OR STATEMENTS SHALL BE DEEMED TOBE A STATEMENT THAT ANY ONE OR MORE OF THE FOLLOWING FACTORS MAY CAUSEACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN SUCH FORWARD-LOOKINGSTATEMENT OR STATEMENTS. We are subject to, among others, the following risks:

 

***We have made significant operational changes in response toboth operational and reporting inefficiencies. An inability to successfullyimplement the changes may reduce our profitability.***

 

During 2008, we experienced many operationalchallenges which were largely a result of an integration of newly acquiredentities, as well as, rapid expansion of our existing businesses. In responseto these challenges, during the second half of 2008, we made a number ofpersonnel changes, as well as implemented changes in our financial reportingand accounting systems. Such corrective actions are essential to the continuedsuccess of Argyle. There is no assurance that such corrective actions andmanagement changes will be successful. Further, any failure to implement newlyinstalled financial controls and accounting oversight could result in negativebudget variances and potential defaults of financial covenants. Such failuresto successfully implement the changes could result in decreased profitabilityand a reduction in our revenues.

 

***We operate under fixed price contracts, and our failure toaccurately estimate our costs may reduce our profitability.***

 

Approximately 90%of our revenues result from fixed price contracts. If we do not accuratelyestimate our costs on projects, we could suffer losses on fixed pricecontracts. Unanticipated increases in the cost of raw materials could alsoresult in our losing money on contracts. If we suffer losses on our contracts,our profitability will be reduced. In addition, the revenues that we record underthese contracts are recognized under the “percentage-of-completion method ofaccounting.” This method requires considerable judgment and, as a result, theestimates derived at any point in time could differ significantly and result inmaterial discrepancies between the estimates and the financial reality of theapplicable contract.

 

***Budget constraints of federal, state and local governmentscould reduce our revenues.***

 

Contracts forwhich federal, state or local governments are the ultimate customer have historicallyaccounted for a major portion of our business. The detention systems segment,the largest revenue-producing business segment, outfits correctional facilitiesand courthouses. Many state and local governments operate under very tightbudget constraints. These budget constraints could cause them to delay, reducethe scope of, or cancel pending projects, which could reduce our revenues.

 

***Our failure to obtain and/or maintain required local/statelicenses could reduce our Revenues.***

 

A portion of ourbusiness depends upon obtaining and maintaining required licenses. All suchlicenses are subject to audit by the relevant government agency. Any failure toobtain or maintain required licenses could result in the termination of certainof our contracts or cause us to be unable to bid or re-bid on certaincontracts. In addition, we and/or our employees may be required to maintaincertain facility security clearances. If we or our employees were found not tobe in compliance, we could be excluded from bidding on certain contracts,removed from projects and/or fined, all of which would adversely impact ourfinancial condition and good standing.

 

ISI had beensubject to one audit of its licensing. In 2005, the Arkansas Licensing Boardconducted a hearing regarding the renewal of ISI’s Contractor License for theState of Arkansas. The outcome of the hearing was successful, and ISI wasissued a Contractor’s License.

 

***Our ability to obtain bid, payment and/or performance bondsis critical to our ability to conduct business.***

 

Bid, performance andpayment bonds are an important component of our business. Many customersrequire that performance and payment bonds be delivered to the customer beforethe customer will enter into a contract. Approximately 30% of Contract Revenuesand 20% of overall Revenues for 2008 were generated by “bonded” contracts(contracts that require performance and payment bonds), and approximately 28%of our revenues in the past three years have been derived from bondedcontracts.

 

We believe that we havesufficient bonding capacity to address the total expected business for theremainder 2009. However, there can be no assurance that such bonding capacitywill be increased or whether it will always be available and as a result of thecurrent economic environment, our bonding requirements may significantlyincrease. If we are unable to secure bonding, then we may not be able to enterinto contracts that require such bonds. This would significantly reduce ourexpected sales and reduce the level of 

 

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our future financialperformance. Some of the additional factors that might cause us to be unable toobtain such bonds include, but are not limited to, unacceptably high premiumrates for such bonds, the unavailability of bonding capacity at an acceptablecost from a bonding company with an acceptable financial rating, or thecollateral/financial requirements of the bonding company. Such requirements aregenerally intended to provide liquidity to a bonding company should it becomeobligated to pay a claim. These requirements can include minimum cash reserves,letters of credit for the benefit of the bonding company and other irrevocablecommitments of working capital that are unacceptably high.

 

***If we are required to make any significant payments as aresult of our indemnification obligations arising from specified ISI*MCSbonding contracts or guarantees, such payments may negatively impact ouroperating results.***

 

Argyle agreedthat, after the acquisition of ISI was consummated, it would indemnify and holdharmless Sam Youngblood and Don Carr, their spouses, attorneys, agents andpermitted assignees against any losses incurred arising from a contract oragreement that is the subject of a performance or payment bond provided byISI*MCS or guarantees by the indemnitees relating to any of the performance orpayment bonds provided by ISI*MCS, to the extent such contract had not beenfully paid as of the closing of the acquisition. These indemnificationobligations survive until July 30, 2011 and the obligations are notsubject to a cap or maximum amount. Although it is not anticipated that Argylewill be required to make any payments under this provision, if Argyle wererequired to do so, it could result in Argyle having to pay Mr. Youngbloodand/or Mr. Carr a significant amount of money. Management estimates thatthe potential risk on such indemnification could be approximately $1,958,815,which consists of all potential liability that could arise from all bondedcontract obligations due and owing as of December 31, 2008 and assumesthat all work performed or to be performed on bonded contracts isunsatisfactorily completed.

 

***Our significant debt could adversely affect our financialhealth and pose challenges for conducting our business.***

 

We have and will continueto have a significant amount of debt and other obligations, primarily tosupport our bonding requirements and customer financing activities. As of December 31,2008, we had $36.4 million of total debt. Our total cash and cash equivalentswas $13.6 million at December 31, 2008 (of which $5.0 million of cash isrestricted). Our substantial debt and other obligations could have importantconsequences. For example, it could (i) increase our vulnerability togeneral adverse economic and industry conditions; (ii) limit our abilityto obtain additional financing for future working capital, capitalexpenditures, acquisitions and other general corporate requirements; (iii) increaseour vulnerability to interest rate fluctuations because a portion of our debthas variable interest rates; (iv) require us to dedicate a substantialportion of our cash flows from operations to service debt and other obligationsthereby reducing the availability of our cash flows from operations for otherpurposes; (v) limit our flexibility in planning for, or reacting to,changes in our business and the industry in which we operate; and (vi) placeus at a competitive disadvantage compared to our competitors that have lessdebt. If new debt is added to our current debt levels such as the incurrence ofdebt to partially fund acquisitions, these related risks could increase.

 

***We may violate certain financial covenants related to oursenior and subordinated debt facilities.***

 

Our ability to complywith the financial and other covenants contained in our senior and subordinateddebt facilities may be affected by our own operating performance, changes ineconomic or business conditions, or other events beyond our control. If we donot comply with these covenants and restrictions, we could be in default andthe debt, together with accrued interest, could be declared immediatelypayable. If we are unable to repay any borrowings when due, the lenders couldproceed to take action to satisfy the obligations by taking possession of theircollateral, which includes most of our assets. If any of our debt isaccelerated, we may not have sufficient assets to repay amounts due. The seniordebt facility entered into by us contains covenants that require us to maintaincertain total and senior debt-to-EBITDA and fixed-charge-coverage ratios. Wehave received a waiver for any violation of covenants at December 31,2008. It is possible that we may violate the financial covenants in its seniordebt facility at some point in the future for which we may not be able toreceive a waiver. There can be no assurance that we will be able to obtainwaivers in the future in the event another violation occurs.

 

***If we are unable to design and market our security solutionsin a timely and efficient manner, we may not remain competitive.***

 

Some of ourmarkets are characterized by continuing technological advancement, changes incustomer requirements and evolving standards. In particular, the detention andcorrections market relies on the development, implementation, and support ofcomplex, integrated software and hardware systems. To compete successfully, wemust develop and market new products that provide increasingly higher levels ofperformance and reliability. Product development is highly uncertain, and wecannot guarantee that we will successfully develop new products. Our inabilityto develop and market these products, or to achieve customer acceptance ofthese products, could limit our ability to compete in the market.

 

In addition, weoffer a wide variety of solutions. If the design or marketing of a securitysolution, is not successful and we must allocate more resources to ensure moresales, it could lower the profitability of the work, or affect customerperceptions as to the quality of the products and services being offered.

 

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***We depend on third-party hardware for our customizedsecurity solutions.***

 

We purchase thehardware for our customized security solutions from third-party vendors.Currently our ISI-Detention and MCS-Detention divisions do not have long-termagreements with the third-party vendors with whom they do business. Anyreduction or interruption in the supply or manufacturing of hardware from thesethird-party vendors could limit our ability to offer and deliver completesecurity solutions to its customers and could result in reduced revenues.

 

MCS-Commercial hasdistribution agreements in place with some of its third-party vendors. If anyof these vendors were to terminate or cancel its agreement with MCS-Commercial,this division would lose its ability to market that vendor’s specific productline to our customers. To the extent that we are unable to find a competingbrand with the same level of acceptance among our customers, we could sufferthe loss of some customers.

 

***We are subject to substantial government regulation thatcould cause delays in the delivery of our products and services and may subjectArgyle to audits or other similar review processes.***

 

As a contractorand subcontractor to agencies of various federal, state and local governments,we are obligated to comply with a variety of regulations governing ouroperations and the workplace. Unforeseen problems in the performance ofcontracts could cause the loss of licensing to do business within a particularcity, county, state, or other governmental entity resulting in us losingcontracts with that entity. In addition, changes in federal, state and locallaws and regulations may impact our ability to secure new contracts or requireus to make costly changes to our operations which could reduce ourprofitability in order to obtain contracts.

 

***Our inability to effectively integrate future acquisitionscould reduce our profitability.***

 

Part of ourbusiness strategy is to grow through strategic acquisitions and, since December 31,2007, we acquired PDI, Com-Tec and Fire Quest. For the acquisition of other newbusinesses to be successful, we must integrate the operations, systems andpersonnel from those acquired businesses into Argyle. This integration processrequires, among other things, that we continually evaluate our operations,financial systems and controls and, when necessary, enhance and adjust thosesystems and controls. If the acquired businesses are not successfullyintegrated into Argyle, the key employees and their relationships with newcustomers, as well as their expertise and reputation in the industry, could belost and/or destroyed, resulting in lower than expected sales and reducedrepeat business, if any, from those acquired customers. Additionally, the newcustomers acquired could be lost which would reduce expected revenues from theacquisition and reduce expected profitability.

 

***We may need additional financing for bonding requirements,working capital and capital expenditures, and additional financing may not beavailable on favorable terms.***

 

In order tooperate the business, we may need to obtain additional surety bonds, maintainworking capital or make significant capital expenditures. In order to do any ofthose things, we may need to obtain additional capital. Therefore, our abilityto operate and grow is dependent upon, and may be limited by, among otherthings, the availability of financing arrangements. If we are not able toobtain the additional capital necessary to pursue new projects or maintain ouroperations, we may not be able to grow as quickly as we plan. In addition, evenif we are able to obtain additional financing, the additional financing may notbe on terms which are favorable to us and could hamper our profitability.

 

***We could potentially incur liability to clients and others.***

 

Our involvement inthe public security, physical security and surveillance and justice businessesexposes us to potential liability claims from our clients. Our products areused in applications where their failure could result in serious personalinjuries or death. In the area of corrections, prisoners are generally viewedas litigious. We have sought ways to minimize losses from these sources byobtaining product liability and professional liability insurance policies;however, a successful claim could result in liability in excess of coveragelimits or the cancellation of insurance coverage and result in our having topay a large amount of our working capital to cover those claims.

 

***We are dependent upon key personnel.***

 

We depend on theexpertise, experience and continued services of our senior management and keyemployees such as:

 

·                                          *Bob Marbut —Chief Executive Officer of ArgyleSecurity, Inc.*Mr. Marbut is the Chief Executive Officerof Argyle, and his knowledge of our business and reputation in the industrymake him important to our success.

 

·                                          *Ron Chaimovski —Executive Chairman of the Board ofArgyle Security, Inc.*Mr. Chaimovski is the ExecutiveChairman of the Board of Directors of Argyle, and his knowledge of our businessand reputation in the industry make him important to our success.

 

·                                          *Sam Youngblood — President and Chief OperatingOfficer of Argyle Security, Inc.*Mr. Youngblood isPresident and 

 

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Chief OperatingOfficer of Argyle, and his knowledge of our business and reputation in theindustry make him important to our success.

 

·                                          *Donald F. Neville — Executive Vice President andChief Financial Officer of Argyle Security, Inc.*Mr. Nevilleis the Chief Financial Officer of Argyle, and his knowledge and experience incapital markets make him important to our success.

 

Our operations andmost decisions concerning our business will be made, or significantlyinfluenced, by such individuals. The loss of members of senior management orkey employees could result in the deterioration or loss of relationships withcertain customers or suppliers, which could result in a material loss ofbusiness.

 

***We are in a competitive industry with well financedcompetitors.***

 

As a result ofincreasing consolidation in the corrections and security industries andincreasing attention from venture funds and private equity groups, many of ourcompetitors, some of which were already larger and better financed than us,have grown and obtained significant financing. Accordingly, we expectcompetition to increase in the near future. We also expect that some of our competitorswill feel increasing pressure to underbid government and commercial projects,in order to deploy their workforces and maintain or step up their activitylevels. This may make it more difficult for us to prevail on competitive bidsfor projects to the degree we have historically experienced.

 

***Many of our new contracts are subject to competitivebidding.***

 

Most governmentalagencies and many commercial customers require that their significant contractsbe competitively bid. Typically they utilize the “Request for Proposal” (RFP)method where several competitors submit their sealed proposals for a particularproject, or the “Request for Qualifications” (RFQ) process where competitorssubmit their qualifications for consideration by the customer. Some contractsare open for bidding, using the standard “Straight Bid” process where thedetailed specifications for a project are published and contractors submit a “Bid”or fixed price, for the contract to build the project. Other competitivebidding processes are also utilized. Our success in responding to an RFP, RFQ,Straight Bid, or other competitive bidding process is dependent upon thequality of our estimating process, knowledge of the industry, knowledge of ourcustomers and other factors requiring significant judgment and expertise.Because of the nature of the bidding process, we cannot know if we will besuccessful on any given bid, which makes it difficult to accurately forecastthe timing of projects and budget the allocation of resources. To the extent wehave made significant capital expenditures in the development and estimating ofa contract or project, we may not recover our entire capital investment in thatproject.

 

When seekingcompetitive bids, one of the factors that most governmental entities andcommercial customers evaluate is the financial strength of the bidders. To theextent they believe we do not have sufficient financial resources, we will beunable to effectively compete for contracts.

 

***Our ability to win new contracts depends on many factorsoutside of our control.***

 

Our growth in thecorrections industry is generally dependent upon our ability to win newcontracts. This depends on a number of factors we cannot control, includingcrime rates and sentencing patterns in various jurisdictions. Accordingly, thedemand for security-related goods and services for new correctional facilitiescould be adversely affected by the relaxation of enforcement efforts, leniencyin conviction and sentencing practices or through the legal decriminalizationof certain activities that are currently proscribed by criminal laws. Forinstance, changes in laws relating to drugs and controlled substances orillegal immigration could reduce the number of persons arrested, convicted andsentenced, thereby potentially reducing demand for new correctional facilitiesto house them. Similarly, reductions in crime rates could lead to reductions inarrests, convictions and sentences requiring new correctional facilities.

 

Furthermore,desirable locations for proposed correctional facilities may be in or nearpopulated areas and, therefore, may generate legal action or other forms ofopposition from residents in areas surrounding a proposed site. Such actionscould substantially delay a correctional project or cause the project to bereduced in scope or be eliminated completely.

 

We offer some bidsfor new contracts directly to government agencies and commercial customers as adirect contractor to provide the security solutions for a project. In otherinstances, we provide our bid for security solutions to a general contractor,who adds our pricing to all the other pricing for an entire project. In thoseinstances we act as a subcontractor to the general contractor. The owner of theproject (the governmental entity or commercial owner) will choose whether theywish to receive bids only from general contractors, or whether they wish toreceive bids separately from the entities providing security solutions, such asus and our competitors. When we are acting as a subcontractor to a generalcontractor, we have far less control and input over the final price for theproject submitted to the owner by the general contractor than when we submit abid directly, therefore, such circumstances reduce our ability to wincontracts.

 

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***Governmental agencies may investigate and audit ourcontracts and, if any improprieties are found, we may be required to refundrevenues, pay unexpected taxes, forego anticipated revenues and/or may besubject to penalties and sanctions, including prohibitions on our bidding inresponse to competitive bidding processes.***

 

Governmentalagencies and most commercial customers will have the authority to audit andinvestigate our contracts with them. As part of that process, some governmentalagencies review our performance on the contract, our pricing practices, changeorders, other compliance with the terms of the contracts, and applicable laws,regulations and standards. For example, if an agency determines that we haveimproperly classified a specific contract as non-taxable, we could be requiredto pay sales, use or other taxes for which no reserve was created at the timethe bid was submitted by us. If the agency determines that we have improperlybilled the governmental entity in violation of the terms of the contract, wecould be required to refund revenues, or forgo anticipated revenues. If agovernment audit uncovers improper or illegal activities by us or it otherwisedetermines that these activities have occurred, we may be subject to civil andcriminal penalties and administrative sanctions, including termination ofcontracts, forfeitures of profits, suspension of payments, fines and suspensionor disqualification from doing business with the government.

 

***Budgetary pressure on federal, state, county and localgovernments may result in contract cancellation by prison operators, whichwould reduce our profitability.***

 

Our cash flow is subjectto the receipt of sufficient funding of and timely payment by contractinggovernmental entities. If the appropriate governmental agency does not receivesufficient appropriations to cover its contractual obligations, a contract maybe terminated or the amounts payable to us may be deferred or reduced.

 

Federal, state, countyand local governments have encountered, and are expected to continue toencounter, significant budgetary constraints that may result in a reduction ofspending on the outsourced services that we provide. Such budgetary limitationsmay cause the contractual commitments for new construction projects to bedelayed, reduced or even eliminated. Many states, as well as the federalgovernment, are facing significant budget deficits and are under pressure toreduce current levels of spending or control additional spending. Examples ofthis budget pressure include the need of the federal government to operateunder a continuing resolution as a result of its failure to pass a new2008/2009 year budget and reported budget pressures in various states,including Georgia and California. If such budgetary pressure continues, we maysee a reduction in the amount of business conducted by the Argyle Correctionsbusiness segment until such funding becomes available.

 

***Public reporting of financial statements and negative mediacoverage, including inaccurate or misleading information, could injure ourreputation and our ability to bid for new business.***

 

Our competitorsand our customers may use our SEC filings, press releases and conference callsto our competitive disadvantage. We compete for new business with somecompanies that do not have public reporting requirements and which do not filepress releases announcing financial results. In some cases, the requirements wehave as a public reporting company may result in public disclosure of financialinformation, although accurate, that may be potentially harmful to ourbusiness.

 

In addition, themedia frequently focuses its attention on contracts with governmental agencies.If the media coverage regarding the contracts for the design, development,construction, financing or operation of a new correctional facility project isnegative, it could influence government officials to slow the pace of buildinga correctional project or cause the cancellation of a planned correctionalfacility.

 

Jails, prisons andother public correctional projects may prompt higher than normal mediascrutiny. In that atmosphere, inaccurate, misleading, or negative mediacoverage about us could harm our reputation and, accordingly, our ability tobid for and win new contracts.

 

***Inability to effectively implement our strategy to moreefficiently and effectively implement our plan to reduce operating costs mayhave a significant impact on our cash flow.***

 

During the second half of2008 and into 2009, we have made significant systematic and personnel changesin order to manage project cost increases as well as our operational expenses.We have employed new individuals or reassigned other individuals to implementour plans.  Achievement of our goals to manage costs is not assured. Inthe event that we do not effectively implement our plans, we may see a decreasein its cash flow and we may continue to have further margin erosion and declinein EBITDA.

 

***Inability to effectively implement changes to our internalcontrols over our financial reporting systems to remedy existing and eliminatefuture significant deficiencies and material weaknesses may have a significantimpact on our business.***

 

During the last severalmonths we have made significant systemic changes in order to attempt to remedycertain organizational and financial reporting deficiencies which have led toour discovery of significant deficiencies and a material weakness in ourinternal controls. We have employed new individuals or reassigned otherindividuals to handle the implementation of our plans.  In the event thatour control system changes are not effective, we may be subject to increasedscrutiny by our independent public accounting firm 

 

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and our Board ofDirectors. Further, in the event that our financial statements or businessmodel are deemed unreliable as a result of significant deficiencies or materialweaknesses in our internal controls for financial reporting, we may become indefault of our loan obligations, may not be able to attract new investors and theprice of our securities on the OTC Bulletin Board may decrease.

 

***The volatility and disruption of the capital and creditmarkets and adverse changes in the economy may negatively impact our ability toaccess financing, and to generate revenues and earnings.***

 

The capital and creditmarkets have been experiencing extreme volatility and disruption for more than12 months.  In the third and fourth quarters of 2008, such volatility anddisruption have reached unprecedented levels.  The markets have exerteddownward pressure on availability of liquidity and credit capacity for manyissuers, including us.

 

While we intend tofinance our operations with existing cash, cash flow from operations andborrowing under our existing senior credit facility, we may require additionalfinancing to support our continued growth.  However, due to the existinguncertainty in the capital and credit markets, access to capital may be limitedon terms acceptable to us, or unavailable.  Our customers may also comeunder greater budgetary pressure as a result of economic and financial marketconditions, which could negatively impact our revenues and earnings.

 

***If we fail to satisfy our contractual obligations, ourability to compete for future contracts will be limited.***

 

Our failure tocomply with contract requirements or to meet our clients’ performanceexpectations when performing a contract could injure our reputation, which, inturn, would impact our ability to compete for new contracts. Our failure tomeet contractual obligations could also result in substantial actual andconsequential damages. In addition, our contracts often require us to indemnifyclients for our conduct that causes losses to the client. Some contracts maycontain liquidated damages provisions and financial penalties related toperformance failures. Although we have liability insurance, the policy limitsmay not be adequate to provide protection against all potential liabilities.

 

 ***We derive a significant portion ofour revenues from a small number of customers, and the loss of a significantcustomer could significantly reduce our revenues.***

 

Ourcustomer base and revenues are concentrated among a limited number ofcustomers, and the loss of any one of these customers could significantlyreduce our revenues.  During the fiscalyear ended December 31, 2008, revenues from our top three customers, whichwere all from the Argyle Corrections business segment, represented 27% of ourtotal revenues.  During the fiscal yearended December 31, 2008, we had revenues from our top two customers, whichwere all from Argyle Corrections, which each represented 19% of our totalrevenues.  These concentrations are upfrom the fiscal year ended December 31, 2007, when the top three customersrepresented 20% of our total revenues, but down from the fiscal year ended December 31,2006, when the top three customers represented 33% of our total revenues.  As a result of the current economicenvironment, there has been a greater emphasis on pricing. In the past, thebest products and value were factors in the bidding process; recently customershave been solely concerned with accepting the lowest bid. Because of thischange, we believe that there is a likelihood that certain future proposals byArgyle Corrections will not be accepted, that may have been accepted in thepast. Although we have existing relationships and technological advantages thatcould result in our proposals being more attractive than a less costlyproposal, there is no guarantee that we will be awarded such contracts in thefuture.

 

***Registration rights held by our stockholders may keep themarket price of our stock lower than it would otherwise be.***

 

Some of ourstockholders, including those who purchased common stock prior to our initialpublic offering and the holders of our Series A Convertible PreferredStock are entitled to demand that we register the resale of their shares atvarious times. If such stockholders exercise their registration rights withrespect to all of their shares, there will be significant additional shares ofcommon stock eligible for trading in the public market. The presence of theseadditional shares could keep the market price of our stock lower than it wouldotherwise be.

 

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***Because we do not intend to pay dividends on our commonstock, stockholders will benefit from an investment in our common stock only ifit appreciates in value.***

 

We have never declared orpaid any cash dividends on our shares of common stock. We intend to retain allfuture earnings, if any, for use in the operations and expansion of thebusiness. As a result, we do not anticipate paying cash dividends in the foreseeablefuture. Any future determination as to the declaration and payment of cashdividends will be at the discretion of our Board of Directors and will dependon factors the Board of Directors deems relevant, including among others, ourresults of operations, financial condition and cash requirements, businessprospects, and the terms of our credit facilities, preferred stock, and otherfinancing arrangements. The debt financing arrangements we put into placeprohibits us from declaring or paying dividends without the consent of ourlenders. Accordingly, realization of a gain on stockholders’ investments willdepend on the appreciation of the price of our common stock. There is noguarantee that our common stock will appreciate in value.

 

***Our securities are quoted on the Over-the-Counter BulletinBoard, which may limit the liquidity and price of our securities more than ifthe securities were quoted or listed on an exchange.***

 

Our securities arequoted on the Over-the-Counter Bulletin Board, a FINRA-sponsored and operatedinter-dealer automated quotation system. Quotation of our securities on theOver-the-Counter Bulletin Board will limit the liquidity and price of oursecurities more than if the securities were quoted or listed on an exchange.

 

***We may choose to redeem our outstanding warrants at a timethat is disadvantageous to the warrant holders.***

 

Subject to therebeing a current prospectus under the Securities Act of 1933, Argyle may redeemall of its outstanding warrants at any time after they become exercisable at aprice of $0.01 per warrant, upon a minimum of 30 days prior written notice ofredemption, if and only if, the last sale price of our common stock equals orexceeds $11.50 per share for any 20 trading days within a 30 trading day periodending three business days before Argyle sends the notice of redemption.Calling all of our outstanding warrants for redemption could force the warrantholders:

 

·                                          Toexercise the warrants and pay the exercise price for such warrants at a timewhen it may be disadvantageous for the holders to do so;

 

·                                          Tosell the warrants at the then current market price when they might otherwisewish to hold the warrants; or

 

·                                          Toaccept the nominal redemption price which, at the time the warrants are calledfor redemption, is likely to be substantially less than the market value of thewarrants.

 

***Our warrant holders may not be able to exercise theirwarrants, which may create liability for us.***

 

Holders of thewarrants we issued in our initial public offering and private placement will beable to receive shares upon exercise of the warrants only if (i) a currentregistration statement under the Securities Act of 1933 relating to the sharesof its common stock underlying the warrants is then effective and (ii) suchshares are qualified for sale or exempt from qualification under the applicablesecurities laws of the states in which the various holders of warrants reside.Although we have agreed to use our best efforts to maintain a currentregistration statement covering the shares underlying the warrants to theextent required by federal securities laws, and we intend to comply with suchagreement, we cannot assure that we will be able to do so. In addition, somestates may not permit us to register the shares issuable upon exercise of ourwarrants for sale. The value of the warrants will be greatly reduced if aregistration statement covering the shares issuable upon the exercise of thewarrants is not kept current or if the securities are not qualified, or exemptfrom qualification, in the states in which the holders of warrants reside.Holders of warrants who reside in jurisdictions in which the shares underlyingthe warrants are not qualified and in which there is no exemption will beunable to exercise their warrants and would either have to sell their warrantsin the open market or allow them to expire unexercised. If and when thewarrants become redeemable, we may exercise our redemption right even if we areunable to qualify the underlying securities for sale under all applicable statesecurities laws. Since our obligations in this regard are subject to a “bestefforts” standard, it is possible that, even if we are able to successfullyassert a defense to a claim by warrant holders due to the impossibility ofregistration, a court may impose monetary damages on us to compensate warrantholders due to the change in circumstances that led to us being unable tofulfill our obligations.

 

***If outstanding public warrants are exercised, the underlyingcommon shares will be eligible for future resale in the public market. ‘‘Marketoverhang’’ from the warrants results in dilution and could keep the marketprice of our stock lower than it would otherwise be.***

 

Outstanding publicwarrants and unit purchase options to purchase an aggregate of 4,075,046 sharesof common stock issued in connection with Argyle’s initial public offering andthose for services rendered in connection with a financing transaction arecurrently exercisable. If they are exercised, a substantial number ofadditional shares of our common stock will be eligible for resale in the publicmarket, which could keep the market price of our stock lower than it wouldotherwise be.

 

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***The agreements governing our shares of convertible preferredstock contain covenants and restrictions that may limit our ability to operateour business.***

 

The terms of our Series Aand Series B Convertible Preferred Stock limit our ability to, among otherthings, declare or pay dividends or distributions on our common equitysecurities, create or incur additional preferred stock, repurchase commonstock, and to utilize funds from the sale of the Series A ConvertiblePreferred Stock for the payment of debt of ISI and its subsidiaries, makeacquisitions or pay bonuses to executive management unless we have $50 millionof bonding availability.  These restrictions could adversely affect ourability to raise additional equity to fund our future operations.  Inaddition, upon any sale or liquidation, the holders of the preferred stockwould be entitled to receive payment of their liquidation preference prior toany payment to our common stockholders.  The holders of our preferredstock also have registration rights which, if exercised, would result inadditional shares of our common stock being available for resale and couldadversely impact the market price of our common stock.

 

**Item1B. Unresolved Staff Comments**

 

None.

 

**Item2. Description of Property**

 

The principal propertiesof the Company at December 31, 2008 are as follows. Property at eachlocation is leased.

 
| ** **                                                              | ** ** | **Office**          | ** ** | **Warehouse**       | ** ** | ** **     | ** ** | **Total**           | ** ** |
|-------------------------------------------------------------------------|------------|---------------------|------------|---------------------|------------|----------------|------------|---------------------|------------|
| **Location**                                                            | ** ** | **Square  Footage** | ** ** | **Square  Footage** | ** ** | **Lease Type** | ** ** | **Square  Footage** | ** ** |
| 12903 Delivery Drive  San Antonio, Texas 78247 (1)                      |       | 16,000              |       | 0                   |       | Capital        |       | 16,000              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 12918 Delivery Drive  San Antonio, Texas 78247 (1)                      |       | 6,000               |       | 2,000               |       | Capital        |       | 8,000               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 12902 Flagship Drive  San Antonio, Texas 78247 (1)                      |       | 7,000               |       | 0                   |       | Capital        |       | 7,000               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 12906 Flagship Drive  San Antonio, Texas 78247 (1)                      |       | 16,587              |       | 2,000               |       | Capital        |       | 18,587              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 2472 Southwell Road  Dallas, Texas 75229                                |       | 14,350              |       | 659                 |       | Operating      |       | 15,009              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 8001 East 196th Street, Ste. B  Noblesville, Indiana 46062         |       | 900                 |       | 0                   |       | Operating      |       | 900                 |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 10624 Rockley Road  Houston, Texas 77099                                |       | 2,303               |       | 4,778               |       | Operating      |       | 7,081               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 12201 Technology  Suite 150  Austin, Texas 78727                   |       | 4,500               |       | 1,500               |       | Operating      |       | 6,000               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 577 and 583 N. Batavia Street  Orange, California  92868           |       | 3,006               |       | 26,703              |       | Operating      |       | 29,709              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 990 S. Cherry Ave.  Tucson, Arizona 85719                               |       | 1,807               |       | 19,692              |       | Operating      |       | 21,499              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 12915 Delivery Drive  San Antonio, Texas 78247 (1)                      |       | 4,975               |       | 9,167               |       | Operating      |       | 14,142              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 1818 West 6th Avenue, Unit 6-A  Golden, Colorado 80401             |       | 1,440               |       | 7,815               |       | Operating      |       | 9,255               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 3030 E. Goodland Drive  Appleton, Wisconsin 54911                       |       | 12,600              |       | 20,400              |       | Operating      |       | 33,000              |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 200  Concord Plaza, Suite 700  San Antonio, TX 78216          |       | 5,457               |       | 0                   |       | Operating      |       | 5,457               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| 156 West 56th Street, Suite 1605  New York, NY 10019 (2) |       | 3,178               |       | 0                   |       | Operating      |       | 3,178               |       |
|                                                                    |       |                |       |                |       |           |       |                |       |
| Total Space                                                             |       | 100,103             |       | 94,714              |       |           |       | 194,817             |       |

 

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(1)  Propertiesleased by Green Wing Management, Ltd., an entity owned and controlled by SamYoungblood and Don Carr.  The leases on these properties were amended aspart of the acquisition of ISI to reflect a term of 12 years ending in 2019 andto require that an appraisal be completed by a qualified appraiser to determinethe market rate of the leases. The rental rate to be paid on these properties,after the acquisition of ISI, is limited to no more than 90% of the market ratedetermined by the third-party appraiser. Additional appraisals by a third-partyappraiser are to be conducted every three years during the 12 year terms andthe annual lease rate in the leases can increase at the time of theseappraisals, but only to a level that does not to exceed 90% of the market ratedetermined by the third-party appraiser. Argyle has the right to purchase thesethree properties at any time, at the then current market value; however, thepurchase price cannot be less than the value determined in the last appraisalpreceding the effective date of the acquisition of ISI.

 

(2)  During the first quarterof 2008, the Company entered into a Board-approved agreement with Sec-TecGlobal, Inc. (“Sec-Tec”) to share certain expenses related to commonoffice space in New York, NY as well as administrative related expenses in theNew York office. These expenses are being borne by the Company to reflectrealistic expenses associated with the Company’s conduct of business in NewYork. The Company has agreed to share expenses totaling $175,000 on an annualbasis that are to be paid in quarterly payments of $43,750. Sec-Tec is awholly-owned subsidiary of Electronics Line 3000 of which the Company’sExecutive Chairman and CEO are stockholders and board members.

 

**Item3. Legal Proceedings**

 

Fromtime to time, the Company has various lawsuits, claims, and contingentliabilities arising from the conduct of its business; however, in the opinionof management, other than specifically mentioned below, they are not expectedto have a material adverse effect on the combined results of operations, cashflows, or financial position of the Company.

 

On April 21,2008, Metroplex Control Systems, Inc. (“MCS”) made claims in the UnitedStates District Court for the District of Colorado for Breach of Contract andBad Faith insurance practices against Travelers and Richard E. Gash ElectricCompany (“Gash”) arising out of a Payment Bond, Bond No. 104612565 wherebythe penal sum of the Bond is $5,998,488.00 (the “Bond”), issued by Travelers assurety on behalf of Gash as principal in relation to the design andconstruction of the access control point at the Pueblo Chemical Depot inPueblo, Colorado (the “Project”). The total loss incurred by MCS as a result ofnon-payment was approximately $950,000. On September 26, 2008, the Partiesentered into a Settlement Agreement in order to provide for payment in full settlementand discharge of all claims against Travelers in any way relating to the Bondand/or Civil Action and for the assignment of claims and judgments which MCShas in regard to Gash’s performance on the Project (the “Settlement”).Travelers paid to MCS a settlement payment of $643,654.20. As a result of theSettlement, MCS accounted for an uncollected receivable of $310,246.

 

On January 23, 2009, MCS-Detention filed aclaim of breach of fiduciary duty against Master Control Systems, Inc. andeach of Mr. Chris Bowling and Mr. John Lyon, two ex-employees of MCSDetention (collectively, the “Defendants”) who started a business in November 2007to specifically compete with MCS-Detention. Further, the individuals solicitedexisting customers and utilized proprietary information in an attempt todisparage MCS-Detention. The case is currently in the discovery phase. On February 23, 2009, the Defendantsresponded to the complaint by entering a general denial of all claims andasserting affirmative defenses. In addition, the Defendants assertedcounterclaims for failure to pay for overtime as non-exempt employees under theU.S. Fair Labor Standards Act and for failure to pay bonuses, vacation pay andpersonal and vehicle expenses incurred during the course of employment. We arepreparing our response to these counterclaims. The Defendants have not requested a specific request for damages.

 

**Item4. Submission of Matters to a Vote of Security Holders**

 

During the fourth quarterof our fiscal year ended December 31, 2008, there were no matterssubmitted to a vote of security holders.

 

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**PART II**

 

**Item5. Market for Registrant’s Common Equity, Related Stockholder Matters andIssuer Purchases of Equity Securities**

 

Argyle’s common stock,warrants and units are quoted on the OTC Bulletin Board under the symbols ARGL,ARGLW and ARGLU respectively.

 

Argyle’s units commencedpublic trading on January 30, 2006, and common stock and warrantscommenced public trading on March 2, 2006. The table below sets forth, forthe calendar quarters indicated, the high and low bid prices for the securitiesas reported on the OTC Bulletin Board in U.S. dollars. These quotations reflectinter-dealer prices, without markup, markdown or commissions, and may notrepresent actual transactions.

 
| ** **                                        | ** ** | **Common Stock** | ** ** | **Warrants** | ** ** | **Units** | ** ** |
|---------------------------------------------------|------------|------------------|------------|--------------|------------|-----------|------------|
| ** **                                        | ** ** | **High**         | ** ** | **Low**      | ** ** | **High**  | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  2007                               |       | 7.50             |       | 7.35         |       | 1.10      |       | 0.80 |   | 8.50 |   | 8.14 |   |
| Second Quarter  2007                              |       | 7.90             |       | 7.42         |       | 1.90      |       | 0.74 |   | 9.75 |   | 8.20 |   |
| Third Quarter  2007                               |       | 7.90             |       | 7.30         |       | 2.15      |       | 1.81 |   | 9.80 |   | 9.30 |   |
| Fourth Quarter  2007                              |       | 7.60             |       | 6.33         |       | 2.15      |       | 1.45 |   | 9.55 |   | 7.75 |   |
|                                              |       |             |       |         |       |      |       |   |   |   |   |   |   |
| First Quarter  2008                               |       | 7.80             |       | 6.50         |       | 2.39      |       | 1.60 |   | 10.00 |   | 8.15 |   |
| Second Quarter  2008                              |       | 7.10             |       | 4.50         |       | 1.75      |       | 0.51 |   | 9.00 |   | 5.00 |   |
| Third Quarter  2008                               |       | 5.00             |       | 2.90         |       | 0.69      |       | 0.40 |   | 5.51 |   | 3.00 |   |
| Fourth Quarter  2008                              |       | 2.75             |       | 0.22         |       | 0.40      |       | 0.00 | (1) | 2.85 |   | 0.21 |   |
|                                              |       |             |       |         |       |      |       |   |   |   |   |   |   |
| First Quarter  2009 (through March 27, 2009) |       | 0.80             |       | 0.35         |       | 0.00      | (1)        | 0.00 | (1) | 0.29 |   | 0.25 |   |

 

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(1)   Price equal less than one cent.

 

**Numberof Holders of Common Stock**

 

As of December 31,2008, there were of record 34 holders of common stock, three of warrants, andone of units. Argyle believes the number of beneficial holders of each of thesesecurities is significantly greater than the number of record holders. Based onthe last search conducted by Broadridge Financial Solutions, Inc. on February 11,2009, we believe there are approximately 134 beneficial holders of our commonstock.

 

**Dividends**

 

We have never declared orpaid cash dividends on our capital stock and do not anticipate declaring orpaying cash dividends in the foreseeable future. Payments of future dividends,if any, will be at the discretion of our board of directors after taking intoaccount various factors, including our financial condition, operating results,current and anticipated cash needs, plans for expansion and other factors thatour board of directors may deem relevant.

 

**RecentSales of Unregistered Securities**

 

During the fourth quarterof our fiscal year ended December 31, 2008, there were no issuances ofsecurities that were not previously reported.

 

On January 8, 2009,we entered into a Securities Purchase Agreement (the “Purchase Agreement “)with Mezzanine Management Fund IV A, L.P. and Mezzanine Management Fund IVCoinvest A, L.P. (the “Purchasers”), and Sam Youngblood, Ron Chaimovski and BobMarbut (together, with their affiliates, the “Stockholders”), pursuant to whichthe Purchasers purchased 27,273 shares of a newly created series of ourpreferred stock, designated “Series B Convertible Preferred Stock”, parvalue $0.0001 per share (the “Series B Preferred Shares”) for $110 pershare, for an aggregate purchase price of $3,000,030 (the “Series B Financing”).

 

Each Series BPreferred Share is convertible into 100 shares of our common stock at any time,at the option of the holder, initially at a conversion price of $1.10 per shareof common stock for up to 2,727,300 shares of common stock, subject toadjustment for stock dividends, stock splits or similar capitalreorganizations, and weighted average price protection for certain issuancesbelow the conversion price.

 

The Series BPreferred Shares have voting rights equal to the number of shares of commonstock the holder would receive if all Series B Preferred Shares had beenconverted into common stock. The holders of the Series B Preferred Sharesmay also designate one individual to serve on the Company’s Board of Directors.

 

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The holders of the Series BPreferred Shares shall be entitled to receive, on a cumulative basis, cashdividends, when, as and if declared by the our Board of Directors, at thegreater of (i) 4% per annum or (ii) the dividend payable on theequivalent amount of common stock into which the Series B Preferred Sharescould be converted; provided, however, that such cash dividend must be paid atthe earliest any of the following occur:  (A) we pay a dividend onthe common stock, (B) we liquidate or there is a change in control, or (C) uponconversion of the Series B Preferred Shares, but only with respect tothose Series B Preferred Shares so converted.

 

The Series BPreferred Shares have a liquidation preference as to both the Series AConvertible Preferred Stock, par value $0.0001 per share (“Series APreferred Shares”) and the common stock equal to the greater of (i) thesum of the original issue price (subject to adjustment for stock dividends,stock splits or similar capital reorganizations) plus all accrued but unpaiddividends, or (ii) the amount the holder would receive if all Series BPreferred Shares had been converted into common stock.

 

For as long as any sharesof Series B Preferred Shares remain outstanding, we will be prohibitedfrom (i) amending, waiving, altering or repealing in a way that adverselyaffects the rights, powers, preferences, or other special rights or privileges ofthe holders of the Series B Preferred Shares, whether by amendment to theCertificate of Incorporation, Bylaws, Certificate of Designation or otherorganization documents, or by merger, consolidation, reorganization orotherwise, (ii) increasing or decreasing (other than by redemption orconversion) the authorized number of shares of preferred stock or Series BPreferred Shares, (iii) creating, issuing or authorizing the issuance ofany equity securities senior to the Series B Preferred Shares, or (iv) repurchasing,redeeming or reissuing any equity securities to which the Series BPreferred Shares rank senior and prior (whether with respect to dividends,redemption, or upon liquidation or otherwise), including the Series APreferred Shares and the common stock, and any rights or options exercisable orconvertible therefor, other than repurchases of shares of common stock fromemployees, officers, directors or consultants under agreements providing forsuch repurchase under certain conditions.

 

Under the PurchaseAgreement, we also granted piggyback registration rights to thePurchasers.  We have granted a preemptiveright to the Purchasers with respect to future financings by Argyle and a rightof first offer to provide financing for certain transactions. In addition, theStockholders have granted a right of first refusal to the Purchasers until January 31,2010 as to any transfers of Argyle’s securities held by the Stockholders.

 

Neither the Series BPreferred Shares, nor the shares of common stock issuable upon conversion ofthe Series B Preferred Shares, have been registered under the SecuritiesAct, and may not be offered or sold in the United States absent registration oran applicable exemption from such registration requirement.

 

On February 1, 2009we granted 90,000 unregistered shares of our common stock to Officers and keyemployees listed below. Ability to sell, transfer or assign these shares vest December 31in three equal tranches on each of 2009, 2010, and 2011. The holders have theright to vote all shares, regardless of the vesting schedule.

 
| **Stockholders**   | ** ** | **Number of Shares** | ** ** |
|--------------------|------------|----------------------|------------|
| Bob Marbut         |       | 25,000               |       |
| Ron Chaimovski     |       | 25,000               |       |
| Donald F.  Neville |       | 15,000               |       |
| Matthew A. Kepke   |       | 15,000               |       |
| Dean Dresser       |       | 10,000               |       |

 

Also, on February 1,2009, we granted options to purchase an aggregate of up to 300,000 shares ofour common stock to Officers and key employees of the listed below. The exercise price of the options is $1.10 pershare and the options vest December 31 in three equal annual tranches oneach of 2009, 2010 and 2011.

 
| **Stockholders**   | ** ** | **Number of Options** | ** ** |
|--------------------|------------|-----------------------|------------|
| Bob Marbut         |       | 50,000                |       |
| Ron Chaimovski     |       | 50,000                |       |
| Sam Youngblood     |       | 50,000                |       |
| Donald F.  Neville |       | 30,000                |       |
| Matthew A. Kepke   |       | 25,000                |       |
| Dean Dresser       |       | 10,000                |       |
| Robert Roller      |       | 25,000                |       |
| Brian LaBad        |       | 10,000                |       |
| Jeff Paulik        |       | 10,000                |       |
| Mike Peterson      |       | 10,000                |       |
| Wally Wallace      |       | 25,000                |       |
| Tim Moxon          |       | 10,000                |       |

 

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In addition, on February 1,2009, we granted 110,000 performance unit awards to Officers and key employeeslisted below. The awards vest fully on December 31, 2012 at which time acash payment amount per unit award shall be determined by the Board based onthe Company achieving or exceeding performance goals set by the CompensationCommittee of the Board.

 
| **Stockholders**   | ** ** | **Number of Unit Awards** | ** ** |
|--------------------|------------|---------------------------|------------|
| Bob Marbut         |       | 25,000                    |       |
| Ron Chaimovski     |       | 25,000                    |       |
| Donald F.  Neville |       | 15,000                    |       |
| Matthew A. Kepke   |       | 15,000                    |       |
| Dean Dresser       |       | 10,000                    |       |

 

On March 19, 2009 wegranted 45,000 unregistered shares of our common stock to the Directors listedbelow. These shares vest in full seven (7) days after the Director is nolonger serving on the Board.

 
| **Stockholders** | ** ** | **Number of Shares** | ** ** |
|------------------|------------|----------------------|------------|
| Lloyd Campbell   |       | 15,000               |       |
| Wesley Clark     |       | 15,000               |       |
| John Smith       |       | 15,000               |       |

 

Such shares, options andperformance unit awards were issued pursuant to the exemption from registrationcontained in Section 4(2) of the Securities Act as they were issuedto Officers and Directors of Argyle.

 

**Repurchasesof Equity Securities**

 

During the fourth quarterof our fiscal year ended December 31, 2008, there were no repurchases ofcommon stock.

 

**Redemptionof Promissory Notes**

 

On January 12, 2009,Argyle elected to redeem each of the unsecured promissory notes issued inconnection with the merger with ISI at a conversion price of one share ofcommon stock for each $10.00 of outstanding principal and accrued and unpaidinterest for an aggregate of 192,763 shares of common stock.

 

**PerformanceGraph**

 

*The information contained in the Performance Graphshall not be deemed to be “soliciting material” or “filed” with the SEC orsubject to the liabilities of Section 18 of the Securities Exchange Act of1934, as amended (the “Exchange Act”), except to the extent that we specificallyincorporate it by reference into a document filed under the Securities Act of1933, as amended (the “Securities Act”), or the Exchange Act.*

 

The following performancegraph compares the performance of our cumulative stockholder return with thatof the NASDAQ composite index and a published industry index (the HemscottGroup Index) for each fiscal year since March 2, 2006, the date wecommenced public trading. The cumulative stockholder return for shares of ourCommon Stock and each of the indices is calculated assuming that $100 wasinvested on March 2, 2006. We paid no cash dividends during the periodsshown. The performance of the indices is shown on a total return (dividendsreinvested) basis. The graph lines merely connect year-end dates and do notreflect fluctuations between those dates.

 

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**COMPARISON OF CUMULATIVE TOTALRETURN**

**AMONG ARGYLE SECURITY, INC.,**

**NASDAQ MARKET INDEX AND HEMSCOTTGROUP INDEX**

 

 

ASSUMES $100 INVESTED ONMAR. 2, 2006

ASSUMES DIVIDENDREINVESTED

FISCAL YEAR ENDING DEC.31, 2008

 

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**Item6. Selected Financial Data**

 

The following table summarizesour selected historical consolidated financial information and selectedconsolidated financial information of ISI, which should be read in conjunctionwith ‘‘Management’s Discussion and Analysis of Financial Condition and Resultsof Operations’’ and the financial statements and related notes includedelsewhere in this document. The information as of and for the periods ended December 31st,and for the seven month period ended July 31, 2007 for ISI, are derivedfrom the respective audited financial statements of Argyle and ISI and theinformation as of and for the other periods presented are derived from theirrespective unaudited interim financial statements.

 

**ISISecurity Group, Inc.**

 
| ** **                           | ** ** | **Year Ended December 31,** | ** ** | **For the  Seven Months  Ended** | ** ** |
|--------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| **($ in thousands)**       | ** ** | **2002**                                   | ** ** | **2003**                                   | ** ** | **2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **July 31, 2007** | ** ** |
| Revenues(1)                          |       | $                                          | 25,881     |                                       | $          | 34,726 |   | $ | 37,303 |   | $ | 24,758 |   | $ | 37,897 |   | $ | 26,394 |   |
| Revenues -  related parties          |       | 0                                          |       | 0                                          |       | 2,872 |   | 14,476 |   | 19,855 |   | 16,740 |   |
| Total revenues                       |       | 25,881                                     |       | 34,726                                     |       | 40,175 |   | 39,234 |   | 57,752 |   | 43,134 |   |
| Cost of revenues                     |       | 17,931                                     |       | 25,082                                     |       | 30,984 |   | 30,865 |   | 45,969 |   | 33,516 |   |
| Gross profit                         |       | 7,950                                      |       | 9,644                                      |       | 9,191 |   | 8,369 |   | 11,783 |   | 9,618 |   |
| General and  administrative expenses |       | 6,892                                      |       | 6,342                                      |       | 6,083 |   | 6,908 |   | 8,860 |   | 6,432 |   |
| Management  special bonus            |       | —                                     |       | —                                     |       | 5,151 |   | — |   | — |   | 1,364 |   |
| Total operating  expenses            |       | 6,892                                      |       | 6,342                                      |       | 11,234 |   | 6,908 |   | 8,860 |   | 7,796 |   |
| Income/(loss)  from operations       |       | 1,058                                      |       | 3,302                                      |       | (2,043 | ) | 1,461 |   | 2,923 |   | 1,822 |   |
| Interest expense                     |       | 59                                         |       | 0                                          |       | 813 |   | 3,178 |   | 3,830 |   | 3,010 |   |
| Other  income/(loss)                 |       | 105                                        |       | (55                                        | )          | (85 | ) | 8 |   | 211 |   | 4 |   |
| Income/(loss)  before income taxes   |       | 1,104                                      |       | 3,247                                      |       | (2,941 | ) | (1,709 | ) | (696 | ) | (1,184 | ) |
| Income tax  expense (benefit)        |       | 486                                        |       | 1,165                                      |       | (894 | ) | (525 | ) | (8 | ) | (1,053 | ) |
| Net  income/(loss)                   |       | $                                          | 618        |                                       | $          | 2,082 |   | $ | (2,047 | ) | $ | (1,184 | ) | $ | (688 | ) | $ | (131 | ) |

 

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(1)                                 ‘‘Revenues- related party’’ are those revenues generated by work sub-contracted fromISI*MCS (an entity owned 67% by Sam Youngbood and 33% by Don Carr, VicePresident of ISI). Messrs. Youngblood and Carr created ISI*MCS in 2004 toprovide bonding on contracts that require bonding. The performance of thosecontracts is subcontracted to ISI as a subcontractor to ISI*MCS. Thesubcontracted work is for third party customers of ISI*MCS that require bondedcontracts. After the merger, ISI*MCS will no longer provide bonding andsubcontract work to ISI and ISI will secure its own bonding capacity and usethat bonding capacity to directly enter into bonded contracts with third partycustomers, thereby eliminating the need to contract for the work as asubcontractor to ISI*MCS. After the merger, the amount of ‘‘Revenues - relatedparty’’ will decrease annually as the contracts with ISI*MCS, outstanding atthe time of the merger, are completed.

 

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**ArgyleSecurity Inc.**

 
| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **($ in thousands, except per share data)**         | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues                                                                          |       | $                                          | 134,843    |   | $ | 44,053 |   | $ | — |   |
| Cost of revenues                                                                  |       | 114,454                                    |       | 34,020 |   | — |   |
| Gross profit                                                                      |       | 20,389                                     |       | 10,033 |   | — |   |
| Total operating  expenses                                                         |       | 53,677                                     |       | 9,812 |   | 1,024 |   |
| Income / (loss)  from operations                                                  |       | (33,288                                    | )          | 221 |   | (1,024 | ) |
| Interest income                                                                   |       | 164                                        |       | 1,005 |   | 1,352 |   |
| Interest expense                                                                  |       | (3,664                                     | )          | (838 | ) | (64 | ) |
| Income / (loss)  before income taxes                                              |       | (36,788                                    | )          | 388 |   | 264 |   |
| Income tax  expense / (benefit)                                                   |       | (5,931                                     | )          | 169 |   | 91 |   |
| Net income /  (loss)                                                              |       | $                                          | (30,857    | ) | $ | 219 |   | $ | 173 |   |
| Deferred  interest, net of taxes, subject to possible redemption                  |       | —                                     |       | — |   | (176 | ) |
| Dividends on  convertible preferred stockholders                                  |       | (312                                       | )          | — |   | — |   |
| Net income  (loss) allocable to holders on non-redeemable common stock            |       | $                                          | (31,169    | ) | $ | 219 |   | $ | (3 | ) |
| Net income  (loss) per share allocable to holders on non-redeemable common stock: |       |                                       |       |   |   |   |   |
| Basic                                                                             |       | $                                          | (5.38      | ) | $ | 0.04 |   | $ | (0.00 | ) |
| Diluted                                                                           |       | $                                          | (5.38      | ) | $ | 0.03 |   | $ | (0.00 | ) |
|                                                                              |       |                                       |       |   |   |   |   |
| **Condensed  Consolidated Balance Sheet Data:**                                   |       |                                       |       |   |   |   |   |
|                                                                              |       |                                       |       |   |   |   |   |
| ** **                                                                        | ** ** | **December 31,**                      | ** ** | ** ** | ** ** |
| **($ in  thousands, except per share data)**                                 | ** ** | **2008**                                   | ** ** | **2007** | ** ** | ** ** | ** ** |
| Total current  assets                                                             |       | $                                          | 57,733     |   | $ | 40,507 |   |   |   |
| Total assets                                                                      |       | $                                          | 82,312     |   | $ | 81,148 |   |   |   |
| Total current  liabilities                                                        |       | $                                          | 27,128     |   | $ | 20,520 |   |   |   |
| Total  stockholders’ equity (deficit)                                        |       | $                                          | 20,025     |   | $ | 36,664 |   |   |   |
| Working capital                                                                   |       | $                                          | 30,605     |   | $ | 19,987 |   |   |   |

 

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**Item7. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

**ForwardLooking Statements**

 

This Annual Report on Form 10-Kincludes forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended. We have based theseforward-looking statements on our current expectations and projections aboutfuture events. These forward-looking statements are subject to known andunknown risks, uncertainties and assumptions about us that may cause our actualresults, levels of activity, performance or achievements to be materiallydifferent from any future results, levels of activity, performance orachievements expressed or implied by such forward-looking statements. In somecases, you can identify forward-looking statements by terminology such as “may,”“should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,”“continue,” or the negative of such terms or other similar expressions. Factorsthat might cause or contribute to such a discrepancy include, but are notlimited to, those described in our other Securities and Exchange Commissionfilings. The following discussion should be read in conjunction with ourFinancial Statements and related Notes thereto included elsewhere in thisreport.

 

**Overview**

 

Argyle Security, Inc.(formerly Argyle Security Acquisition Corporation) was incorporated in Delawarein June 2005 as a blank check company formed to acquire, through merger,capital stock exchange, asset acquisition, or other similar businesscombination, a business in the security industry. Argyle completed its initialpublic offering in January 2006.  On July 31, 2007, Argyleconsummated its initial acquisition through the acquisition of 100% of theoutstanding capital stock of ISI and its subsidiaries.

 

Argyle is acomprehensive security solutions provider to our diverse customer base becauseit addresses the majority of their physical electronic securityrequirements.  Argyle is a detention and commercial equipment contractorthat specializes in designing and integrating security solutions, includingturnkey installations, design, engineering, supply, and installation of variousdetention, surveillance and access control equipment and software solutions forcorrectional facilities and commercial institutions. The work is performed underfixed-price contracts. The projects are located in various cities throughoutthe United States. The length of the contracts varies but is typically lessthan two years. Argyle also provides turnkey installations covering the fullspectrum of electronic security and low voltage systems, including fire alarm,access control, closed circuit television, intercom, sound/paging and othercustom designed systems.

 

In February 2008,we organized our business under the name of “Argyle Security USA” and then, in January 2009,we eliminated the name “Argyle Security USA” and, for the sole purpose of debtcovenant compliance calculation which only considers the operating business’financial condition, organized the operational business of Argyle under thename “Argyle Security Operations”, or “ASO”, through which we provide securitysolutions to commercial, governmental and correctional customers.

 

**CriticalAccounting Policies**

 

Our discussion andanalysis of our financial condition and results of operations is based on theaccompanying consolidated financial statements, which have been prepared inaccordance with U.S. generally accepted accounting principles. As such, we arerequired to make estimates and assumptions that affect the reported amounts ofassets and liabilities and disclosure of contingent assets and liabilities atthe date of the consolidated financial statements and the reported amounts ofRevenues and expenses during the reporting period. By their nature, theseestimates and judgments are subject to an inherent degree of uncertainty. Ourmanagement reviews its estimates on an on-going basis, including those relatedto revenue recognition based on the percentage-of-completion methodology, salesallowances, recognition of service sales revenues and the allowance fordoubtful accounts. We base our estimates and assumptions on historicalexperience, knowledge of current conditions and our understanding of what webelieve to be reasonable that might occur in the future considering availableinformation. Actual results may differ from these estimates, and materialeffects on our operating results and financial position may result.

 

*Percentage-of-CompletionEstimates* — Other than for PDI, each of our business unitsuses percentage-of-completion accounting to determine revenues and gross marginearned on projects. Estimating the percentage completion on a project is acritical estimate used by Argyle when budgeting for its projects. This estimateis determined as follows:

 

·                                          The contractamount and all contract estimates are input into a job cost accounting systemwith detail of all significant estimates of purchases by vendor type,subcontractor and labor.

 

·                                          As theproject is performed and purchases and costs are incurred, these are recordedin the same detail as the original estimate.

 

·                                          The contractamount and estimated contract costs are updated monthly to record the effect ofany contract change order received.

 

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·                                          Ona monthly basis, management, along with project managers who are overseeing thecontracts, review these estimated costs to complete the project and comparethem to the original estimate and the estimate that was used in the prior monthto determine the percentage-of-completion. If the cost to complete, determinedby management and the project managers for the current month, confirms that theestimate used in the prior month is correct, then no action is taken to changethe estimate and/or the percentage complete in that current month. However, ifthe current cost-to-complete estimate calculated by the management and theproject managers differ, then adjustments are made. If the costs are in excessof the estimate used in the prior month, then a decrease in the percentagecomplete on the project through the current month in the accounting period ismade. If the costs are less than the estimate used in the prior accountingperiod, then the new estimate increases the percentage complete on the project.

 

·                                          Revenuesfrom construction contracts are recognized on the percentage-of-completionmethod in accordance with SOP 81-1. We recognize revenues on signed letters ofintent, contracts and change orders. Argyle generally recognizes revenues onunsigned change orders where it has written notices to proceed from thecustomer and where collection is deemed probable. Percentage-of-completion forconstruction contracts is measured principally by the percentage of costsincurred and accrued to date for each contract to the estimated total costs foreach contract at completion. We generally consider contracts to besubstantially complete upon departure from the work site and acceptance by thecustomer. If any jobs are identified during the review process which are estimatedto be a loss job (where estimated costs exceed contract price), the entireestimated loss is recorded in full, without regard to the computedpercentage-of-completion.

 

These estimatespercentage-of-completion of a project determine the amounts of revenues andgross margin that are earned to date on a project. For example, if a contractis $100,000 with a 20% gross margin of $20,000, then a project that isestimated to be 50% complete accrues $50,000 in revenues and $10,000 in grossmargin. If the percentage completed is adjusted to 25%, then the revenues onthe contact would be $25,000, and the earned gross margin would be $5,000.These estimates would be changed in the current month, and the actual accrualof the revenues and gross margin earned on this project would be reduced in thecurrent month.

 

During the year ended December 31,2008, we conducted regular reviews and evaluations for the cost estimatesassociated with all of the approximately 1,200 active Construction Contracts inour Work—in-Process.  As a result of the review, the cost estimates forthe Work-in-process Construction Contracts (that existed as of year-ended December 31,2007) increased by a net $6.1 million. In a few cases, the reviews resulted ina total of $46,000 ($0.01 basic and diluted earnings per share) in contractloss accruals that have been have been computed as cost-of-sales for the yearended December 31, 2008.  Of the aforementioned net estimatedcost increases of $6.1 million, 41 contracts had cost estimate changes of approximately$100,000 or greater resulting in $7.1 million of the net increase.  30 ofthe 41 contracts resulted in cost estimate increases totaling $9.5 millionwhile 11 contracts had estimated cost decreases totaling $2.4 million. Approximately 1,150 of the remaining contracts with variances of less than$100,000 resulted in a net decrease in cost estimates of $1.0 million.

 

Another effect of thechange in the estimated costs and percentage complete is that it changes thepercentage of gross margin earned. For example, in the project mentioned above,if the estimated costs changed to 90% from 80% because of projected costoverruns, this would then reduce the gross margin percentage to 10% from 20%.Management recognizes losses (overruns of cost estimates) as soon as they canbe quantified. Management attempts to recognize gains (under-runs of costestimates) when they can be quantified and are certain.

 

Costs incurred prior tothe award of contracts are expensed as incurred. The balances billed but not paidby customers pursuant to retainage provisions in construction contracts will bedue upon completion of the contracts and acceptance by the customer. Based onour experience with similar contracts in recent years, the retention balance ateach balance sheet date will be collected within the subsequent fiscal year.

 

The current asset “Costsand Estimated Earnings in Excess of Billings on Incomplete Contracts”represents revenues recognized in excess of amounts billed which managementbelieves will be billed and collected within the subsequent year. The currentliability “Billings in Excess of Costs and Estimated Earnings on IncompleteContracts” represents billings in excess of revenues recognized.

 

*RevenueRecognition for Shipped Products* - Revenues are recognized byPDI when the product is shipped by the customer in accordance with thecontractual shipping terms. In almost all cases, the shipping of products toPDI’s customers is FOB Origin, whereby title passes to the purchaser when theproduct leaves the PDI premises under the bail of a common carrier.  In only rare instances (less than 2% of allshipments), are products shipped to PDI customers as FOB Destination, wherebytitle passes to the purchaser when the product reaches the destination. Whendelivery to the customer’s delivery site has occurred, the customer takes titleand assumes the risks and rewards of ownership.

 

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*ServiceSales -** ***Servicerevenues are recognized when the services have been delivered to andaccepted by the customer. These are generally short-term projects which areevidenced by signed service agreements or customer work orders or purchase orders.These sales agreements/customer orders generally provide for billing tocustomers based on time that are at quoted hourly or project rates, plus costsof materials and supplies furnished by us.

 

*IBNREstimates for Health Insurance* - On a quarterly basis, Argyleestimates its health insurance cost, for its self-insured employee base at theacquired companies, ISI, PDI and Com-Tec, based upon expected health insuranceclaims for the current year. The insurance company which provides both thestop-loss and total aggregate insurance coverage also provides the average orexpected and maximum claims for each class. The average and maximum claims arebased on our demographics and prior claim history. Argyle uses the averageclaims history for the trailing the 12 months as its basis for accruing healthcare cost.

 

*Sales and Use Taxes*— The Company collects and remits taxes on behalf of various state and localtax authorities. For the year ended 2008, the Company collected $0.7 millionand remitted $0.5 million in taxes.

 

*DeferredIncome Taxes* - Deferred income taxes are provided fortemporary differences between the carrying amount of assets and liabilities forfinancial reporting purposes and the amounts for tax purposes. Valuationallowances are provided against the deferred tax asset amounts when therealization is uncertain.

 

*Allowancefor Doubtful Accounts* - Argyle provides an allowance for baddebt through an analysis in which the bad debts that had been written off overprevious periods are compared on a percentage basis to the aggregate sales forthe same periods. The resulting percentage is applied to the year-to-datesales, and a monthly reserve is accrued accordingly. Additionally, managementanalyzes specific customer accounts receivable for any potentiallyuncollectible accounts and will add such accounts to the reserve, or write themoff if warranted, after considering lien and bond rights, and then considersthe adequacy of the remaining unallocated reserve compared to the remainingaccounts receivable balance (net of specific doubtful accounts).

 

*Impairment of Long-livedIntangible Assets* - Long-lived assets are evaluated forimpairment whenever events or changes in circumstances indicate the carryingvalue may not be recoverable. Examples include a significant adverse change inthe extent or manner in which we use a long-lived asset or a change in itsphysical condition.   When evaluatinglong-lived assets for impairment, we compare the carrying value of the asset tothe asset’s estimated undiscounted future cash flows.  Impairment is indicated if the estimatedfuture cash flows are less than the carrying value of the asset. The impairmentis the excess of the carrying value over the fair value of the long-livedasset.  We recorded impairment chargesrelated to long-lived assets in accordance with Statement of FinancialAccounting Standards No. 144, *Accounting for the Impairmentor Disposal of Long-Lived Assets*, of $4.5 million in fiscal year2008.

 

Our impairment analysiscontains uncertainties due to judgment in assumptions and estimates surroundingundiscounted future cash flows of the long-lived asset, including forecastinguseful lives of assets and selecting the discount rate that reflects the riskinherent in future cash flows to determine fair value.

 

We have not made anymaterial changes in the accounting methodology used to evaluate the impairmentof long-lived assets during the last two fiscal years.  We do not believe there is a reasonablelikelihood there will be a material change in the estimates or assumptions usedto calculate impairments of long-lived assets. The Company’s discount rate, theWeighted Average Cost of Capital (“WACC”) and the growth rates assumed forrevenues have not changed significantly in the last two planning cycles giventhe last two year of operations. However, if actual results are not consistent with our estimates andassumptions used to calculate estimated future cash flows, we may be exposed toimpairment losses that could be material.

 

*Goodwill*- Represents the excess of the purchase price over the fair value of net assetsacquired, including the amount assigned to identifiable intangibleassets.  Goodwill is reviewed for impairment annually, or more frequentlyif impairment indicators arise.  Our annual impairment review requiresextensive use of accounting judgment and financial estimates.   Theanalysis of potential impairment of goodwill requires a two-step process.   The first step is to identify if a potentialimpairment exists by comparing the fair value of a reporting unit with itscarrying amount, including goodwill. If the fair value of a reporting unitexceeds its carrying amount, Goodwill of the reporting unit is not consideredto have a potential impairment, and the second step of the impairment test isnot necessary. However, if the carrying amount of a reporting unit exceeds itsfair value, the second step is performed to determine if goodwill is impairedand to measure the amount of impairment loss to recognize, if any.

 

The second step comparesthe implied fair value of goodwill with the carrying amount of goodwill. If theimplied fair value of goodwill exceeds the carrying amount, then goodwill isnot considered impaired. However, if the carrying amount of goodwill exceedsthe implied fair value, an impairment loss is recognized in an amount equal tothat excess.

 

The implied fair value ofgoodwill is determined in the same manner as the amount of goodwill recognizedin a business combination (i.e., the fair value of the reporting unit isallocated to all the assets and liabilities, including any unrecognizedintangible assets, as if the reporting unit had been acquired in a businesscombination and the fair value of the reporting unit were the purchase pricepaid to acquire the reporting unit).

 

We have elected to makethe first day of the third quarter the annual impairment assessment date forgoodwill and other intangible assets. However, we could be required to evaluatethe recoverability of goodwill and other intangible assets prior to the requiredannual assessment if we experience disruptions to the business, unexpectedsignificant declines in operating results, divestiture of a 

 

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significant component ofthe business or a sustained decline in market capitalization.

 

The Company identifiedits reporting units under the guidance of SFAS 142 Goodwill and OtherIntangible Assets (FAS 142) and EITF Topic D-101, Clarification of ReportingUnit Guidance in Paragraph 30 of FASB Statement No. 142. The Company’sreporting units are ISI-Detention, MCS-Detention, PDI, Com-Tec (which comprisethe Argyle Corrections segment), and MCS-Commercial which comprises the ArgyleCommercial segment.

 

During the quarter ended September 30,2008, we began an analysis of goodwill impairment in accordance with SFAS 142,*Goodwill and Other Intangible Assets,* forthe acquisition of ISI completed July 31, 2007, the acquisition of FireQuest on January 1, 2008, the acquisition of PDI on January 4, 2008and the acquisition of Com-Tec on January 31, 2008.   Theinitial analysis (first step) was performed by our management team and avaluation firm after the conclusion of the third quarter.  Based on acombination of factors, including the current economic environment, ouroperating results and a sustained decline in our market capitalization, weconcluded that there were a number of indicators which required us to perform agoodwill impairment analysis as of September 30, 2008. For the purposes ofthis analysis, our estimates of fair value were based on a combination of theincome approach, which estimates the fair value of our reporting units based onthe future discounted cash flows, and the market approach, which estimates thefair value of our reporting units based on comparable market prices.  Accordingly, we recorded a $16.9 millionnon-cash goodwill impairment charge, representing our best estimate of theimpairment loss, during the third quarter of fiscal year 2008.

 

We estimate the fairvalue of our reporting units, using various valuation techniques, with theprimary technique being a discounted cash flow analysis. A discounted cash flowanalysis requires us to make various judgmental assumptions about sales,operating margins, growth rates and discount rates. Assumptions about sales,operating margins and growth rates are based on our budgets, business plans,economic projections, anticipated future cash flows and marketplace data.Assumptions are also made for varying perpetual growth rates for periods beyondthe long-term business plan period.

 

While estimating the fairvalue of our reporting units, we assumed operating margins in future years inexcess of the margins realized in the most current year. The fair valueestimates for these reporting units assume normalized operating marginassumptions and improved operating efficiencies based on anticipatedimprovements, given recent changes in the management structure and actual operations.  In our analyses, the carrying value of all ofour reporting units except Com-Tec was in excess of the fair value thusrequiring impairment charges.  Ourestimates in the fair value of our Corrections and Commercial reportingsegments would not have been in excess of their carrying amount, includinggoodwill, even by sustaining long-term operating margins of over 20%, since theCompany’s total market capitalization and implied fair value of equity as of December 31,2008 was approximately $2.9 million and $38.6 million versus:

 

·                  workingcapital of $31.4 million and $20.0 for 2008 and 2007;

·                  nettangible assets of $66.4 million and $43.2 million for 2008 and 2007 and ;

·                  netequity of $7.3 million and $4.7 million for 2008 and 2007, respectively.

 

Other intangible assetfair values have been calculated for trademarks using a relief from royaltyrate method and using the present value of future cash flows for patents andin-process technology. Assumptions about royalty rates are based on the ratesat which similar brands and trademarks are licensed in the marketplace.

 

Our impairment analysiscontains uncertainties due to uncontrollable events that could positively ornegatively impact the anticipated future economic and operatingconditions.  We have not made anymaterial changes in the accounting methodology used to evaluate impairment ofgoodwill and other intangible assets during the last two years.

 

While we believe we havemade reasonable estimates and assumptions to calculate the fair value of thereporting units and other intangible assets, it is possible a material changecould occur. If our actual results are not consistent with our estimates andassumptions used to calculate fair value, we may be required to perform thesecond step in future periods which could result in further impairments of ourremaining goodwill.

 

During the fourth quarterof fiscal year 2008, the management team and a valuation firm began thetwo-step valuation process of the impairment to our goodwill and intangibleassets.  During the latter part of thesecond half of fiscal year 2008 and continuing into December 2008, ourmarket capitalization was below book value. We considered this information, aswell as our discount rate and WACC of 14% and overall revenue and operatinggrowth rate assumptions for fiscal years 2009 through 2012.   We considered the market capitalizationdecline in our evaluation of fair value of goodwill and believe the decline tobe primarily attributed to the negative market conditions as a result of thecredit crisis, indications of a possible recession and current issues withinthe overall economy in the United States and globally.

 

Our fiscal 2008 goodwilland intangible asset impairment analysis resulted in a December 31, 2008charge of $9.7 million in addition to the estimate made as of September 30,2008 of $16.9 million.  The non-cash,total impairment charges for goodwill and intangible assets for the year ended December 31,2008 were $26.6 million.

 

*NonCash Compensation Expense* - On January 1, 2006, Argyleadopted SFAS No. 123 (revised 2004),*Share Based Payment*. SFAS No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values.

 

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Purchase options (ISO /non-qualified) grants:

 

We compute the value ofnewly-issued purchase options (Incentive Stock Options and Non-Qualified StockOptions) on the date of grant by utilizing the Black-Scholes valuation modelbased upon their expected life vesting period, industry comparables forvolatility and the risk-free rate on U.S. Government securities with matchingmaturities. The value of the purchase options are then straight-line expensedover the life of the purchase options.

 

Restricted stock andperformance unit award grants:

 

We compute the value ofnewly issued stock grants on the date of grant based on the share price as ofthe award date. The values of the common shares are then straight-line expensedover the life of the corresponding vesting period.

 

We recognize compensationexpense on the performance unit awards based on the fair value of the underlyingcommon stock at the end of each quarter over the remaining vesting period.

 

**ProForma and Adjusted Pro Forma Financial Information**

 

Because we acquired ISIin July 2007, and Fire Quest, PDI and Com-Tec in January 2008, we donot believe a comparison of the results of operations and cash flows forthe years ended December 31, 2008 versus December 31, 2007 isbeneficial to our stockholders. In order to assist investors in betterunderstanding the changes in our business between the years ended December 31,2007 and December 31, 2008, we are presenting in this Management’sDiscussion and Analysis section, the Pro Forma and Adjusted Pro Forma resultsof operations for the Company and the acquisitions for the years ended December 31,2008 and December 31, 2007 as if the acquisitions occurred on January 1,2008 and January 1, 2007, respectively. We derived the pro forma resultsand adjusted pro forma results of operations from (i) the unauditedconsolidated financial statements of ISI for the one and seven months ended July 31,2007, (ii) the unaudited consolidated financial statements of Com-Tec forthe one month ended January 31, 2008 and the audited  consolidated financial statements of Com-Tecyear ended December 31, 2007, (iii) the audited financial statementsof PDI for the year ended December 31, 2007, (iv) the unauditedfinancial statements of Fire Quest for the year ended December 31, 2007and (v) the audited consolidated financial statements of the Company forthe year ended December 31, 2008 and 2007. We are presenting the pro formaand the adjusted pro forma information in order to provide, what we believe tobe, a more meaningful comparison of our operating results with prior periods.

 

Adjusted pro forma netincome is an alternative view of performance used by management, and we believethat investors’ understanding of our performance is enhanced by disclosing thisperformance measure. We report adjusted pro forma net income in order topresent the results of our major operations, the construction, installation,marketing and sale of various electronic security systems for commercialaccounts, and detention hardware (including security doors and frames, jailfurniture, security glazing, and other security-based systems) and electroniccontrol systems for correctional facilities, prior to considering certainincome statement elements, principally amortization of intangible assets.**  We have defined adjusted pro forma net incomeas net income before the impact of purchase accounting for acquisitions,acquisition-related costs, amortization of intangibles, discontinued operationsand certain significant items including one-time expenses associated with stockappreciation rights. The****adjusted pro forma netincome measure is not, andshould not be viewed as, a substitute for U.S. GAAP net income.**

 

The adjusted pro formanet income measure is an important internal measurement for us. We measure theperformance of the overall Company on this basis. The following are examples ofhow the adjusted pro forma net income measure was utilized for the year ended December 31,2008:

 

·                                          Seniormanagement receives a monthly analysis of our operating results that isprepared on an adjusted pro forma net income basis;

 

·                                          Ourannual budgets are prepared on an adjusted pro forma net income basis; and

 

·                                          Annualand long-term compensation, including annual cash bonuses, merit-based salaryadjustments, and share-based payments for various levels of management willconsider financial measures that include adjusted pro forma net income and theassociated earnings per share. The adjusted pro forma net income measure willrepresent a significant portion of target objectives that are utilized todetermine the annual compensation for various levels of management, althoughthe actual weighting of an objective may vary by level of management and jobresponsibility and may be considered in the determination of certain long-termcompensation plans.

 

**Despitethe importance of this measure to management in goal setting and performancemeasurement, we stress that****adjusted proforma net income is a non-GAAPfinancial measure that has no standardized meaning under US-GAAP and therefore,has limits in its usefulness to investors. Because of its non-standardizeddefinition, adjusted pro forma net income****(unlike U.S. GAAP Net Income) may not be comparable with the calculationof similar measures for other companies.**

 

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** **

**A****djusted pro forma net income****is presented solely to permit investors to more fully understand howmanagement assesses our performance.**

 

**Wealso recognize that, as an internal measure of performance, the****adjusted pro forma net income and the associated earnings per share measure has limitations which isthe reason we do not restrict our performance-management process solely to thismetric. A limitation of the adjusted pro forma net income measure is that it provides a view of ouroperations without including all events during a period such as the effects ofan acquisition or amortization of purchased intangibles and does not provide acomparable view of our performance to other companies in the security detentionand construction industries.**

 

**Inaddition, annual and long-term compensation, including annual cash bonuses,merit-based salary adjustments and share-based payments for various levels ofmanagement that may be made in future years may include a non-discretionaryformula that measures our performance using revenue growth and relative totalshareholder return.**

 

Adjusted pro forma EBITDAis used by management as a performance measure for benchmarking against theCompany’s peers and competitors. The Company believes that EBITDA is useful toinvestors because it is frequently used by securities analysts, investors andother interested parties to evaluate companies in the security industry.Additionally, we use adjusted pro forma EBITDA for internal performancemeasurements. EBITDA is not a recognized term under GAAP. We compute EBITDAusing the same consistent method from quarter to quarter. EBITDA includes netincome before interest, taxes, depreciation and amortization. The presentationof EBITDA is not intended to be considered in isolation or as a substitute forthe financial information prepared and presented in accordance with GAAP.

 

**TheAdjusted Pro Forma Results of Operations are not necessarily indicative of theresults of operations that may have actually occurred had the merger takenplace on the dates noted, or our future financial position or operatingresults. The pro forma adjustments are based upon available information andassumptions that we believe are reasonable. The presentation of EBITDA(earnings before interest, taxes, depreciation and amortization) and adjustedpro forms results is not intended to be considered in isolation or as asubstitute for the financial information prepared and presented in accordancewith GAAP.**

 

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Below is a table showingArgyle’s Adjusted Pro Forma Consolidated Statements of Operations. The ProForma Consolidated Statements of Operations are included in the notes to ourfinancial statements on page F-14.

 

**ArgyleSecurity, Inc**

**AdjustedPro Forma Consolidated Statements of Operations**

**(inthousands, except per share data)**

**(unaudited)**

** **
| ** **                                                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
| Revenues:                                                                                                            |       |                                       |       |   |   |
| Contract revenues                                                                                                    |       | $                                          | 100,324    |   | $ | 54,712 |   |
| Contract  revenues - related party                                                                                   |       | 16,782                                     |       | 31,788 |   |
| Service and  other revenues                                                                                          |       | 19,455                                     |       | 19,541 |   |
| Total revenues                                                                                                       |       | 136,561                                    |       | 106,041 |   |
| Cost of  revenues:                                                                                                   |       |                                       |       |   |   |
| Contract costs                                                                                                       |       | 91,722                                     |       | 66,079 |   |
| Service and  other costs, excluding amortization of intangibles                                                      |       | 19,414                                     |       | 14,325 |   |
| Total cost of  revenues                                                                                              |       | 111,136                                    |       | 80,404 |   |
| Gross profit                                                                                                         |       | 25,425                                     |       | 25,637 |   |
| Operating  expenses:                                                                                                 |       |                                       |       |   |   |
| Salaries and  related expense, including stock-based compensation of $1,187 and $236,  respectively.                 |       | 13,004                                     |       | 9,860 |   |
| Professional  fees and outside services                                                                              |       | 3,439                                      |       | 2,176 |   |
| General and  administrative expenses                                                                                 |       | 7,205                                      |       | 6,291 |   |
| Depreciation                                                                                                         |       | 2,004                                      |       | 1,408 |   |
| Goodwill and  intangible assets impairment charge                                                                    |       | 26,603                                     |       | — |   |
| Amortization of  intangible assets                                                                                   |       | —                                     |       | — |   |
| Total operating  expenses                                                                                            |       | 52,255                                     |       | 19,735 |   |
| Operating loss                                                                                                       |       | (26,830                                    | )          | 5,902 |   |
| Other income  (expense):                                                                                             |       |                                       |       |   |   |
| Interest income                                                                                                      |       | 164                                        |       | 230 |   |
| Interest expense                                                                                                     |       | (3,708                                     | )          | (2,891 | ) |
| Total other  income (expense)                                                                                        |       | (3,544                                     | )          | (2,661 | ) |
| Income (loss)  before provision for income taxes                                                                     |       | (30,374                                    | )          | 3,241 |   |
| Provision  (benefit) for income taxes                                                                                |       | (3,510                                     | )          | (455 | ) |
| Net income  (loss)                                                                                                   |       | $                                          | (26,864    | ) | $ | 3,696 |   |
| Deferred  interest, net of taxes, subject to possible redemption                                                     |       | —                                     |       | — |   |
| Dividends on  convertible preferred stockholders                                                                     |       | (312                                       | )          | — |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                               |       | $                                          | (27,176    | ) | $ | 3,696 |   |
|                                                                                                                 |       |                                       |       |   |   |
| EBITDA  Calculation:                                                                                                 |       |                                       |       |   |   |
| Interest, net                                                                                                        |       | 3,544                                      |       | 2,661 |   |
| Depreciation                                                                                                         |       | 2,109                                      |       | 1,585 |   |
| Taxes, net                                                                                                           |       | (3,510                                     | )          | (455 | ) |
| EBITDA                                                                                                               |       | $                                          | (24,721    | ) | $ | 7,487 |   |
|                                                                                                                 |       |                                       |       |   |   |
| Weighted-average  number of shares of commomn stock outstanding exclusive of shares subject to  possible redemption: |       |                                       |       |   |   |
| Basic                                                                                                                |       | 5,797,293                                  |       | 5,187,086 |   |
| Diluted                                                                                                              |       | 5,797,293                                  |       | 6,515,689 |   |
| Net income  (loss) per share allocable to holders of non-redeemable common stock:                                    |       |                                       |       |   |   |
| Basic                                                                                                                |       | $                                          | (4.69      | ) | $ | 0.71 |   |
| Diluted                                                                                                              |       | $                                          | (4.69      | ) | $ | 0.57 |   |

 

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Below is a reconciliationof GAAP net income (loss) to: pro forma net income (loss); to adjusted proforma net income (loss); and to pro forma EBITDA. The presentation of EBITDA isnot intended to be considered in isolation or as a substitute for the financialinformation prepared and presented in accordance with GAAP.

 

**Reconciliationof GAAP Net Income to Pro Forma Net Income**

**AdjustedPro Forma Net Income and Pro Forma EBITDA**

**(inthousands except per share data)**

**(unaudited)**

 
| ** **                                                                                  | ** ** | **Year Ended December 31,** | ** **  |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------------|-------------|
| ** **                                                                                  | ** ** | **2008**                                   | ** **  | **2007** | ** ** |
| **GAAP  net income (loss)**                                                                 | ** ** | **$**                                      | **(30,857** | **)** | **$** | **219** | ** ** |
| Pro forma  adjustments - addbacks (reductions)                                              |       |                                       |        |   |   |
| Argyle salary  expense (increase) for management team in 2007                               |       | —                                     |        | (518 | ) |
| SARS expense  reduction for 2007                                                            |       | —                                     |        | 1,364 |   |
| Non-cash  compensation expense (increase) for 2007                                          |       | —                                     |        | (424 | ) |
| Depreciation  expense (increase) on revalued assets in 2007                                 |       | —                                     |        | (258 | ) |
| Amortization of  intangible expense (increase) in cost of goods sold for 2008 and 2007      |       | (37                                        | )           | (3,726 | ) |
| Amortization of  intangible expense (increase) in operating expenses for 2008 and 2007      |       | (20                                        | )           | (1,180 | ) |
| Reduction in  rent expense for 2008 and 2007                                                |       | 6                                          |        | 139 |   |
| Interest income  increase / (reduction) for 2008 and 2007                                   |       | —                                     |        | (763 | ) |
| Interest expense  (increase) / reduction for 2008 and 2007                                  |       | (39                                        | )           | 1,591 |   |
| Income / (loss)  from predecessor - ISI for 2007                                            |       |                                       |        | (131 | ) |
| Income / (loss)  from predecessor - Fire Quest for 2007                                     |       | —                                     |        | 239 |   |
| Income / (loss)  from predecessor - PDI for 2007                                            |       | —                                     |        | 346 |   |
| Income / (loss)  from predecessor - Com-Tec for January 2008 and 2007                  |       | 44                                         |        | 368 |   |
| Provision  (benefit) for income taxes on pro forma adjustments for 2008 and 2007            |       | 34                                         |        | 1,433 |   |
| **Pro  forma net income (loss)**                                                            | ** ** | **$**                                      | **(30,869** | **)** | **$** | **(1,301** | **)** |
| Amortization of  intangible expense in cost of goods sold for 2008 and 2007                 |       | 4,725                                      |        | 5,127 |   |
| Amortization of  intangible expense in operating expenses for 2008 and 2007                 |       | 1,735                                      |        | 1,735 |   |
| Provision  (benefit) for income taxes on pro forma adjustments for 2008 and 2007            |       | (2,455                                     | )           | (1,865 | ) |
| **Adjusted  pro forma net income (loss)**                                                   | ** ** | **$**                                      | **(26,864** | **)** | **$** | **3,696** | ** ** |
| Interest, net                                                                               |       | 3,544                                      |        | 2,661 |   |
| Depreciation  expense                                                                       |       | 2,109                                      |        | 1,585 |   |
| Taxes, net                                                                                  |       | (3,510                                     | )           | (455 | ) |
| **Pro  forma EBITDA**                                                                       | ** ** | **$**                                      | **(24,721** | **)** | **$** | **7,487** | ** ** |
|                                                                                        |       |                                       |        |   |   |
| **GAAP  weighted average common shares outstanding - basic**                                | ** ** | **5,797,293**                              | ** **  | **5,187,086** | ** ** |
| Restricted stock                                                                            |       | —                                     |        | — |   |
| **Pro  forma and adjusted pro forma weighted average common shares outstanding -  basic**   | ** ** | **5,797,293**                              | ** **  | **5,187,086** | ** ** |
|                                                                                        |       |                                       |        |   |   |
| **GAAP  weighted average common shares outstanding - diluted**                              | ** ** | **5,797,293**                              | ** **  | **6,213,189** | ** ** |
| Restricted stock                                                                            |       | —                                     |        | 110,000 |   |
| Convertible debt                                                                            |       | —                                     |        | 192,500 |   |
| **Pro  forma and adjusted pro forma weighted average common shares outstanding -  diluted** | ** ** | **5,797,293**                              | ** **  | **6,515,689** | ** ** |

 

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Below is a table ofadjusted pro forma revenues, cost of sales, and gross margins for years ended December 31,2008 and 2007.

 
| ** **                                            | ** ** | **Year  Ended December 31, 2008** | ** ** | **Year  Ended December 31, 2007** | ** ** | **Percent  Increase (Decrease)** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **Corrections**                        | ** ** | **Commercial**                         | ** ** | **Total**                        | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net revenues                                          |       |                                   |       |                                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues / contract revenues - related party |       | $                                      | 92,223     |                                   | $          | 24,883                           |       | $ | 117,106 |   | $ | 65,427 |   | $ | 21,073 |   | $ | 86,500 |   | 41.0 | % | 18.1 | % | 35.4 | % |
| Service and other revenues                            |       | 10,814                                 |       | 8,641                                  |       | 19,455                           |       | 9,021 |   | 10,520 |   | 19,541 |   | 19.9 | % | (17.9 | )% | (0.4 | )% |
| Total net revenues                                    |       | $                                      | 103,037    |                                   | $          | 33,524                           |       | $ | 136,561 |   | $ | 74,448 |   | $ | 31,593 |   | $ | 106,041 |   | 38.4 | % | 6.1 | % | 28.8 | % |
| *% of total*                                          | * *   | *75.5*                                 | *%*        | *24.5*                                 | *%*        | * *                         | * *   | *70.2* | *%* | *29.8* | % |   |   |   |   |   |   |   |   |
| Cost of revenues                                      |       |                                   |       |                                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract costs / contract costs - related party       |       | $                                      | 72,227     |                                   | $          | 19,495                           |       | $ | 91,722 |   | $ | 49,107 |   | $ | 16,971 |   | $ | 66,078 |   | 47.1 | % | 14.9 | % | 38.8 | % |
| Service and other costs                               |       | 13,043                                 |       | 6,371                                  |       | 19,414                           |       | 6,680 |   | 7,646 |   | 14,326 |   | 95.3 | % | (16.7 | )% | 35.5 | % |
| Total cost of revenues                                |       | $                                      | 85,270     |                                   | $          | 25,866                           |       | $ | 111,136 |   | $ | 55,787 |   | $ | 24,617 |   | $ | 80,404 |   | 52.8 | % | 5.1 | % | 38.2 | % |
| Gross margin                                          |       |                                   |       |                                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract margins / contract margins - related party   |       | $                                      | 19,996     |                                   | $          | 5,388                            |       | $ | 25,384 |   | $ | 16,320 |   | $ | 4,102 |   | $ | 20,422 |   | 22.5 | % | 31.4 | % | 24.3 | % |
| Service and other margins                             |       | (2,229                                 | )          | 2,270                                  |       | 41                               |       | 2,341 |   | 2,874 |   | 5,215 |   | 195.2 | % | (21.0 | )% | (99.2 | )% |
| Total gross margin                                    |       | $                                      | 17,767     |                                   | $          | 7,658                            |       | $ | 25,425 |   | $ | 18,661 |   | $ | 6,976 |   | $ | 25,637 |   | (4.8 | )% | 9.8 | % | (0.8 | )% |
| Gross margin percentage                               |       |                                   |       |                                   |       |                             |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract revenues / contract revenues - related party |       | 21.7                                   | %          | 21.7                                   | %          | 21.7                             | %          | 24.9 | % | 19.5 | % | 23.6 | % | (12.9 | )% | 11.3 | % | (8.1 | )% |
| Service and other revenues                            |       | (20.6                                  | )%         | 26.3                                   | %          | 0.2                              | %          | 26.0 | % | 27.3 | % | 26.7 | % | 179.2 | % | (3.7 | )% | (99.3 | )% |
| Total gross margin percentage                         |       | 17.2                                   | %          | 22.8                                   | %          | 18.6                             | %          | 25.1 | % | 22.1 | % | 24.2 | % | (31.5 | )% | 3.2 | % | (23.1 | )% |

 

**Discussion of Adjusted Pro Forma Financial Results**

 

For the year ended December 31,2008, Argyle Corrections’ revenues increased by 38.4% of total Company revenuesfrom the same period in 2007.  Argyle Commercial Security’s revenues roseby 6.1%.  The total Company margin decrease from 24.2% to 18.6% wasdirectly attributable to the decreased margins in Argyle Corrections (whichdecreased 31.5%) while the Argyle Commercial Security’s gross margins increasedby 3.2% over the same period.

 

Argyle Correctionscaptured additional market share due to its repeat customers.  Thiscapture rate enabled Argyle Corrections to enjoy revenue growth. Althoughthe Argyle Corrections enjoyed an increase in revenues during the year ended December 31,2008, gross margins eroded largely as a result of the inability to control jobrelated expenses and efficiently staff a number of projects.  Initially, alack of experience (of our existing workforce and newly hired workforce)resulted in a large learning curve to become efficient and effective in ouroperations. The need to properly train our workforce resulted in a high levelof inefficiencies that caused greater labor hours to be utilized which were notinitially accounted for in the projected project budget.

 

**Effectof New Sales Bookings**

 

Typically, new bookingsresult in revenues within six to twelve months due to the incubation period forconstruction projects. Despite an increase in market share, shortfalls inanticipated new sales bookings in the fourth quarter of 2007 and the first halfof 2008 had caused an negative impact on gross margin in 2008.  This shortfallis primarily due to a slowdown in the activity of larger private prisondevelopers. Based on discussions with industry professionals and municipalcustomers, it appears that this slowdown has been caused by two factors: (i) theturbulent and uncertain economy, which is reducing availability of financingand state and municipal tax revenues and (ii) the fact that 2008 was anpresidential election year, when historically many politicians have waiteduntil after the elections to decide or vote on things, such as jail and prisonfunding.

 

We have, however,recently seen that the number of new projects for smaller, boutique privateprison operators has increased and that the volume of pending work (which isquoted work, waiting on a customer’s final decision to buy) for these projectshas increased over the past few months.  We believe that the projectsinvolving larger private prison operators and state and federal-run prisonswill likely be slower given the current deterioration in the state of the generaleconomy.  Any decrease in the number andamount new bookings or lower margins to be realized from newly booked projectswill not have a material effect on revenues until 2010.

 

*Revenues*

 

More than 92% aregenerated by fixed-price contracts (both “hard-bid” and design-buildcontracts). The success of a fixed-price contract is based in large part uponthe quality of the process utilized when estimating the costs that will beincurred in performing the contract. The larger the project and the longer theterm of completion of the contract, the greater the number of variable factorsthere are to be considered and evaluated in estimating costs. A successfulestimating process requires substantial experience and judgment. Management isaware of the significant need for experienced and qualified estimatingpersonnel and regularly monitors the estimating process and its results.

 

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The most obviousbenchmark that management considers in evaluating the estimating process iswhether the amount estimated, and submitted as a bid, was reasonably similar tothe amount bid by our competitors on the same project. If possible, managementevaluates the bids that were submitted in competition with our bid, based ontheir knowledge of each competitor’s history and character (for example, sometypically bid high, some typically bid low), the condition of the market, thecomplexity of the project, the type of construction and other factors. Thisreview provides management with an ongoing general basis for evaluating theestimating process that result in fixed-price contracts. Evaluating the resultsof bidding competitions allows management to evaluate the Company’s estimatingcapabilities at the beginning or “front end” of a new contract or project.Other benchmarks are used to evaluate the estimating process while a project isongoing.

 

We also generate servicerevenues from one-time or recurring contracts. These are generally short-termprojects which are evidenced by signed service agreements, customer work ordersor purchase orders. These sales agreements/customer orders generallyprovide for billing to customers based on time at quoted hourly or projectrates, plus costs of materials and supplies furnished by us. Service revenuesare recognized when the services have been delivered to and accepted by thecustomer.

 

*Cost ofRevenues*

 

Cost of revenues consistsof the direct costs to complete a fixed-price contract (both bid and designbuild contracts) and includes variable costs related to the project, such asmaterial, direct labor, project management costs, travel related expenses tothe projects, hotel costs spent while the project is on-going, truck expensesutilized on those projects and cell phones of the personnel while they are onthose projects. We also review our inventories for indications of obsolescenceor impairment and provide reserves as deemed necessary.

 

*Selling,General and Administrative Expenses*

 

Selling, general andadministrative expenses consist primarily of salaries, commissions and benefitsfor sales, labor and administrative personnel, including human resources,executive, accounting and legal personnel. These expenses also include fees forprofessional services and other administrative expenses.

 

*GoodwillImpairment*

 

In accordance with SFAS142, “*Goodwill and Other Intangible Assets*”(“SFAS 142”), we apply a fair-value based impairment test to the net book valueof goodwill and indefinite-lived intangible assets on an annual basis and, ifcertain events or circumstances indicate that an impairment loss may have beenincurred, on an interim basis. The analysis of potential impairment of goodwillrequires a two-step process. The first step is the estimation of fair value. Ifstep one indicates that impairment potentially exists, the second step isperformed to measure the amount of impairment, if any. Goodwill impairmentexists when the estimated fair value of goodwill is less than its carryingvalue.

 

During our quarter ended September 30,2008, based on a combination of factors, including the current economicenvironment, our operating results and a sustained decline in our marketcapitalization, we concluded that there were a number of indicators whichrequired us to perform a Goodwill impairment analysis as of September 30,2008. For the purposes of that analysis, our estimates of fair value are basedon a combination of the income approach, which estimates the fair value of ourreporting units based on the future discounted cash flows, and the marketapproach, which estimates the fair value of our reporting units based oncomparable market prices. As of the filing of the Quarterly Report on Form 10-Qfor the third quarter of fiscal 2008, we had not completed the entire two-stepanalysis due to the complexities involved in determining the implied fair valueof the goodwill of each business unit. However, based on the work performed todate, we have concluded that an impairment loss is probable and can bereasonably estimated.

 

Accordingly, we recordeda $16.9 million non-cash Goodwill impairment charge, representing our bestestimate of the impairment loss, during the third quarter of fiscal 2008. During the fourth quarter of fiscal year 2008 the management team and avaluation firm began the Goodwill and Intangible Assets impairment two stepvaluation process.  During the latterpart of the second half of fiscal year 2008 and continuing into December 2008,our market capitalization was below book value. We considered this information,as well as our discount rate and WACC of 14% and overall revenue and operatinggrowth rate assumptions for fiscal years 2009 through 2012.   We considered the market capitalizationdecline in our evaluation of fair value of goodwill and believe the decline tobe primarily attributed to the negative market conditions as a result of thecredit crisis, indications of a possible recession and current issues withinthe economy globally and the U.S.

 

Our analysis of other goodwilland intangible asset impairment during 2008 resulted in a quarter ended December 31,2008 charge of $9.7 million in addition to the estimate made for the ninemonths ended September 30, 2008 of $16.9 million.  The total impairment charges for Goodwill andIntangible assets for the year ended December 31, 2008 was $26.6 million.

 

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**Revenues**

 

Prior to our acquisitionof ISI in the third quarter of 2007, we had no revenues. Because of the timingof the acquisition, a comparison of the year ended December 31, 2007versus 2008 would not be a meaningful comparison. As a result, we are presentingthe pro forma information below in order to provide, what we believe to be, amore meaningful comparison of our revenues for the year ended December 31,2008 to the 2007 period.

 

*ProForma Net Revenues*

 

The following tablepresents pro forma net revenues for the years ended December 31, 2008 and2007 (in thousands):

 
| ** **                             | ** ** | **Pro Forma Revenues** | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|----------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                             | ** ** | **Year Ended**              | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **                             | ** ** | **December 31, 2008**  | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                             | ** ** | **Amount**                       | ** ** | **% of  Revenues**         | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract  revenues**                 |       | $                                | 100,324    |                            | 73.5       | %                            | $          | 54,712 |   | 51.6 | % | $ | 45,612 |   | 83.4 | % |
| **Contract  revenues - related party** |       | 16,782                           |       | 12.3                            | %          | 31,788                       |       | 30.0 | % | (15,006 | ) | (47.2 | )% |
| **Service  and other revenues**        |       | 19,455                           |       | 14.2                            | %          | 19,541                       |       | 18.4 | % | (86 | ) | (0.4 | )% |
| **Total  revenues**                    |       | $                                | 136,561    |                            | 100.0      | %                            | $          | 106,041 |   | 100.0 | % | $ | 30,520 |   | 28.8 | % |

 

In the last three years,the corrections and commercial security markets have been growing, which hasbeen a factor in our increased revenues.  We have seen an increase inrevenues as a result of an increase in the sale of prison furniture by PDI, anincrease in the sales made by Com-Tec and a substantial increase in the numberof sales and service calls by Argyle Commercial Security. ISI-Detention andMCS-Detention also saw growth due to an increase in the number of projectsperformed during the period.  On a pro forma basis, we had revenues of$136.6 million (including related party revenues of $16.8 million) and$106.0 million (including related party revenues of $31.8 million) for theyears ended December 31, 2008 and 2007, respectively, representing anincrease of $30.5 million or 28.8%. The increase in revenues is also due to anincrease in contract revenues in our Argyle Corrections business segment. Theincrease in the number of contracts is primarily due to several major factorsincluding, but not limited to, the development and integration of new productsolutions through the development of internal software applications that hasallowed us to capture a larger part of the market in Argyle Corrections.Year-over-year service revenues (when excluding Other Revenues frommanufacturing) have decreased by $303,000 for the year ended December 31,2008 versus 2007.  

 

The pro forma revenue mixwas 81.5% contract revenues and 18.5% service and other revenues for the yearended December 31, 2008, which was consistent with the mix in thecorresponding period in 2007.

 

As used in this analysis,“related party revenues” are revenues which are generated by work subcontractedfrom ISI*MCS (an entity owned by Sam Youngblood and by Don Carr).  Messrs. Youngbloodand Carr created ISI*MCS in 2004 to provide bonding on contracts that requiredbonding. The performance of those contracts was subcontracted to ISI as asubcontractor to ISI*MCS.  The subcontracted work was for third partycustomers of ISI*MCS that required bonded contracts.  Since theacquisition of ISI by Argyle, ISI*MCS no longer provides bonding andsubcontract work to ISI.  We have secured our own bonding capacity andwill use that bonding capacity to directly enter into bonded contracts withthird-party customers.  As a result, the amount of related party revenueswill continue to decrease as the contracts with ISI*MCS outstanding at the timeof the merger are completed.

 

**Cost ofRevenues**

 

Prior to our acquisitionof ISI in the third quarter of 2007, we had no cost of revenues. Because of thetiming of the acquisition, a comparison of the year ended December 2007versus 2008 would not be a meaningful comparison. As a result, we arepresenting the pro forma and the adjusted pro forma information below in orderto provide, what we believe to be, a more meaningful comparison of our cost ofrevenues for the years ended December 31, 2008 to the 2007 period.

 

*AdjustedPro Forma Cost of Revenues*

 

The following tablereconciles adjusted pro forma cost of revenues to pro forma cost of revenuesfor the years and December 31, 2008 and 2007 (in thousands):

 

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| ** **                                                             | ** ** | **Adjusted Pro Forma Cost of Revenues** | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **Year Ended**                                              | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **                                                             | ** ** | **December 31, 2008**                                  | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                                             | ** ** | **Amount**                                                       | ** ** | **% of  Revenues**         | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Contract  costs**                                                    |       | $                                                                | 91,722     |                            | 67.2       | %                            | $          | 66,079 |   | 62.3 | % | $ | 25,643 |   | 38.8 | % |
| **Service  and other costs, excluding amortization of intangibles**    |       | 19,414                                                           |       | 14.2                            | %          | 14,325                       |       | 13.5 | % | 5,089 |   | 35.5 | % |
| **Adjusted  pro forma total cost of revenues**                         |       | 111,136                                                          |       | 81.4                            | %          | 80,404                       |       | 75.8 | % | 30,732 |   | 38.2 | % |
| **Amortization  of intangibles**                                       |       | 4,725                                                            |       | 3.5                             | %          | 5,127                        |       | 4.8 | % | (402 | ) | (7.8 | )% |
| **Pro  forma cost of revenues, including amortization of intangibles** |       | $                                                                | 115,861    |                            | 84.8       | %                            | $          | 85,531 |   | 80.7 | % | $ | 30,330 |   | 35.5 | % |

 

On a pro forma basis,cost of revenues increased by $30.3 million, or 35.5%, to $115.9 million forthe year ended December 31, 2008, compared to $85.5 million for thecorresponding period in 2007. On an adjusted pro forma basis, cost of revenuesincreased by $30.7 million, or 38.2%, to $111.1 million for the year ended December 31,2008, compared to $80.4 million for the corresponding period in 2007. Theamortization of acquired backlog has been allocated to Cost of Revenues.  The impact of this amortization (which wasexcluded from adjusted pro forma cost of revenues) for the year ended December 31,2008 was $4.7 million. The increase in cost of revenues resulted from workingon a greater number of projects in 2008 than in 2007.  The percentage ofCost of Revenues has increased in 2008, due primarily to numerous projects thatran over budget. In order to timely complete projects and service the customer,we incurred higher travel, overtime and contracting expenses to complete thework. In addition, on certain projects there were costs which weresubstantially higher than anticipated, and such costs were not recovered.

 

The hiring and trainingprocess for the critical role of project managers (“PM” or “PMs”) haddiminished significantly as management responded to the dramatic growth in sales. This resulted in a quick hiring process with minimal vetting to meet demand.Subsequently, newly hired PMs managed substantial projects with very littleoversight and without following established operational controls andsystems.  A significant factor contributing to the reduced margins atISI-Detention and MCS-Detention was the poor handling of several projects,including a single project at ISI-Detention and MCS-Detention that had costoverruns of approximately $3.3 million through December 31, 2008. However, without the effect of the single job, ISI-Detention has had sufficientother jobs that were/are in a net under-run position such that ISI-Detentionwas in an acceptable “small-slip” condition for the year.

 

Another major impact onthe cost of revenues was the escalation of steel prices which began to risetoward the end of the second quarter. Domestic material cost increases ofapproximately 40% have increased our cost of sales on U.S. manufactured productby approximately $150,000 per month.  Pricing climbed from an average of$0.40 per pound to $0.56 per pound.  Although PDI was able to renegotiatesome contracts, and others had existing pricing that was high enough to absorbthe higher steel prices, we were unable to recover about $50,000 per month fromsmaller contracts and contracts that we were unable to renegotiate recentpricing. Indicators, such as reductions in scrap prices (the base material inthe production of steel) and very low demand, have been putting downwardpressure on the price of steel.

 

During the later part ofthe year, we accelerated a plan to reduce costs and improveefficiencies. We have negotiated reduced salaries with certain employees,and we unfortunately had to terminate a number of employees (some because theirpositions were eliminated and others because of performance reasons). Inaddition, we have implemented plans to reduce expenditures for items such ascellular phones, computers and tools. Further, we have implemented aCompany-wide plan to review cost-to-complete estimates and man-loadingefficiencies.  We have also implemented a comprehensive training programintended to increase the effectiveness of our labor force (particularly in allaspects of project management) and create redundancies which should reduce thehigher-than-expected cost for overtime and rework.

 

Another reason for theincrease in expenses involved the direct and indirect expenses related torework on product that did not meet our customer’s specifications. The laborthat PDI has used in order to affect the rework repairs was taken from PDI’sregular work force and, therefore, reduced the amount of labor available toproduce customer orders, thereby reducing the material markup that would havereduced cost of sales.  PDI was not able to recapture the expenses bycharging customers more for products.

 

The amortization ofacquired backlog in the cost of sales section has been allocated to cost ofrevenues and represents the only difference between pro forma gross margins andadjusted pro forma gross margins for the years ended December 31, 2008 and2007 period.

 

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** **

**Gross Margin**

 

Prior to our acquisition of ISI in the third quarterof 2007, we had no gross margin. Because of the timing of the acquisition, acomparison of the year ended December 2007 versus 2008 would not be ameaningful comparison. As a result, we are presenting the pro forma and theadjusted pro forma information below in order to provide, what we believe tobe, a more meaningful comparison of our gross margin for the year ended December 31,2008 to the 2007 period.

 

*Adjusted Pro Forma Gross Margin*

 

The following table reconciles adjusted pro formagross margin to pro forma gross margin for the year ended December 31,2008 and 2007 (in thousands):

 
| ** **                           | ** ** | **Adjusted Pro Forma Gross Margin** | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **Year Ended**                                     | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **                           | ** ** | **December 31, 2008**                         | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                           | ** ** | **Amount**                                              | ** ** | **% of  Revenues**              | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma gross margin** |       | $                                                       | 25,425     |                            | 18.6       | %                            | $          | 25,637 |   | 24.2 | % | $ | (212 | ) | (0.8 | )% |
| **Amortization  of intangibles**     |       | (4,725                                                  | )          | (3.5                            | )%         | (5,127                       | )          | (4.8 | )% | 402 |   | (7.8 | )% |
| **Pro  forma gross margin**          |       | $                                                       | 20,700     |                            | 15.2       | %                            | $          | 20,510 |   | 19.3 | % | $ | 190 |   | 0.9 | % |

 

On a pro forma basis for the year ended December 31,2008, gross margin was $20.7 million compared to gross margin of $20.5 millionfor the corresponding period in 2007. On an adjusted pro forma basis for theyear ended December 31, 2008, gross margin was $25.4 million compared to agross margin of $25.6 million for the corresponding period in 2007.  Thepro forma gross margin fell from 19.3% to 15.2%, and the adjusted pro formagross margin fell from 24.2% to 18.6% because of the increase in expensesdescribed above.

 

In general, we realized gross margin erosion primarilyas a result of net job costs exceeding estimates at MCS-Detention, cost controlissues at ISI-Detention (including significant, cost overruns at a single job),as well as increases in the cost of raw materials and single-source suppliercost increases at PDI. As noted previously, the major issue causingISI-Detention margin erosion is related to a single project that is currentlybeing finished. Margin erosion in MCS-Detention largely relates to issuessimilar to those experienced by ISI-Detention. Additionally, we did not have asystem in place at MCS-Detention that prevented overselling to potentialcustomers based on our capacity to perform their work.  In order to meetcustomer expectations, excessive overtime and additional manpower was requiredwith tight delivery deadlines, which added unexpected costs to certainprojects.

 

Margin erosion at PDI was attributable to variousreasons, including the impact of several issues occurring simultaneously. Oneof the main issues involved inefficient job scheduling.  When PDI provideda quote for its customers, PDI did not typically know the schedule for when thework will need to be performed once a quote is accepted. PDI had historicallyonly been concerned with the overall size of its backlog and not the timing forproduction and delivery.  Despite the fact that PDI had been growing,there was always excess capacity which historically had never been asignificant issue.  However, as the third quarter of 2008 progressed, PDIwas faced with delivery demands by multiple customers within the same timeframe. During the fourth quarter, many of these issues had been resolved as aresult of the implementation of more efficient and accurate systems forestimating costs and monitoring inventory.

 

**Operating Expenses**

 

Operating expenses increased to $53.7 million for theyear ended December 31, 2008, compared to $9.8 million for thecorresponding period in 2007.  A significant factor contributing to theseexpense increases were $26.6 million in non-cash goodwill and intangibleimpairment charges, $3.4 million in professional fees and outside services and$1.2 million in non-cash compensation expenses resulting from SFAS123(R).  Absent non-cash charges, operating expenses typically consist ofsalaries and benefits for selling and administrative personnel, including humanresources, executive, finance and legal. These expenses also include fees forprofessional services and other administrative expenses as well as amortizationof intangible assets.  In addition, we saw an increase in operatingexpenses as a result of the hiring of new personnel and the associatedrecruiting costs and various other costs associates with the transition fromformer privately held companies into becoming fully integrated businesssegments of a public reporting company.  To assist us in reducingoperating expenses in the future Argyle has implemented cost reductioninitiatives to reduce overhead and discretionary spending. Also, we have hiredan in-house general counsel which is anticipated to reduce legal costs. Also,the Executive Chairman, Chief Executive Officer and Chief Financial Officeragreed to forego agreed upon cash bonus compensation and the Executive Chairmanand Chief Executive Officer agreed to not request reimbursement for travel andentertainment expenses.  Each of the Executive Chairman, Chief ExecutiveOfficer and Chief Financial Officer agreed to a reduction of their basesalaries for the 2009 fiscal year. In addition, no employee at Argyle receivedan increase in base salary for the 2009 fiscal year. During the second half of

 

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2008, steps were taken to reduce total operating expenses byapproximately $1.5 million (annualized) at Argyle Corrections. Further, In October 2008,Mr. Youngblood agreed to not seek reimbursement for expenses incurred inconnection with tickets and club dues that he was entitled to in his employmentagreement until at least the middle of 2009, when it was agreed that theCompany would review its financial condition and assess whether it is in thebest interest of the Company to make the reimbursement. Such amount ofnon-reimbursed expenses for 2008 was approximately $10,000 (approximately$60,000 per year).

 

In order to achieve this reduction, ISI-Detention andMCS-Detention eliminated their bonus plan for the last half of 2008, reducedthe base salaries of several management employees and terminated both directand indirect employees.

 

*Adjusted Pro Forma OperatingExpenses*

 

The following table reconciles adjusted pro formaoperating expenses to pro forma operating expenses for the year ended December 31,2008 and 2007 (in thousands):

 
| ** **                                       | ** ** | **Adjusted Pro Forma Operating Expenses** | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                       | ** ** | **Year Ended**                                           | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **                                       | ** ** | **December 31, 2008**                               | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                       | ** ** | **Amount**                                                    | ** ** | **% of  Revenues**         | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma total operating expenses** |       | $                                                             | 52,255     |                            | 38.3       | %                            | $          | 19,735 |   | 18.6 | % | $ | 32,520 |   | 164.8 | % |
| **Amortization  of intangible assets**           |       | 1,735                                                         |       | 1.3                             | %          | 1,735                        |       | 1.6 | % | — |   | 0.0 | % |
| **Pro  forma total operating expenses**          |       | $                                                             | 53,990     |                            | 39.5       | %                            | $          | 21,470 |   | 20.2 | % | $ | 32,520 |   | 151.5 | % |

 

On a pro forma basis, operating expenses increased$32.5 million, or 151.5% to $54.0 million for the year ended December 31,2008, from $21.5 million for the corresponding period in 2007. On an adjustedpro forma basis, operating expenses increased $32.5 million, or 164.8% to $52.2million for the year ended December 31, 2008, from $19.7 million for thecorresponding period in 2007. The increase is primarily due to the impact of anon-cash goodwill impairment charge and additional expenses needed to supportthe increased number of projects on which we are working, increased salesand marketing efforts to promote future growth, and corporate services expensesassociated with the parent company entity.  The increase in operatingexpenses is also attributable to the increase in accounting personnel requiredto migrate several of our subsidiaries from privately held companies to becomeintegrated into a public company.  In addition to the reportingrequirements of a public company, the growth in revenues and correspondingincrease in projects also required additional personnel and the relatedrecruiting cost.  Other increased costs associated with a public companyincluded legal fees, along with external accounting and consulting fees.

 

As discussed above, $26.6 million in non-cash goodwilland intangible impairment charges were recognized in the year ended December 31,2008.  This increase accounted for 81.8% of the $32.5 million increase forthe year ended December 31, 2008. Operating expenses excluding thenon-cash goodwill impairment increased $5.9 million or 27.4% over the sameperiod in 2007.

 

Additionally, $1.2 million in non-cash compensationexpense related to restricted stock grants and employee stock options wasincluded in the operating expenses for the year ended December 31, 2008,compared to $0.6 million for the same period in 2007. The amortization ofcustomer base and software has been allocated to operating expenses andprimarily relates to the acquisition of ISI on July 31, 2007 and Com-Tec,PDI, and Fire Quest during the quarter ended March 31, 2008.  Theimpact of this amortization, which was excluded from pro forma operatingexpenses, was $1.7 million.

 

**Other Income/Expense**

 

Prior to July 2007, total other income/expenserepresented interest earned on the net proceeds of our initial public offeringand the private placement held in trust through the date of the acquisition ofISI.  Interest expense represents interest on our senior debt facilities,unsecured subordinated debt and notes issued during January 2008 inconnection with the acquisition of Com-Tec, PDI, and Fire Quest. Total otherincome/expense for the year ended December 31, 2008 was ($3.5) million,compared to other income of $167,000 for the corresponding period in 2007.

 

*Pro Forma Interest Income andInterest Expense*

 

The following table presents pro forma interest andother income for the year ended December 31, 2008 and 2007 (in thousands):

 

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| ** **                        | ** ** | **Pro Forma Other Income (Expense)** | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|-----------------------------------|------------|----------------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **Year Ended**                                      | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **                        | ** ** | **December 31, 2008**                          | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                        | ** ** | **Amount**                                               | ** ** | **%  of Revenues**         | ** ** | **Amount**                   | ** ** | **%  of Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Interest  income**              |       | $                                                        | 164        |                            | 0.1        | %                            | $          | 230 |   | 0.2 | % | $ | (66 | ) | (28.7 | )% |
| **Interest  expense**             |       | (3,708                                                   | )          | (2.7                            | )%         | (2,891                       | )          | (2.7 | )% | (817 | ) | 28.3 | % |
| **Total  other income (expense)** |       | $                                                        | (3,544     | )                               | (2.6       | )%                           | $          | (2,661 | ) | (2.5 | )% | $ | (883 | ) | 33.2 | % |

 

Pro forma interest income for the year ended December 31,2008 mainly represents interest earned on the excess cash from the net proceedsof our preferred stock offering.  Pro forma interest expense for the yearended December 31, 2008 and 2007 mainly represents interest on our seniordebt facilities, unsecured subordinated debt, and our notes issued during January 2008for the acquisitions of Com-Tec, PDI and Fire Quest. Pro forma other income/expense increased $0.9 million for the year ended December 31, 2008 to($3.5) million from ($2.7) million for the corresponding period in 2007.

 

**Net Income/(Loss)**

 

For the year ended December 31,2008, we had net loss of ($31.2) million, compared to a net income of $219,000for the corresponding period in 2007.  The most significant cause of thenet loss for the 2008 period was non-cash charges, including, the $26.6 millionin non-cash goodwill and intangible impairment charges and $1.2 million innon-cash compensation charges. Our only source of income prior to theconsummation of our initial business combination with ISI was interest earnedon the funds held in the trust account.

 

*Adjusted Pro Forma Net Income /(Loss)*

 

The following table reconciles adjusted pro forma netincome / (loss) to pro forma income / (loss) for the year ended December 31,2008 and 2007 (in thousands):

 
| ** **                                | ** ** | **Pro Forma Net Income (Loss)** | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|-------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **Year Ended**                                 | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **                                | ** ** | **December 31, 2008**                     | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **                                | ** ** | **Amount**                                          | ** ** | **% of  Revenues**         | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Adjusted  pro forma net income (loss)** |       | $                                                   | (26,864    | )                               | (19.7      | )%                           | $          | 3,696 |   | 3.5 | % | $ | (30,560 | ) | (826.8 | )% |
| **Amortization  of intangible assets**    |       | (6,460                                              | )          | (4.7                            | )%         | (6,862                       | )          | (6.5 | )% | 402 |   | (5.9 | )% |
| **Taxes,  net**                           |       | 2,455                                               |       | 1.8                             | %          | 1,865                        |       | 1.8 | % | 590 |   | 31.6 | % |
| **Total  pro forma net income (loss)**    |       | $                                                   | (30,869    | )                               | (22.6      | )%                           | $          | (1,301 | ) | (1.2 | )% | $ | (29,568 | ) | 2272.7 | % |

 

For the year ended December 31, 2008, we had apro forma net loss of ($30.9) million, compared to a pro forma net loss of($1.3) million for the corresponding period in 2007.  For the year ended December 31,2008, we had an adjusted pro forma net loss of ($26.9) million compared to anadjusted pro forma net income of $3.7 million for the corresponding period in2007. Our only source of income prior to the consummation of our initialbusiness combination with ISI was interest earned on the funds raised by Argylein connection with its initial public offering and held in a trust account foruse in a business combination.

 

**Earnings before Interest, Taxes,Depreciation and Amortization (“EBITDA”)**

** **
| ** **            | ** ** | **Pro Forma EBITDA**  | ** ** | ** **                      | ** ** | ** **                   | ** ** |
|-----------------------|------------|---------------------------------|------------|---------------------------------|------------|------------------------------|------------|
| ** **            | ** ** | **Year Ended**             | ** ** | **Year Ended**             | ** ** | **Year to Year**   | ** ** |
| ** **            | ** ** | **December 31, 2008** | ** ** | **December 31, 2007** | ** ** | **Increase (Decrease)** | ** ** |
| ** **            | ** ** | **Amount**                      | ** ** | **% of  Revenues**         | ** ** | **Amount**                   | ** ** | **% of  Revenues** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Pro  forma EBITDA** |       | $                               | (24,721    | )                               | (18.1      | )%                           | $          | 7,487 |   | 7.1 | % | $ | (32,208 | ) | (430.2 | )% |
|                       |            |                                 |            |                                 |            |                              |            |  |  |  |  |  |  |  |  |  |

 

Pro forma EBITDAdecreased by $32.2 million to ($24.7) million in the year ended December 31,2008 (the “Fiscal Year 2008 EBITDA”), compared to $7.5 million in thecorresponding period in 2007.  The EBITDA margin decreased to (18.1%) from7.1% in the corresponding period in 2007.   The Fiscal Year 2008EBITDA includes $26.6 million in non-cash goodwill and intangible

 

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impairment charges compared to $0 in the same period in 2007. Additionally, the Fiscal Year 2008 EBITDA includes $1.2 million in non-cashcompensation expense related to restricted stock grants and employee stockoptions for that period, compared to $0.6 million for the same period in 2007.

 

**Results of Operations for the YearEnded December 31, 2007**

 

We reported net income of $219,000 for the year ended December 31,2007.  Revenues for the five months,since the acquisition of ISI on July 31, 2007, were $44.1 million withmargins of $10.0 million.

 

For the year ended December 31, 2007, we incurredexpenses of $3.9 million for salaries and related expenses, including $236,000of non-cash charges related to stock compensation, $1.7 million for consultingand professional fees, $1.3 million for depreciation and amortization ofintangibles, $145,000 franchise taxes, $349,000 for insurance expense, $228,000for rental expense pursuant to the Company’s lease of office space and otheroperating costs of $2.1 million.

 

The consulting and professional fees of $1.7 for theyear ended December 31, 2007 relate primarily to monthly consulting fees,that cumulatively totaled approximately $0.5 million, legal fees ofapproximately $0.2 million, auditing, tax and accounting fees of approximately$0.8 million, and other outside services expenses of approximately $0.2million.

 

The franchise tax expense of $148,516 for the yearended December 31, 2007 was paid to the state of Delaware during the firstquarter of 2008.

 

The insurance expense of $349,000 for the year ended December 31,2007 relates to the amortization of the prepaid directors and officersinsurance policy and general liability and property policies.  The directors and officers policy which wasacquired in January 2007 and extended through January 2008, totaled$90,000 and general liability and property policies totaled $259,000.

 

The other operating costs of $2.1 million for the yearended December 31, 2007 relate primarily to travel expenses ofapproximately $0.6 million, recruiting expenses of $364,000, bad debt expenseof $323,000, marketing expenses of $302,000 and $0.6 million of various general and administrative expenses.

 

**Results of Operations for the YearEnded December 31, 2006**

 

Argyle reported net income of $172,512 for the yearended December 31, 2006, before the deduction of $175,747 of interestincome, net of taxes, attributable to common stock subject to possibleredemption. Argyle incurred a net loss of $7,743 for the period from inception(June 22, 2005) through December 31, 2005.

 

Argyle’s trust account earned interest of $1.3 millionfor the year ended December 31, 2006, and its funds outside the trustaccount earned interest of $20,242. Argyle had no funds in trust as of December 31,2005.

 

For the year ended December 31, 2006, Argyleincurred expenses of $0.5 million for consulting and professional fees,$130,632 for stock compensation, $148,516 for franchise taxes, $82,411 forinsurance expense, $61,467 for rental expense pursuant to Argyle’s lease ofoffice space and other operating costs of $131,521.

 

The consulting and professional fees of $0.5 millionfor the year ended December 31, 2006 relate primarily to monthlyconsulting fees that, cumulatively, totaled approximately $0.3 million, legalfees of approximately $52,000, auditing, tax and accounting fees ofapproximately $103,000 and bankers’ fees and expenses of approximately $25,000.As of December 31, 2006, four consultants were assisting Argyle. Theconsultants are being paid (and have been paid since August 2006) a totalof approximately $24,000 per month and are assisting Argyle in theidentification of target businesses, due diligence, securities compliance andadministration. Additionally, Argyle paid an outstanding obligation ofapproximately $53,000 in March 2006 to Liberty Defense Group LLC. AlanWachtel was paid approximately $71,000 during the year ended December 31,2006 in addition to his compensation as a part-time employee at Sec-Tec.

 

On February 1, 2006, Argyle’s officers anddirectors exercised options and purchased 18,761 shares of common stock for anaggregate cost of $507. The compensation cost associated with these options of$130,632 was recorded in the first quarter of 2006 and was computed utilizingthe Black-Scholes pricing model.

 

The franchise tax expense of $148,516 for the yearended December 31, 2006 was due to the state of Delaware, andapproximately $145,000 of this amount was paid in the first quarter of 2007.

 

The insurance expense of $82,411 for the year ended December 31,2006 relates to the amortization of the prepaid directors and officersinsurance policy which was acquired in January 2006.

 

The other operating costs of $131,520 for the yearended December 31, 2006 relate primarily to travel expenses ofapproximately

 

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$48,000, computer server hosting expense of approximately $21,000,communications expenses of approximately $12,000, stock transfer fees of$13,000, office supplies and expenses of approximately $6,000 and othermiscellaneous costs of approximately $31,000.

 

**Liquidity and Capital Resources**

 

As of December 31, 2008, we had $13.6 million incash and cash equivalents, including $2.5 million of restricted cash which isinvested in a certificate of deposit earning interest of 2.5% per year and $9.5million of cash which is deposited in Certificate of Deposit Account RegistryService (CDARS) earning interest at a variable rate of return. The remaining$1.6 million is deposited in several non-interest bearing operating bankaccounts.  The Company believes that it has enough cash available andexpects to have enough income from operations to operate for at least the next12 months.

 

In January 2006, we completed a private placementof 125,000 units to our executive officers and their affiliates and receivednet proceeds of approximately $0.9 million (the “Private Placement”). On January 30,2006, we consummated our initial public offering of 3,700,046 units (whichincluded 75,046 units sold as part of the underwriter’s over-allotment option)(the “Public Offering”). Each unit in both the Private Placement and the PublicOffering consisted of one share of common stock and one redeemable common stockpurchase warrant. Each warrant entitles the holder to purchase one share of ourcommon stock at an exercise price of $5.50 per share.

 

Net proceeds from the sale of our units, afterdeducting certain offering expenses of approximately $2.4 million (includingunderwriting discounts of approximately $1.8 million) were approximately $28.2million. Approximately $27.3 million of the proceeds from our Public Offeringand the Private Placement, each occurring prior to the acquisition of ISI, wereplaced in a trust account for our benefit. Except for $0.6 million in interestthat was earned on the funds contained in the trust account and that wasreleased to Argyle to be used as working capital, and the amounts released toArgyle for the payment of taxes, Argyle was not able to access the amounts heldin the trust until we consummated a business combination. The amounts heldoutside of the trust account were used to provide for business, legal, andaccounting due diligence on prospective acquisitions and continuing general andadministrative expenses. Prior to releasing the funds held in trust, the trustaccount contained $1.4 million reserved for the compensation of theunderwriters in the Public Offering which was paid to them upon completion ofthe business combination. All amounts held in trust were released on July 31,2007 to fund the acquisition of ISI.

 

On April 16, 2007, our officers and directors, anaffiliate of Bob Marbut, our Chief Executive Officer, and certain of ourconsultants, pursuant to a note and warrant acquisition agreement, loanedArgyle an aggregate of $0.3 million and in exchange received promissory notesin the aggregate principal amount of $0.3 million and warrants to purchase anaggregate of up to 37,500 shares of common stock at an exercise price of $5.50per share. The promissory notes were repaid in full, plus accrued interest, in August 2007.

 

On July 31, 2007, we consummated a businesscombination, acquiring 100% of the outstanding capital stock of ISI and itssubsidiaries, the value of which our Board of Directors determined was greaterthan 80% of our assets at the time of the merger. Prior to the acquisition ofISI, we had no operations and was considered a developmental stage enterprise.ISI is deemed to be a ‘‘predecessor’’ to the combined company. The accompanyingconsolidated balance sheet includes the assets and liabilities related to theacquisition of ISI, adjusted to fair value pursuant to Statement of FinancialAccounting Standards (SFAS) No. 141,*  Business Combinations* ..

 

We used an estimated $20.5 million (excluding transactioncosts) of the net proceeds of the initial public offering to acquire ISI. Atthe closing of the merger, the following consideration was paid by us to thestockholders and debt holders of ISI:

 

·                      $18.6million in cash;

 

·                      1,180,000shares of common stock (valued at approximately $9.2 million); and

 

·                      $1.9 millionof unsecured promissory notes convertible into shares of common stock at aconversion price of $10 per share.

 

Additionally, we incurred total transaction costs ofapproximately $1.7 million, including legal costs paid to Loeb & LoebLLP of $0.5 million, $0.6 million related to certain Macquarie Securities (USA)Inc.’s (formerly Giuliani Capital Advisors) advisory fees and fairness opinion,$0.3 million paid in M&A fees to WFG Investments and additional costs of$0.3 million related to accountants, consultants, printer fees and othermiscellaneous expenses. Such costs do not include transaction costs ofapproximately $1.0 million incurred by ISI (related primarily to attorney,brokerage and accounting fees).

 

As part of the acquisition of ISI, public stockholdersholding 211,965 of the aggregate number of shares sold in the Public Offeringelected to redeem such shares. The per-share redemption price was equal to$7.80 per share, including interest earned thereon in the trust account, net oftaxes paid and payable, $0.6 million of interest income which was released fromthe trust account in September 2006 to fund our working capital, andamounts owed to the underwriter for the Private Placement (approximately $0.5

 

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million plus interest). Approximately $1.6 million was paid toredemptive shareholders in August of 2007.

 

In April 2008, we completed a private placementof 18,750 shares of Series A Convertible Preferred Stock (convertibleinitially into 1,875,000 shares of common stock) to accredited investors andreceived gross proceeds of $15.0 million. Rodman & Renshaw, LLC, awholly owned subsidiary of Rodman & Renshaw Capital Group, Inc.,served as the exclusive placement agent for the offering and received $900,000and 112,500 warrants to purchase an aggregate of up to 112,500 shares of Argyle’scommon stock; exercisable at $8.00 per share, as a placement fee.

 

In January 2009, we completed a private placementof 27,273 shares of Series B Voting Convertible Preferred Stock(convertible initially into 2,727,300 shares of common stock) to accreditedinvestors and received gross proceeds of $3,000,030.

 

 ***WorkingCapital***

 

Our primary liquidity needs are for financing workingcapital (including premiums, fees and letters of credit incurred in connectionwith bid and performance bonds) and the purchase of vehicles and relatedequipment. The nature of our business and operations as a security solutionsprovider causes cash flow from operations to be highly volatile. Argyle’s largesecurity contracts can produce or consume cash. The production or consumptionof cash is dependent on factors inherent to the construction industry,including billing and payment terms of the contracts.

 

Following the closing of a new loan facility on October 3,2008, we had in place a $25.0 million credit facility, whereby ISI is the borrower,to allow it to manage its working capital and project bonding requirements,subject to borrowing capacity based on certain financial covenants. See thesection entitled “Subsequent Events” regarding certain amendments to the loanfacility where by the availability was decreased to $18.1 million.

 

At December 31, 2008, we had current assets of$58.7 million and current liabilities of $27.3 million resulting in a workingcapital surplus of approximately $31.4 million, compared to a surplus of $20.0 millionat December 31, 2007.

 

***Long-Term Debt***

 

Notes payable and Long-Term Debt consist of thefollowing (in thousands):

 
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| **Collateral**                             | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Notes payable:                             |       |                  |       |   |   |
| Vehicles and  equipment                    |       | $                     | 418        |   | $ | 190 |   |
| Unsecured debt -  related party            |       | 11,393                |       | 5,952 |   |
| Unsecured  convertible debt - stockholders |       | 1,925                 |       | 1,925 |   |
| Seller notes                               |       | 6,106                 |       | — |   |
| Line of credit  and senior term debt       |       | 12,951                |       | 7,979 |   |
|                                       |       | $                     | 32,793     |   | $ | 16,046 |   |
| Less - current  maturities                 |       | 3,235                 |       | 81 |   |
| Long term debt                             |       | $                     | 29,558     |   | $ | 15,965 |   |

 

***Vehicles andEquipment***

 

Amounts attributed to vehicles and equipment in theabove table include notes in favor of The Frost National Bank related tovehicles and various equipment lines. Vehicle and equipment notes are staggeredwith regard to their maturities, each amortizing over 36 — 48 monthperiods.  Interest rates on the individual notes range from prime plus1.0% to a fixed rate of 10%. The weighted average interest rate for theseborrowings was 9.4% and 8.2% at December 31, 2008 and December 31,2007, respectively.  Argyle has agreed toguarantee the obligations of ISI under the notes up to $1 million.

 

***UnsecuredDebt — Related Parties***

 

On January 2, 2008an additional $5.0 million in unsecured debt was funded by the same relatedparty for which $6.0 million was outstanding at December 31, 2007. All notes are unsecured and subordinated to the line of credit facility. Theunsecured note agreements contain prepayment options with prepayment penalties.Interest on the additional $5.0 million of debt accrues at 11.58% per annum andis payable quarterly in arrears, deferred interest at the rate of 8.42% perannum, and default interest of an additional 2% per annum. The total debt of$11.0 million plus accrued and unpaid interest is due and payable in one singlepayment on January 31, 2011. Argyle has agreed to guarantee the payment ofthe outstanding unsecured debt. There are both financial and restrictive

 

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covenants associated with the note agreements.  As of December 31,2008, the Company was in compliance or had received a waiver of non-compliancewith all covenants. In addition, the company modified future covenants (SeeNote 24), and expects to be in compliance with the modified covenants for thenext year.

 

 On October 28,2008, the Board approved the Company’s providing guarantees to ISI and itssubsidiaries as an alternative to bonding, in an aggregate amount of up to$15.0 million, in order to allow us the ability to bid projects withoutobtaining bonding.

 

***UnsecuredConvertible Debt — Stockholders***

 

As part of the mergerconsideration paid to acquire ISI, we issued unsecured convertible debt to thestockholders of ISI in the amount of $1.9 million, at a rate of interest of 5%per annum, paid semiannually. The notes were able to be converted in whole orin part into shares of the Company’s common stock at the election of the noteholder at a share price of $10.00 any time after January 1, 2008 orredeemed at the same price by the Company after January 1, 2009. On January 12,2009, the notes were redeemed in full by the Company at $10.00 per share for anaggregate of 192,763 shares of common stock.

 

In April 2007, ourofficers and directors, an affiliate of our Executive Chairman and ChiefExecutive Officer, and certain of our consultants, pursuant to a note andwarrant acquisition agreement, loaned us an aggregate of $300,000 and, inexchange, received promissory notes in the aggregate principal amount of$300,000 and warrants to purchase an aggregate of up to 37,500 shares of commonstock. The warrants are exercisable at $5.50 per share of common stock andexpire on January 24, 2011. The warrants also may be exercised on anet-share basis by the holders of the warrants. We have estimated, based upon aBlack-Scholes model, that the fair value of the warrants on the date of issuewas approximately $2.48 per warrant (a total value of approximately $93,000,using an expected life of two years, volatility of 2.39% and a risk-free rateof 5%). However, because the warrants have a limited trading history, thevolatility assumption was based on information then available to management.The promissory notes had an interest at a rate of 4% per year and wererepayable 30 days after the consummation of a business combination. The notesand the associated accrued interest were paid in full in August 2007.

 

***Seller Notes***

 

In connection with the PDI acquisition, ISI issuedconvertible promissory notes (the “PDI Promissory Notes”) in the aggregateprincipal amount of $3.0 million. The aggregate principal amount of the PDIPromissory Notes may be reduced, depending on the occurrence of certain eventsdescribed in the Asset Purchase Agreement. The payment of the PDI PromissoryNotes is guaranteed by and secured by the assets of ISI and its subsidiaries,and they bear interest at 6% paid quarterly through December 2009. Argyle provided a guaranty of payment and performance of ISI’s obligationsunder the PDI Promissory Notes. After December 2009, principal andinterest payments of $133,000 are due monthly with final payment occurring on December 31,2012.  From June 1, 2009 through November 15, 2009, we have theoption to (i) convert $500,000 of the outstanding principal into commonstock of Argyle based on 95% of the closing price of the common stock for a20-day trading period preceding notice of the Company’s intent to convert; or (ii) extendthe $500,000 principal due in 2010 to January 3, 2011 for an additionalpayment of $15,000 plus accrued interest.  The aforementioned options toconvert or extend the PDI Promissory Notes resulted in the creation of compoundembedded derivatives for which the Company has performed valuations at the endof each fiscal quarter. The Company will mark to market the derivatives,for which any changes in fair value will be recognized in the statement ofoperations, in all the subsequent quarters until they are exercised or haveexpired.  The valuation of these derivatives held a value of $23,000 as ofDecember 31, 2008.

 

In connection with the Com-Tec acquisition, ISI issueda secured subordinated promissory note in the aggregate principal amount of$3.5 million (the “Com-Tec Promissory Note”). The Com-Tec Promissory Note isguaranteed by and secured by the assets of ISI and its subsidiaries, bearsinterest at 7% per year and have a maturity date of April 1, 2011. Argyle provided a guaranty of payment and performance of ISI’s obligationsunder the Com-Tec Promissory Note. Interest only payments were made for eachthree-month period beginning on May 2008 and August 2008;  asingle principal payment of $100,000 was due and paid on December 15,2008; and level principal and interest payments in the cumulative amount of$128,058 were due monthly beginning on August 1, 2008 and continuingmonthly thereafter on the first day of each month for consecutive monthsthrough December 2008; then level principal and interest payments in thecumulative amount of $123,748 due monthly beginning on January 1, 2009,and continuing monthly thereafter on the first day of each month through December 2009,then for 25 consecutive months until the maturity date. On March 2, 2009, theprincipal of the Com-Tec Promissory Note was reduced to $3,491,290.80 as aresults of adjustments made because of uncollected accounts receivable.

 

In connection with the Fire Quest acquisition, theCompany issued a promissory note in the aggregate principal amount of $250,000(the “Fire Quest Promissory Note”). The Fire Quest Promissory Note, wasguaranteed by and secured by the assets of ISI and its subsidiaries and bearsinterest at the rate of 7.25% per year and became due and payable on January 1,2009. Argyle had provided a guaranty of payment and performance of ISI’sobligations under the Fire Quest Promissory Note.  The Company has paid quarterly payments ofaccrued and unpaid interest of $4,531.25 until the maturity date and made afinal payment on the maturity date equal to the unpaid principal amounttogether with any then unpaid and accrued interest and other amounts payablethereunder. As a result, the Fire Quest Promissory Note is no longer anoutstanding obligation of ISI or its subsidiaries.

 

Collectively, the Fire Quest Promissory Note, the PDIPromissory Notes and the Com-Tec Promissory Note are hereinafter collectivelyreferred to as the “Seller Notes”.

 

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*** ***

***Senior SecuredCredit Facility***

 

At December 31 2008, ISI had a line of creditfacility for (i) a secured revolving line of credit in the maximum amountof $10.0 million with a $5.0 million sublimit for the issuance of letters ofcredit, (ii) a secured revolving line of credit in the maximum amount of$5.0 million, to be used solely for the issuance of letters of credit and (iii) aterm loan in the maximum amount of $10.0 million (collectively, the “Loans”). The Loans have a three-year maturity that mature on October 2, 2011 and, uponclosing, the proceeds were used to pay off existing indebtedness, with theremaining availability to be used for working capital and other generalcorporate purposes. The Loans are secured by liens on and security interests inthe personal property of ISI and guaranteed by the subsidiaries of ISI.

 

The interest rates of the Loans are, at ISI’s optionfrom time to time, (i) a floating per annum rate of interest equal to theprime rate plus the Applicable Margin, or (ii) the LIBOR Rate plus theApplicable Margin. The “Applicable Margin” means the rate per annum added tothe prime rate and LIBOR as determined by the ratio of total debt to EBITDA ofISI and its subsidiaries for the prior fiscal quarter. The weighted averageinterest rate for these borrowings was 5.9% and 6.9% at December 31, 2008and December 31, 2007, respectively. The intercompany loan, with a principal amount of $2.0 million advancedon September 30, 2008 at an interest rate of 5%, was repaid in full uponthe closing of the Loans with the Bank on October 3, 2008.

 

In connection with the Loans, the holders of eachSeller Note agreed to be subordinated to the lender with respect to payment andperfection. In addition, the maturity dates of each Seller Note was effectivelyextended to be no earlier than the date on which all of the outstandingobligations of ISI to repay the outstanding principal and accrued and unpaidinterest relating to the Loans are satisfied.

 

The agreement contains both financial and restrictivecovenants, including a restriction on the payment of dividends by ISI. Underthe terms of the credit facility, as of December 31, 2008, the Company isindebted for $9.5 million in term debt and $3.5 million through the line ofcredit.  As of December 31, 2008, the Company was in compliance orhad received a waiver of non-compliance with all covenants. In addition, theCompany modified future covenants (see Note 24), and expects to be incompliance with the modified covenants for the next year.

 

Aggregate maturities required on all debt at December 31,2008 are as follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2009                                        |       | $          | 3,235      |   |
| 2010                                        |       | 4,936      |       |
| 2011                                        |       | 24,485     |       |
| 2012                                        |       | 66         |       |
| 2013                                        |       | 71         |       |
| Thereafter                                  |       | —     |       |
|                                        |       | $          | 32,793     |   |

 

As a result of a review of anticipated capitalexpenditures for the remainder of the 2008 fiscal year, on November 12,2008, the Company discovered that it was in excess of the limit of $2.5 millionprovided for in its loan agreement with its subordinated debt lender and,accordingly, on November 12, 2008, the Company requested and received awaiver to increase the limit to $3 million in exchange for a $25,000 fee.  As of December 31, 2008, the Company wasin compliance of all the loan covenants.

 

As summarized below under the section entitled “SubsequentEvents”, on January 8, 2009, ISI amended certain covenants related to thesenior line of credit facility and its subordinated debt.  In connection with the amendment of thesenior line of credit facility, Argyle agreed to provide a guaranty of theobligations ISI and its subsidiaries under the facility.

 

***Interest Rate Risk Management***

 

We use derivative instruments to protect against therisk of changes in prevailing interest rates adversely affecting future cashflows associated with changes in the London Inter-bank Offer Rate (“LIBOR”)applicable to its variable rate debt discussed above. We utilizes interest rateswap agreement to convert a portion of the variable rate debt to a fixed rateobligation. We account for the interest rate swaps in accordance with SFAS No. 133,*Accounting for Derivative Instruments and HedgingActivities*.

 

During the fourth quarter of 2008, we entered into aU.S. dollar amortizing interest rate swap agreement, which became effective on December 1,2008, with a notional amount starting at $10.0 million. The notional amount ofthe swap is set to decrease periodically as set forth in the swap agreement.The Company presents the fair value of the interest rate swap agreement at theend of the period in other long term liabilities, as applicable, on itsconsolidated balance sheet.

 

At December 31, 2008, the interest rate swap hada fair value (net of taxes) of approximately $116,000. During the year ended December 31,2008, we recognized interest (expense) income from hedging activities relatingto interest rate swaps of $3,062. There were no ineffective amounts recognizedduring the period ended December 31, 2008, and we do not expect thehedging activities to result in an ineffectiveness being recognized in theearnings.

 

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At December 31, 2008, accumulated othercomprehensive income included a deferred pre-tax net loss of $188,000 relatedto the interest rate swap. For the year ended December 31, 2008, we didnot reclassify any pre-tax expense into interest expense from accumulated othercomprehensive income as adjustments to interest payments on variable rate debt.

 

***Capital Leases***

 

ISI sold itsowner-occupied real estate to a partnership owned by ISI’s stockholders during2004 and entered into a leaseback of the properties with the partnership. ISIentered into a second lease on another property owned by the same partnershipin 2006. ISI entered into a third lease on another property owned by the samepartnership in June 2008.  All three leases are triple net leases. Atriple net lease is a lease agreement on a property by where the tenant orlessee agrees to pay all real estate taxes, building insurance and maintenance(the three ‘Nets’) on the property in addition to any normal fees that areexpected under the agreement (rent, etc.). In such a lease, the tenant orlessee is responsible for all costs associated with repairs or replacement ofthe structural building elements of the property.

 

The terms of theaforementioned leases were modified on July 31, 2007 to extend theexpiration date from 2018 to 2019. The modification did not materially affectthe carrying value of the assets or related liabilities recorded in theaccompanying consolidated balance sheet.

 

In December 1, 2008the Company entered into a 36 month capital lease totaling $65,000 forTele-Trac equipment to be installed in its fleet of service vehicles to enablemanagement to better monitor and manage productivity for the installation andfield-service workforce.

 

***Commitments***

 

We lease office space andequipment under operating leases expiring through 2012.   Thecorporate office lease space in San Antonio, TX expired as of July 31,2007, and we operated under a month-to-month lease arrangement until it wasrenewed in January 2008.  The new lease expanded the space fromapproximately 2,500 square feet to 5,500 square feet for a total expense in2008 of $121,000. This lease expires in January 2013.

 

As part of theacquisition of PDI on January 4, 2008, ISI assumed PDI’s existing leasesin California and Arizona.  On September 5, 2008, ISI entered into alease relating to approximately 29,709 square feet of property located at 577and 583 North Batavia Street, Orange, California. The term of the new lease isfor two years commencing September 1, 2008 and ending August 31,2010. The aggregate monthly base rent is $16,934.  In connection withthe lease, on September 5, 2008, Argyle entered into a guaranty pursuantto which Argyle has agreed to guarantee the payment and performance obligationsof ISI under the lease. The PDI lease in Arizona is a four year lease. Thethree facilities occupy a total of 55,709 square feet (26,000 square footfacility in Arizona and the 29,709 square foot facilities in California) withaggregate monthly payments of $32,934.

 

As part of the Com-Tecacquisition that occurred at January 31, 2008, we signed a new lease forthe existing facility.  The Com-Tec lease is a five year lease, for the33,000 square foot facility, with aggregate monthly payments of $14,000beginning in year three with the total rent expense being recognized on astraight-line basis over the life of the lease.

 

Rental expense was $1.2million and $228,000 for the year ended December 31, 2008 and 2007,respectively.  Rental expense was $103,000 and $266,000 for the sevenmonths ended July 31, 2007 (Predecessor), respectively.

 

In August 2007, weentered into a letter of credit facility with a financial institution. Theletter of credit may not exceed $500,000. The facility requires a 1% annualcommitment fee on the unused portion of the letter of credit facility and ispaid quarterly.

 

In May 2008, weentered into a letter of credit facility with a financial institution, securedby $2.5 million of restricted cash. The letter of credit may not exceed $2.5million. The facility does not have a fee on the unused portion of the letterof credit facility.

 

**Off Balance Sheet Arrangements**

 

Argyle does not have any off-balance sheetarrangements.

 

**Contractual Obligations**

 

Aggregate amounts at December 31,2008 are as follows (in thousands):

 

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| ** **                               | ** ** | **Total** | ** ** | **< 1 Year** | ** ** | **1 < 3 Years** | ** ** | **3 < 5 Years** | ** ** | **> 5 Years** | ** ** |
|------------------------------------------|------------|-----------|------------|---------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|----------------------------|------------|
| Principal on  Long Term Debt Obligations |       | $         | 32,793     |                      | $          | 3,235                             |       | $                                 | 29,421     |                       | $          | 137 |   | $ | — |   |
| Capital Lease  Obligations               |       | 5,377     |       | 516                       |       | 1,030                             |       | 986                               |       | 2,845                      |       |
| Operating Lease  Obligations             |       | 3,545     |       | 895                       |       | 1,606                             |       | 938                               |       | 106                        |       |
| Interest on Long  Term Debt Obligations  |       | 10,918    |       | 2,961                     |       | 5,399                             |       | 2,558                             |       | —                     |       |
| **Total**                                | ** ** | **$**     | **52,633** | ** **                | **$**      | **7,607**                         | ** ** | **$**                             | **37,456** | ** **                 | **$**      | **4,619** | ** ** | **$** | **2,951** | ** ** |

 

**Subsequent Events**

 

*Series B Purchase Agreement*

 

On January 8, 2009, Argyle entered into aSecurities Purchase Agreement (the “Purchase Agreement”) with MezzanineManagement Fund IV A, L.P. and Mezzanine Management Fund IV Coinvest A, L.P.(the “Purchasers”), and Sam Youngblood, Ron Chaimovski and Bob Marbut(together, with their affiliates, the “Stockholders”), pursuant to which thePurchasers purchased 27,273 shares of a newly created series of our preferredstock, designated “Series B Convertible Preferred Stock”, par value$0.0001 per share (the “Series B Preferred Shares”) for $110 per share,for an aggregate purchase price of $3,000,030 (the “Series B Financing”).

 

Each Series B Preferred Share is convertible into100 shares of common stock, at any time, at the option of the holder, initiallyat a conversion price of $1.10 per share of Common Stock, subject to adjustmentfor stock dividends, stock splits or similar capital reorganizations, andweighted average price protection for certain issuances below the conversionprice.

 

The Series B Preferred Shares have voting rightsequal to the number of shares of common stock the holder would receive if all Series BPreferred Shares had been converted into common stock. The holders of the Series BPreferred Shares may also designate one individual to serve on the Company’sBoard of Directors.

 

The holders of the Series B Preferred Sharesshall be entitled to receive, on a cumulative basis, cash dividends, when, asand if declared by the our Board of Directors, at the greater of (i) 4%per annum or (ii) the dividend payable on the equivalent amount of commonstock into which the Series B Preferred Shares could be converted;provided, however, that such cash dividend must be paid at the earliest any ofthe following occur:  (A) we pay a dividend on the common stock, (B) weliquidate or there is a change in control, or (C) upon conversion of the Series BPreferred Shares, but only with respect to those Series B Preferred Sharesso converted.

 

The Series B Preferred Shares have a liquidationpreference as to both our Series A Convertible Preferred Stock, par value$0.0001 per share (“Series A Preferred Shares”) and our common stock equalto the greater of (i) the sum of the original issue price (subject toadjustment for stock dividends, stock splits or similar capitalreorganizations) plus all accrued but unpaid dividends, or (ii) the amountthe holder would receive if all Series B Preferred Shares had beenconverted into common stock.

 

For as long as any shares of Series B PreferredShares remain outstanding, we will be prohibited from (i) amending,waiving, altering or repealing in a way that adversely affects the rights,powers, preferences, or other special rights or privileges of the holders ofthe Series B Preferred Shares, whether by amendment to the Certificate ofIncorporation, Bylaws, Certificate of Designation or other organizationdocuments, or by merger, consolidation, reorganization or otherwise, (ii) increasingor decreasing (other than by redemption or conversion) the authorized number ofshares of preferred stock or Series B Preferred Shares, (iii) creating,issuing or authorizing the issuance of any equity securities senior to the Series BPreferred Shares, or (iv) repurchasing, redeeming or reissuing any equitysecurities of the Company to which the Series B Preferred Shares ranksenior and prior (whether with respect to dividends, redemption, or uponliquidation or otherwise), including the Series A Preferred Shares and theCommon Stock, and any rights or options exercisable or convertible thereof,other than repurchases of shares of Common Stock from employees, officers,directors or consultants under agreements providing for such repurchase undercertain conditions.

 

Under the Purchase Agreement, we also grantedpiggyback registration rights to the Purchasers.

 

We granted a preemptive right to the Purchasers withrespect to future financings and a right of first offer to provide financingfor certain transactions. In addition, the Stockholders have granted a right offirst refusal to the Purchasers until January 31, 2010 as to any transfersof our securities held by the Stockholders.

 

The gross proceeds of the Series B Financing wereused to reduce a portion of the outstanding balance of the PrivateBank Loans(see below).

 

Neither the Series B Preferred Shares, nor theshares of common stock issuable upon conversion of the Series B PreferredShares, have been registered under the Securities Act, and may not be offered orsold in the United States absent registration or an applicable

 

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exemption from such registration requirement.

 

*Amendment to Blair PurchaseAgreement*

 

On January 8, 2009, ISI entered into a SixthAmendment (the “Blair Amendment”) to the Note and Warrant Purchase Agreementdated as of October 22, 2004 (as amended) between ISI and William BlairMezzanine Capital Fund III, L.P. (“Blair”), a fund managed by Merit CapitalPartners. Pursuant to the terms of the Blair Amendment, Blair has agreed toamend its existing covenants to have a 10% cushion to Private Bank’s amendedcovenants and has agreed to an extension of the maturity of its debt for oneyear, until January 31, 2011.  The senior debt-to-EBITDAcovenant was increased to 2.50x at March 31, 2009 and June 30,2009.  The senior debt to EBITDA covenant will become 2.20x at September 30,2009. A total debt-to-EBITDA ratio covenant was created whereby the ratio atthe end of the fiscal quarter must be no greater than to 5.94 to 1.00 at March 31,2008, 5.78 to 1.00 at June 30, 2009, 4.40 to 1.00 at September 30,2009 and, thereafter, it will be 3.85 to 1.00.  The maximum capitalexpenditures covenant has been increased to $330,000 per each fiscal quarterending March 31, 2009, June 30, 2009 and September 30, 2009,respectively. The fixed charge coverage ratio has been amended to take intoaccount payments made to subordinated debt holders. The interest rate on alloutstanding notes will increase by 4.0% if the outstanding notes are not repaidby September 30, 2010.

 

*Amendment to PrivateBank LoanAgreement*

 

On January 8, 2009, ISI entered into Amendment No. 1dated January 8, 2009 (the “Loan Amendment”) to the Loan Agreement dated October 3,2008 with The PrivateBank and Trust Company, an Illinois banking corporation(the “Bank”). Pursuant to and subject to the terms and conditions of the LoanAgreement, the Bank had made available to ISI (a) a secured revolving lineof credit in the maximum amount of $10,000,000, with a $5,000,000 sublimit forthe issuance of letters of credit, (b) a secured revolving line of creditin the maximum amount of $5,000,000, to be used solely for the issuance ofletters of credit, and (c) a term loan in the maximum amount of$10,000,000 (collectively, the “PrivateBank Loans”).

 

Pursuant to the terms of the Loan Amendment, ISI paiddown the existing term loan by $3.0 million (effectively paying down the termloan by $2.5 million and pre-paying the March 31, 2009 principal paymentof $500,000).  All debt covenants were waived at December 31,2008.  The applicable margin for LIBOR rate loans under the revolvinglines of credit between January 1, 2009 through September 30, 2009was increased to 3.5%, the applicable margin for Prime rate loans under therevolving lines of credit between January 1, 2009 and September 30,2009 was increased to 1.50%, the applicable margin for LIBOR rate loans underthe term loan was increased to 4.0%, and the applicable margin for Prime rateloans under the term loan was increased to 2.0%.  The letter ofcredit fee was also increased to 3.5%.  The senior debt-to-EBITDAcovenant was increased from 2.00x to 2.25x at March 31, 2009 and June 30,2009.  The senior debt-to-EBITDA covenant will return to 2.00x at September 30,2009. The total debt to EBITDA covenant was increased from 4.00x to 5.40x at March 31,2008 and 5.25x at June 30, 2009 and will return to 4.00 at September 30,2009 and thereafter it will be 3.50.  There is a new maximum capitalexpenditures covenant of $300,000 per quarter in Q1 2009, Q2 2009, and Q3 2009and the fixed charge coverage ratio has been amended to take into accountpayments made to subordinated debt holders.

 

Argyle agreed to provide a guaranty of the PrivateBankLoans up to $18.1 million until the completion of an audit for the fiscal yearended 2009 (the “Guaranty Agreement”); provided, however that the GuarantyAgreement will terminate on the earlier of (a) the payment in full of allobligations under the Loan Agreement or (b) at the time the Bankdetermines in its sole judgment that ISI’s financial statements issued pursuantto the Loan Agreement for the fiscal year ended December 31, 2009 establishthat ISI is in compliance with the amended financial covenants of the LoanAgreement.  The line of credit that is used solely for letters ofcredit was decreased from $5.0 million to $1.1 million, and the promissory noteevidencing the line of credit was amended and restated to reflect the principalamount reduction. The Loans will continue to be secured by liens on andsecurity interests in the personal property of ISI and guaranteed by thesubsidiaries of ISI.

 

*Line of Credit Facility*

 

In February 2009,Argyle entered into a letter of credit facility with the PrivateBank,collateralized by $2.5 million in restricted cash. The letter of credit may notexceed $2.5 million. The facility does not have a fee on the unused portion ofthe letter of credit facility.

 

*Restricted Stock, Options and Performance UnitAwards*

 

On February 1, 2009, we granted 90,000unregistered shares of our common stock to Officers and key employees listedbelow. Ability to sell, transfer or assign these shares vest December 31in three equal tranches on each of 2009, 2010, and 2011. The holders have theright to vote all shares, regardless of the vesting schedule.

 
| **Stockholders**   | ** ** | **Number of Shares** | ** ** |
|--------------------|------------|--------------------------------|------------|
| Bob Marbut         |       | 25,000                         |       |
| Ron Chaimovski     |       | 25,000                         |       |
| Donald F.  Neville |       | 15,000                         |       |
| Matthew A. Kepke   |       | 15,000                         |       |
| Dean Dresser       |       | 10,000                         |       |

 

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Also, on February 1,2009, we granted options to purchase an aggregate of up to 300,000 shares ofour common stock to Officers and key employees of the listed below. The exercise price of the options is $1.10 pershare and the options vest December 31 in three equal annual tranches oneach of 2009, 2010 and 2011.

 
| **Stockholders**   | ** ** | **Number of Options** | ** ** |
|--------------------|------------|---------------------------------|------------|
| Bob Marbut         |       | 50,000                          |       |
| Ron Chaimovski     |       | 50,000                          |       |
| Sam Youngblood     |       | 50,000                          |       |
| Donald F.  Neville |       | 30,000                          |       |
| Matthew A. Kepke   |       | 25,000                          |       |
| Dean Dresser       |       | 10,000                          |       |
| Robert Roller      |       | 25,000                          |       |
| Brian LaBad        |       | 10,000                          |       |
| Jeff Paulik        |       | 10,000                          |       |
| Mike Peterson      |       | 10,000                          |       |
| Wally Wallace      |       | 25,000                          |       |
| Tim Moxon          |       | 10,000                          |       |

 

In addition, on February 1, 2009, we granted110,000 performance unit awards to Officers and key employees listed below. Theawards vest fully on December 31, 2012 at which time a cash payment amountper unit award shall be determined by the Board based on the Company achievingor exceeding performance goals set by the Compensation Committee of the Board.

 
| **Stockholders**   | ** ** | **Number of Unit Awards** | ** ** |
|--------------------|------------|------------------------------------------|------------|
| Bob Marbut         |       | 25,000                                   |       |
| Ron Chaimovski     |       | 25,000                                   |       |
| Donald F.  Neville |       | 15,000                                   |       |
| Matthew A. Kepke   |       | 15,000                                   |       |
| Dean Dresser       |       | 10,000                                   |       |

 

On March 19, 2009,we issued 45,000 unregistered shares of our common stock to the Directorslisted below. These shares vest in full seven (7) days after the Directoris no longer serving on the Board.

 
| **Stockholders** | ** ** | **Number of Shares** | ** ** |
|------------------|------------|--------------------------------|------------|
| Lloyd Campbell   |       | 15,000                         |       |
| Wesley Clark     |       | 15,000                         |       |
| John Smith       |       | 15,000                         |       |

 

Such shares, options and performance unit awards wereissued pursuant to the exemption from registration contained in Section 4(2) ofthe Securities Act as they were issued to officers and directors of Argyle.

 

**Item 7A.Quantitative and Qualitative Disclosures About Market Risk**

 

Market risk is the sensitivity of income to changes ininterest rates, foreign exchanges, commodity prices, equity prices, and othermarket-driven rates or prices.

 

At December 31, 2008, ISI had a line of creditfacility totaling $10.0 million and $10.0 million in debt. The line of creditand term debt are secured by all of our tangible and intangible assetsexcluding vehicles. Interest on the line of credit is payable quarterly and iscalculated at the lender’s base rate (greater of prime or federal funds rate)plus 0.5% for the applicable period. Interest on the term debt is payablequarterly and is calculated at 350 basis points in excess of LIBOR for theapplicable period. The outstanding balance on the line of credit and term debtat December 31, 2008 was $13.0 million. The facility has a maturity dateof October 2, 2011.

 

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Changes in market rates may impact the bank’s LIBORrate or prime rate. For instance, if either the LIBOR or prime rate were toincrease or decrease by one percentage point (1.0%), our annual interestexpense would change by approximately $250,000 based on the total creditavailable to Argyle.

 

**Item 8.Financial Statements and Supplementary Data**

 

Financial statements are attached hereto beginning on Page F-1.

 

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

 

There were no changes in or disagreements with ouraccountants on accounting and financial disclosure, nor were there any “reportableevents”, as that term is described in Item 304(a)(1)(v) of Regulation S-K,for the years ended December 31, 2007 and 2008 or for any subsequentinterim period.

 

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

 

**Disclosure Controls and Procedures**

 

Disclosure controls and procedures are designed toensure that information required to be disclosed by us in reports filed orsubmitted under the Securities Exchange Act of 1934, as amended (“Exchange Act”)is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms. Disclosure controls and proceduresinclude, without limitation, controls and procedures designed to ensure thatinformation required to be disclosed under the Exchange Act is accumulated andcommunicated to management, including the principal executive and financialofficers, as appropriate to allow timely decisions regarding requireddisclosure. There are inherent limitations to the effectiveness of any systemof disclosure controls and procedures, including the possibility of human errorand the circumvention or overriding of the controls and procedures.Accordingly, even effective disclosure controls and procedures can only providereasonable assurance of achieving their control objectives.

 

Our management, under the supervision of our ChiefExecutive Officer, President and Chief Operating Officer, Chief FinancialOfficer and Corporate Controller performed an evaluation of the effectivenessof the design and operation of our disclosure controls and procedures as of December 31,2008. Based on that evaluation, our management, including the Chief ExecutiveOfficer, President and Chief Operating Officer, Chief Financial Officer andCorporate Controller, concluded that our disclosure controls and procedureswere effective as of December 31, 2008.

 

**Management’s Report on InternalControl Over Financial Reporting**

 

Our management, including the Chief Executive Officer,President and Chief Operating Officer, Chief Financial Officer and CorporateController, is responsible for establishing and maintaining adequate internalcontrol over financial reporting, as defined in Rules 13a-15(f) and15d-15(f) of the Securities Exchange Act of 1934, as amended. Our internalcontrols were designed to provide reasonable assurance as to the reliability ofour financial reporting and the preparation and presentation of theconsolidated financial statements for external purposes in accordance withaccounting principles generally accepted in the United States, as well as tosafeguard assets from unauthorized use or disposition.

 

Internal control over financial reporting cannotprovide absolute assurance of achieving financial reporting objectives becauseof its inherent limitations. Internal control over financial reporting is aprocess that involves human diligence and compliance and is subject to lapsesin judgment and breakdowns resulting from human failures. Internal control overfinancial reporting also can be circumvented by collusion or impropermanagement override. Because of such limitations, there is a risk that materialmisstatements may not be prevented or detected on a timely basis by internal controlover financial reporting. However, these inherent limitations are knownfeatures of the financial reporting process. Therefore, it is possible todesign into the process safeguards to reduce, though not eliminate, this risk.Management is responsible for establishing and maintaining adequate internalcontrol over financial reporting for the company.

 

Management assessed the effectiveness of the Company’sinternal control over financial reporting as of December 31, 2008. Management has excluded PDI and Com-Tec from its assessment ofinternal control over financial reporting as of December 31, 2008. Fire Quest was acquired and its assets fully absorbed by MCS–Commercial onJanuary 1 2008, PDI was acquired on January 4, 2008, and Com-Tec wasacquired on January 31, 2008. In making this assessment, it usedthe criteria set forth in*InternalControl—Integrated Framework* issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

 

At December 31,2008, total assets, total assets less goodwill and net tangible assets, andtotal revenues subject to PDI’s internal control over financial reportingrepresented 6.3%, 9.6%, and 6.6% of Argyle’s consolidated total assets, totalassets less goodwill and net intangible assets, and total revenues as of andfor the year ended December 31, 2008. At December 31, 2008, totalassets, total assets less goodwill and net tangible assets, and total revenuessubject to Com-Tec’s internal control over financial reporting represented 20.3%,8.9%, and 14.3% of Argyle’s consolidated total assets, total assets lessgoodwill and net intangible assets, and total revenues as of and for the yearended December 31, 2008.

 

Management’s annual report on internal control overfinancial reporting does not include an attestation report of the registrant’sregistered public accounting firm pursuant to rules of the Securities andExchange Commission that permit the registrant to provide only management’sreport in its annual report.

 

This annual report does not include an attestationreport of the company’s registered public accounting firm regarding internalcontrol over financial reporting. Management’s report was not subject toattestation by the company’s registered public accounting firm pursuant totemporary rules of the Securities and Exchange Commission that permit thecompany to provide only management’s report on this annual report.

 

**Changes in Internal Control overFinancial Reporting**

 

During the quarter ended December 31, 2008,management had completed testing and determined that the controls surroundingthe previously disclosed material weakness regarding revenue recognition wereoperating effectively. Management has concluded that remediation has beencompleted and this represents a significant change in internal control overfinancial reporting.

 

These represent the only changes to our internalcontrols over financial reporting that were identified in connection with theevaluation required by Rules 13a-15(d) or 15d-15(d) under theExchange Act during the year ended December 31, 2008 that have materiallyaffected, or are reasonably likely to materially affect, Argyle Security, Inc.’sinternal control over financial reporting. We do not provide assurance that noadditional material weaknesses will be identified in the future.

 

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**Item 9B.Other Information**

 

On March 30, 2009, ISI entered into Amendment No. 2to the Loan and Security Agreement with PrivateBank and the Seventh Amendmentof Note and Warrant Purchase Agreement with Blair. The purpose of entering intothe agreements was to clarify the definition of permitted indebtedness underthe subordinated debt facility and establish the maximum capital expenditurelimits after the quarter ended September 30, 2009 for each of the seniordebt facility and the subordinated debt facility.  In addition, ISI executed an Allonge to ThirdAmended and Restated Senior Subordinated Promissory Note and Amended andRestated Senior Subordinated Promissory Note A for the purpose of amending theschedule of payments. Copies of the amendments and the allonges are attached asexhibits to this annual report on Form 10-K as Exhibits 10.96, 10.97, 10.98and 10.99.

 

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**PART III**

 

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

 

Information with respect to this item is incorporatedherein by reference to Argyle’s Proxy Statement for its Annual Meeting ofStockholders to be held in 2009.

 

**Item 11.Executive Compensation**

 

Information with respect to this item is incorporatedherein by reference to Argyle’s Proxy Statement for its Annual Meeting ofStockholders to be held in 2009.

 

**Item 12.Security Ownership of Certain Beneficial Owners and Management and RelatedStockholder Matters**

 

Information with respect to this item is incorporatedherein by reference to Argyle’s Proxy Statement for its Annual Meeting ofStockholders to be held in 2009.

 

**Item 13.Certain Relationships and Related Transactions, and Director Independence**

 

Information with respect to this item is incorporatedherein by reference to Argyle’s Proxy Statement for its Annual Meeting ofStockholders to be held in 2009.

 

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

 

Ernst & Young LLP audited our financialstatements for the year ended December 31, 2008, 2007 and 2006.

 

Padgett, Stratemann & Co. LLP auditedpredecessor (ISI) financial statements for the period ended July 31, 2007and the year end December 31, 2006.  In addition, the firm auditedthe predecessor (ISI) employee benefit plans for the years ended December 31,2007, 2006 and 2005.

 

**Audit Fees**

 

Fees for audit services provided by Ernst &Young LLP totaled $815,000, $409,502 and $132,878 in 2008, 2007 and 2006,respectively, including fees associated with the audit of the annual financialstatements for the fiscal year ended December 31, 2008, 2007 and 2006, thereviews of the Company’s quarterly reports on Form 10-Q, and for servicesperformed in connection with the Company’s registration statements.

 

Fees for audit services provided by Padgett,Stratemann & Co., LLP totaled $77,875, $236,425 and $144,200 in 2008,2007 and 2006, respectively, including fees associated with the audit of ISIDetention Contracting Group, Inc.  (ISI) financial statements for theseven months ending July 31, 2007 and fiscal year ended December 31,2006, quarterly reviews of ISI for purposes of filing in Argyle 8-K filingsduring the acquisition period of ISI by the Company, and services performed inconnection with the Company’s registration statements.

 

**Audit-Related Fees**

 

Fees for audit-related services provided by Ernst &Young LLP totaled $0, $269,600 and $28,500 in 2008, 2007 and 2006,respectively. Audit-related services principally include due diligence inconnection with acquisitions in 2006, and a balance sheet audit in 2007 as aresult of the ISI acquisition.

 

Fees for audit related services provided by Padgett,Stratemann & Co. LLP totaled $22,300, $22,975 and $7,500 in 2008, 2007and 2006, respectively.  Audit related services included due diligence inconnection with acquisitions in 2007 and audits of ISI’s employee benefit plansfor the year ended December 31, 2006.

 

**Tax Fees**

 

Fees for tax services provided by Ernst &Young LLP, including tax compliance, tax advice, and tax planning, totaled $0,$5,350 and $11,015 in 2008, 2007 and 2006, respectively.

 

Fees for tax services provided by Padgett, Stratemann &Co., LLP, including tax compliance, tax advice, and tax planning, totaled$180,805, $57,935 and $ 39,220 in 2008, 2007 and 2006, respectively.

 

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**All Other Fees**

 

There were no fees billed by Ernst & YoungLLP for other professional services rendered during the fiscal years ended December 31,2008, 2007 or 2006.

 

Fees for other professional services rendered byPadgett Stratemann &Co., Inc totaled $36,625, $34,425 and $2,000during the 2008, 2007 and 2006, respectively.

 

**Pre-Approval of Services**

 

Since our Board of Directors performed the duties ofan audit committee in 2007, they evaluated and approved in advance the scopeand cost of the engagement of an auditor before the auditor rendered the auditand non-audit services. We did not rely on pre-approval policies andprocedures.

 

In 2008, in accordance with the SEC’s auditorindependence rules, the Audit Committee established the following policies andprocedures by which it approves in advance any audit or permissible non-auditservices to be provided to us by our independent auditor.

 

Prior to the engagementof the independent auditors for any fiscal year’s audit, management submits tothe Audit Committee for approval lists of recurring audit, audit-related, taxand other services expected to be provided by the independent auditors duringthat fiscal year. The Audit Committee adopts pre-approval schedules describingthe recurring services that it has pre-approved, and is informed on a timelybasis, and in any event by the next scheduled meeting, of any such servicesrendered by the independent auditor and the related fees.

 

The fees for any serviceslisted in a pre-approval schedule are budgeted, and the Audit Committeerequires the independent auditor and management to report actual fees versusthe budget periodically throughout the year. The Audit Committee will requireadditional pre-approval if circumstances arise where it becomes necessary toengage the independent auditor for additional services above the amount of feesoriginally pre-approved. Any audit or non-audit service not listed in apre-approval schedule must be separately pre-approved by the Audit Committee ona case-by-case basis.

 

Every request to adopt oramend a pre-approval schedule or to provide services that are not listed in apre-approval schedule must include a statement by the independent auditors asto whether, in their view, the request is consistent with the SEC’s rules onauditor independence.

 

The Audit Committee willnot grant approval for:

 
|   | · | any services  prohibited by applicable law or by any rule or regulation of the SEC or  other regulatory body applicable to us;                                                                                                                                                                                                                            |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                           |
|   | · | provision by the  independent auditors to us of strategic consulting services of the type  typically provided by management consulting firms; or                                                                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                                                                                           |
|   | · | the retention of  the independent auditors in connection with a transaction initially  recommended by the independent auditors, the tax treatment of which may not  be clear under the Internal Revenue Code and related regulations and which it  is reasonable to conclude will be subject to audit procedures during an audit  of our financial statements. |

 

Tax services proposed tobe provided by the auditor to any director, officer or employee of Argyle whois in an accounting role or financial reporting oversight role must be approvedby the Audit Committee on a case-by-case basis where such services are to bepaid for by us, and the Audit Committee will be informed of any services to beprovided to such individuals that are not to be paid for by us.

 

In determining whether togrant pre-approval of any non-audit services in the “all other” category, theAudit Committee will consider all relevant facts and circumstances, includingthe following four basic guidelines:

 
|   | · | whether the  service creates a mutual or conflicting interest between the auditor and us;            |
|--------|--------|------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                 |
|   | · | whether the  service places the auditor in the position of auditing his or her own work;             |
|   |   |                                                                                                 |
|   | · | whether the  service results in the auditor acting as management or an employee of our  company; and |
|   |   |                                                                                                 |
|   | · | whether the  service places the auditor in a position of being an advocate for our  company.         |

 

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**PART IV**

 

**Item 15.Exhibits and Financial Statement Schedules**

 

(a)     (1) Consolidated Financial Statements

 

An index toConsolidated Financial Statements appears on page F-1.

 

 (2) Schedules

 

 Allfinancial statement schedules are omitted because they are not applicable, notrequired under the instructions or all the information required is set forth inthe financial statements or notes thereto.

 

(b) Exhibits

 

The following Exhibitsare filed as part of this report

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                      |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                  |       | Second Amended and  Restated Certificate of Incorporation (1)                                                                                        |
|                 |       |                                                                                                                                                 |
| 3.2                  |       | By-laws(1)                                                                                                                                           |
|                 |       |                                                                                                                                                 |
| 3.3                  |       | Certificate of  Designations, Preferences and Rights of Series A Convertible Preferred  Stock. (12)                                             |
|                 |       |                                                                                                                                                 |
| 3.4                  |       | Certificate of  Designations, Preferences and Rights of Series B Convertible Preferred  Stock. (17)                                             |
|                 |       |                                                                                                                                                 |
| 4.1                  |       | Specimen Unit  Certificate(1)                                                                                                                        |
|                 |       |                                                                                                                                                 |
| 4.2                  |       | Specimen Common Stock  Certificate (1)                                                                                                               |
|                 |       |                                                                                                                                                 |
| 4.3                  |       | Specimen Warrant  Certificate(1)                                                                                                                     |
|                 |       |                                                                                                                                                 |
| 4.4                  |       | Form of Warrant  Agreement between American Stock Transfer & Trust Company and the  Registrant(1)                                      |
|                 |       |                                                                                                                                                 |
| 4.5                  |       | Form of Unit  Purchase Option granted to Rodman & Renshaw, LLC(1)                                                                      |
|                 |       |                                                                                                                                                 |
| 4.6                  |       | Warrant to Purchase  Common Stock between the Company and Wesley Clark (7)                                                                           |
|                 |       |                                                                                                                                                 |
| 4.7                  |       | Warrant to Purchase  Common Stock between the Company and John J. Smith (7)                                                                          |
|                 |       |                                                                                                                                                 |
| 4.8                  |       | Warrant to Purchase  Common Stock between the Company and Bob Marbut (7)                                                                             |
|                 |       |                                                                                                                                                 |
| 4.9                  |       | Warrant to Purchase  Common Stock between the Company and Ron Chaimovski (7)                                                                         |
|                 |       |                                                                                                                                                 |
| 4.10                 |       | Warrant to Purchase  Common Stock between the Company and Graham Wallis (7)                                                                          |
|                 |       |                                                                                                                                                 |
| 4.11                 |       | Warrant to Purchase  Common Stock between the Company and Alan Wachtel (7)                                                                           |
|                 |       |                                                                                                                                                 |
| 4.12                 |       | Warrant to Purchase  Common Stock between the Company and Argyle Global Opportunities, L.P. (7)                                                      |
|                 |       |                                                                                                                                                 |
| 10.1                 |       | Form of Stock  Escrow Agreement between the Registrant, American Stock Transfer &  Trust Company and the pre-offering stockholders (1) |
|                 |       |                                                                                                                                                 |
| 10.2                 |       | Form of  Registration Rights Agreement among the Registrant and the pre- initial  public offering stockholders(1)                               |

 

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| 10.3   |   | Warrant Clarification  Agreement between the Company and American Stock Transfer & Trust  Company, dated August 10, 2006 (2)                                                                     |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                           |
| 10.4   |   | Unit Purchase Option  Clarification Agreement between the Company and I-Bankers, Inc., dated  August 10, 2006 (2)                                                                                    |
|   |   |                                                                                                                                                                                                           |
| 10.5   |   | Unit Purchase Option  Clarification Agreement between the Company and Rodman & Renshaw,  LLC, dated August 10, 2006 (2)                                                                          |
|   |   |                                                                                                                                                                                                           |
| 10.6   |   | Merger Agreement by and  among Argyle Security, Inc., ISI Security Group, Inc. and ISI  Detention Contracting, Inc. (4)                                                                         |
|   |   |                                                                                                                                                                                                           |
| 10.7   |   | Lease between the  Company and Frost National Bank, Trustee For A Designated Trust (5)                                                                                                                         |
|   |   |                                                                                                                                                                                                           |
| 10.8   |   | Unit Purchase Agreement  between and among ISI Controls, Ltd., Com-Tec Security, LLC, the holders of  units in Com-Tec and Jeffery E. Corcoran (9)                                                             |
|   |   |                                                                                                                                                                                                           |
| 10.9   |   | First Amendment to the  Lease Agreement between the Company and Frost National Bank, Trustee for a  Designated Trust dated January 19, 2007.                                                              |
|   |   |                                                                                                                                                                                                           |
| 10.10  |   | Second Amendment to the  Lease Agreement between the Company and Frost National Bank, Trustee for a  Designated Trust dated January 18, 2008.                                                             |
|   |   |                                                                                                                                                                                                           |
| 10.11  |   | Guarantee of Lease  Agreement dated February 6, 2008 between the Company and Investment  Property, Ltd. for the guarantee of ISI’s lease for its facility in San  Antonio.                           |
|   |   |                                                                                                                                                                                                           |
| 10.12  |   | Asset Purchase  Agreement between ISI Detention Contracting Group, Inc, and Peterson Detention  Inc. dated as of January 1, 2008 (9)                                                                      |
|   |   |                                                                                                                                                                                                           |
| 10.13  |   | Guaranteed Convertible  Promissory Note by ISI Detention Contracting Group, Inc. in favor of  Peterson Detention Inc. dated as of January 1, 2008 (9)                                                |
|   |   |                                                                                                                                                                                                           |
| 10.14  |   | Guaranteed Convertible  Promissory Note by ISI Detention Contracting Group, Inc. in favor of  Peterson Detention Inc. dated as of January 1, 2008 (9)                                                |
|   |   |                                                                                                                                                                                                           |
| 10.15  |   | Employment Agreement  between ISI Detention Contracting Group, Inc. and Michael Peterson dated  as of January 1, 2008 (9)                                                                            |
|   |   |                                                                                                                                                                                                           |
| 10.16  |   | Employment Agreement  between ISI Detention Contracting Group, Inc. and Leonard Peterson  dated as of January 1, 2008 (9)                                                                       |
|   |   |                                                                                                                                                                                                           |
| 10.17  |   | Note and Warrant  Purchase Agreement between ISI Detention Contracting Group, Inc, William  Blair Mezzanine Capital Fund III, L.P. and the Guarantors dated  October 22, 2004.                            |
|   |   |                                                                                                                                                                                                           |
| 10.18  |   | Omnibus First Amendment  to Note and Warrant Purchase Agreement between ISI Detention Contracting  Group, Inc, William Blair Mezzanine Capital Fund III, L.P. and the Guarantors  dated November 1, 2005. |
|   |   |                                                                                                                                                                                                           |
| 10.19  |   | Omnibus Second  Amendment to Note and Warrant Purchase Agreement between ISI Detention  Contracting Group, Inc, William Blair Mezzanine Capital Fund III, L.P. and  the Guarantors.                            |
|   |   |                                                                                                                                                                                                           |
| 10.20  |   | Third Amendment to Note  and Warrant Purchase Agreement dated January 2, 2008 by and among ISI,  Argyle and the other Guarantors, and William Blair Mezzanine Capital Fund  III, L.P. (9)                 |
|   |   |                                                                                                                                                                                                           |
| 10.21  |   | Senior Subordinated  Promissory Note of ISI issued to William Blair Mezzanine Capital Fund III,  L.P., dated January 2, 2008 (9)                                                                          |

 

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| 10.22  |   | Unsecured Promissory  Note by MCFSA, Inc. in favor of Fire Quest, Inc., dated as of  January 1, 2008 (9)                                                                             |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                |
| 10.23  |   | Unit Purchase Agreement  by and between ISI Controls, Ltd., the holders of units in Com-Tec and  Jeffrey E. Corcoran, as the Seller (10)                                                            |
|   |   |                                                                                                                                                                                                |
| 10.24  |   | Subordinated Promissory  Note by ISI Controls, Ltd. in favor of Jeffrey E. Corcoran and Janell D.  Corcoran (10)                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.25  |   | Amended and Restated  Loan and Security Agreement by and between ISI Security Group, Inc. and  LaSalle Bank National Association (10)                                                          |
|   |   |                                                                                                                                                                                                |
| 10.26  |   | Amended and Restated  Revolving Note by ISI Security Group in favor of LaSalle Bank National  Association dated January 23, 2008 (10)                                                          |
|   |   |                                                                                                                                                                                                |
| 10.27  |   | Term Note by ISI  Security Group in favor of LaSalle Bank National Association dated  January 23, 2008 (10)                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.28  |   | Amended and Restated  Pledge Agreement among ISI Security Group, Inc., its wholly owned  subsidiaries and LaSalle Bank National Association dated January 23,  2008 (10)                  |
|   |   |                                                                                                                                                                                                |
| 10.29  |   | Amended and Restated  Pledge Agreement among ISI Security Group, Inc., its wholly owned  subsidiaries and LaSalle Bank National Association dated January 23,  2008 (10)                  |
|   |   |                                                                                                                                                                                                |
| 10.30  |   | Amended and Restated  Continuing Unconditional Guaranty among ISI Security Group, Inc., its  wholly owned subsidiaries and LaSalle Bank National Association dated  January 23, 2008 (10) |
|   |   |                                                                                                                                                                                                |
| 10.31  |   | Note and Warrant  Acquisition Agreement between the Company and Wesley Clark (6)                                                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.32  |   | Note and Warrant  Acquisition Agreement between the Company and John J. Smith (6)                                                                                                                   |
|   |   |                                                                                                                                                                                                |
| 10.33  |   | Note and Warrant  Acquisition Agreement between the Company and Bob Marbut (6)                                                                                                                      |
|   |   |                                                                                                                                                                                                |
| 10.34  |   | Note and Warrant  Acquisition Agreement between the Company and Ron Chaimovski (6)                                                                                                                  |
|   |   |                                                                                                                                                                                                |
| 10.35  |   | Note and Warrant  Acquisition Agreement between the Company and Graham Wallis (6)                                                                                                                   |
|   |   |                                                                                                                                                                                                |
| 10.36  |   | Note and Warrant  Acquisition Agreement between the Company and Alan Wachtel (6)                                                                                                                    |
|   |   |                                                                                                                                                                                                |
| 10.37  |   | Note and Warrant  Acquisition Agreement between the Company and Argyle Global Opportunities,  L.P. (6)                                                                                              |
|   |   |                                                                                                                                                                                                |
| 10.38  |   | Note made by the  Company in favor of Wesley Clark (6)                                                                                                                                              |
|   |   |                                                                                                                                                                                                |
| 10.39  |   | Note made by the  Company in favor of John J. Smith (6)                                                                                                                                             |
|   |   |                                                                                                                                                                                                |
| 10.40  |   | Note made by the  Company in favor of Bob Marbut (6)                                                                                                                                                |
|   |   |                                                                                                                                                                                                |
| 10.41  |   | Note made by the  Company in favor of Ron Chaimovski (6)                                                                                                                                            |
|   |   |                                                                                                                                                                                                |
| 10.42  |   | Note made by the  Company in favor of Graham Wallis (6)                                                                                                                                             |
|   |   |                                                                                                                                                                                                |
| 10.43  |   | Note made by the  Company in favor of Alan Wachtel (6)                                                                                                                                              |
|   |   |                                                                                                                                                                                                |
| 10.44  |   | Note made by the  Company in favor of Argyle Global Opportunities, L.P. (6)                                                                                                                         |

 

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| 10.45  |   | Second Fully Restated  Commercial Lease Agreement by and between Green Wing Management, Ltd. and ISI  Security Group, Inc., dated July 31, 2007. (9)                                                                                                                                                                                                            |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.46  |   | First Fully Restated  Commercial Lease Agreement by and between Green Wing Management, Ltd. and ISI  Security Group, Inc., dated July 31, 2002. (9)                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.47  |   | Form of  Non-Qualified Option Agreement (9)                                                                                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.48  |   | Form of Restricted  Stock Agreement                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.49  |   | Form of Incentive  Stock Option Agreement                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.50  |   | Sixth Amendment to Loan  and Security Agreement by and between LaSalle Bank National Association and  ISI Security Group, Inc., dated September 14, 2007. (9)                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.51  |   | Allonge to Second  Agreement and Restated Senior Subordinated Promissory Note by and between ISI  Security Group, Inc., and William Blair Mezzanine Capital Fund III, LP,  dated September 14, 2007. (9)                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.52  |   | Employment Agreement  dated October 19, 2004 between Sam Youngblood and Detention Contracting  Group, Ltd.                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.53  |   | Employment Agreement  dated October 19, 2004 between Don Carr and Detention Contracting Group,  Ltd.,                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.54  |   | Employment Agreement  dated October 19, 2004 between Tim Moxon and Metroplex Control  Systems, Inc.                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.55  |   | Employment Agreement  dated October 19, 2004 between Mark McDonald and Metroplex Control  Systems, Inc.                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.56  |   | Intellectual Property  Rights Transfer Agreement dated March 4, 2008 by and between Mark  McDonald and ISI Security Group, Inc.                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.57  |   | Assignment and  Amendment of Lease effective as of January 1, 2008 by and between  CC&E LLC, a California limited liability company (Landlord), Peterson  Detention, Inc., a California corporation (Assignor) and ISI Detention  Contracting Group, Inc., a California corporation (Assignee) covering  577 North Batavia Street, Orange, California. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.58  |   | Assignment of Lease  effective as of January 1, 2008 by and between SAK Properties, LLC, an  Arizona limited liability company (Landlord), Peterson Detention, Inc.,  a California corporation (Assignor) and ISI Detention Contracting  Group, Inc., a Texas corporation (Assignee) covering 990 South Cherry,  Tucson, Arizona.                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.59  |   | Lease Agreement dated  February 1, 2008 by and between J.J.C. Valley Properties, LLC (Lessor)  and ISI Controls, Ltd. (Lessee) covering 3030 East Goodland Drive, City of  Appleton, Outagamie County, Wisconsin.                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.60  |   | Lease Agreement dated  January 19, 1996 by and between Neil Fielder (Landlord) and ISI  Controls, Ltd. (Lessee) as amended, covering 2472 Southwell Drive, Dallas,  Callas County, Texas.                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.61  |   | Arapahoe Business Park  I Lease Agreement dated as of November 19, 2002 by and between WKB Value  Partners (Landlord) and MCFSA, Ltd. (Tenant) covering 7388 South Revere  Parkway, Suite 601, Centennial Colorado.                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.62  |   | Industrial Building  Lease dated as of December 20, 2006 by and between Carlyle/FR Houston  Investors, L.P. (Landlord), and MCFSA, Ltd. (Tenant) covering 10624 Rockley  Road, Houston, Texas 77099.                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.63  |   | Lease dated as of  July 31, 2007 by and between Indiana Automation, Inc. (Landlord)  and Metroplex (Tenant) covering 8001 East 196 th Street,  Noblesville, Indiana 46062.                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 10.64  |   | Commercial Lease dated  January 1, 2008 by and between William L. Cavin (Landlord) and MCFSA,  Ltd. (Tenant) covering 7823 Fortune Drive, Bexar County, Texas.                                                                                                                                                                                                       |

 

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| 10.65  |   | Commercial-Industrial  Lease Agreement dated as of February 1, 2008 by and between Investment  Properties, Ltd. (Landlord) and ISI Security Group, Inc. (Tenant)  covering 12915 Delivery Drive, San Antonio, Texas 78247.                                                                                                                                                                                                                                                                                                           |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.66  |   | First Fully Restated  Commercial Lease Agreement effective August 1, 2007 by and between Green  Wing Management, Ltd. (Lessor) and ISI Controls, Ltd (Lessee) covering 12902  and 12906 Flagship Drive, San Antonio, Bexar County, Texas.                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.67  |   | Second Fully Restated  Commercial Lease Agreement effective August 1, 2007 by and between Green  Wing Management, Ltd. (Landlord) and ISI Detention Contracting Group, a Texas  corporation (Lessee) covering 12903 and 12918 Delivery Drive, San Antonio,  Bexar County, Texas.                                                                                                                                                                                                                                                          |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.68  |   | Permanent Executive  Services Agreement between Argyle and Tatum, LLC, dated effective  January 1, 2008. (11)                                                                                                                                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.69  |   | Securities Purchase  Agreement, dated as of April 22, 2008, among the Company, certain  stockholders and purchasers named therein. (12)                                                                                                                                                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.70  |   | COMMERCIAL LEASE  AGREEMENT dated June 10, 2008 by and between Green Wing Management, Ltd.  and ISI Security Group, Inc. (13)                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.71  |   | Lease Agreement between  ISI Detention Contracting Group, Inc. and CC&E, LLC dated  July 21, 2008. (14)                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.72  |   | Guaranty of Lease by  Argyle Security, Inc. dated July 21, 2008. (14)                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.73  |   | Loan Agreement by and  between ISI Security Group, Inc. and The PrivateBank and Trust Company  dated as of October 3, 2008. (15)                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.74  |   | Promissory Note dated  as of October 3, 2008 from ISI Security Group, Inc. in favor of The  PrivateBank and Trust Company in the principal amount of up to $10,000,000.  (15)                                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.75  |   | Promissory Note dated  as of October 3, 2008 from ISI Security Group, Inc. in favor of The  PrivateBank and Trust Company in the principal amount of up to $5,000,000.  (15)                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.76  |   | Promissory Note dated  as of October 3, 2008 from ISI Security Group, Inc. in favor of The  PrivateBank and Trust Company in the principal amount of up to $10,000,000.  (15)                                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.77  |   | Unconditional  Continuing Guaranty dated as of October 3, 2008 by and among DETENTION  CONTRACTING GROUP, LTD., ISI DETENTION CONTRACTING GROUP, INC., ISI DETENTION  CONTRACTING GROUP, INC., ISI DETENTION CONTRACTING GROUP, INC., ISI DETENTION  SYSTEMS, INC., ISI SYSTEMS, LTD., METROPLEX CONTROL SYSTEMS, INC., ISI  CONTROLS, LTD., METROPLEX COMMERCIAL FIRE AND SECURITY ALARMS, INC., MCFSA,  LTD., COM-TEC SECURITY, LLC, COM-TEC CALIFORNIA LIMITED PARTNERSHIP for the  benefit of The PrivateBank and Trust Company. (15) |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.78  |   | Pledge Agreement dated  as of October 3, 2008 by and among ISI SECURITY GROUP, INC., DETENTION  CONTRACTING GROUP, LTD., ISI DETENTION CONTRACTING GROUP, INC., ISI DETENTION  CONTRACTING GROUP, INC., ISI DETENTION CONTRACTING GROUP, INC., ISI DETENTION  SYSTEMS, INC., ISI SYSTEMS, LTD., METROPLEX CONTROL SYSTEMS, INC., ISI  CONTROLS, LTD., METROPLEX COMMERCIAL FIRE AND SECURITY ALARMS, INC., MCFSA,  LTD., COM-TEC SECURITY, LLC, COM-TEC CALIFORNIA LIMITED PARTNERSHIP and The  PrivateBank and Trust Company. (15)       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.79  |   | Security Agreement  dated as of October 3, 2008 by and among ISI SECURITY GROUP, INC.,  DETENTION CONTRACTING GROUP, LTD., ISI DETENTION CONTRACTING GROUP, INC., ISI  DETENTION CONTRACTING GROUP, INC., ISI DETENTION CONTRACTING GROUP, INC., ISI  DETENTION SYSTEMS, INC., ISI SYSTEMS, LTD., METROPLEX CONTROL SYSTEMS, INC.,  ISI CONTROLS, LTD., METROPLEX COMMERCIAL FIRE AND SECURITY ALARMS, INC., MCFSA,  LTD., COM-TEC SECURITY, LLC, COM-TEC CALIFORNIA LIMITED PARTNERSHIP and The  PrivateBank and Trust Company. (15)     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.80  |   | Loan Agreement by and  between Argyle Security, Inc. and ISI Security Group, Inc. dated  September 30, 2008. (15)                                                                                                                                                                                                                                                                                                                                                                                                               |

 

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| 10.81  |   | Promissory Note dated  September 30, 2008 from ISI Security Group, Inc. in favor or Argyle  Security, Inc. in the principal amount of $2 million. (15)                                  |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                   |
| 10.82  |   | Subordination Agreement  dated September 30, 2008 between Argyle Security, Inc. and LaSalle  Bank National Association. (15)                                                                 |
|   |   |                                                                                                                                                                                                   |
| 10.83  |   | Severance and  Non-Competition Agreement dated October 3, 2008 between Argyle Security, Inc.  and Bob Marbut. (15)                                                                           |
|   |   |                                                                                                                                                                                                   |
| 10.84  |   | Severance and  Non-Competition Agreement dated October 3, 2008 between Argyle  Security, Inc. and Ron Chaimovski. (15)                                                                       |
|   |   |                                                                                                                                                                                                   |
| 10.85  |   | Severance and  Non-Competition Agreement dated October 3, 2008 between Argyle Security, Inc.  and Donald F. Neville. (15)                                                                    |
|   |   |                                                                                                                                                                                                   |
| 10.86  |   | Severance and  Non-Competition Agreement dated October 3, 2008 between Argyle  Security, Inc. and Dean Dresser. (15)                                                                         |
|   |   |                                                                                                                                                                                                   |
| 10.87  |   | Fifth Amendment and  Waiver to Note and Warrant Purchase Agreement dated November 13, 2008 by  and among ISI and William Blair Mezzanine Capital Fund III, L.P. (16)                              |
|   |   |                                                                                                                                                                                                   |
| 10.88  |   | Securities Purchase  Agreement, dated as of January 8, 2009, among the Company, certain of  its stockholders and the purchasers named therein. (17)                                               |
|   |   |                                                                                                                                                                                                   |
| 10.89  |   | Sixth Amendment to Note  and Warrant Purchase Agreement, dated as of January 8, 2009, between ISI  and Blair. (17)                                                                                |
|   |   |                                                                                                                                                                                                   |
| 10.90  |   | Third Amended and  Restated Senior Subordinated Promissory Note dated January 8, 2009 from  ISI in favor of Blair in the aggregate original principal amount of  $5,951,609. (17)                 |
|   |   |                                                                                                                                                                                                   |
| 10.91  |   | Amended and Restated  Senior Subordinated Promissory Note A dated January 8, 2009 from ISI in  favor of Blair in the aggregate original principal amount of $5,000,000. (17)                      |
|   |   |                                                                                                                                                                                                   |
| 10.92  |   | Amendment No.1 to Loan  and Security Amendment, dated as of January 8, 2009, between ISI and  PrivateBank. (17)                                                                                   |
|   |   |                                                                                                                                                                                                   |
| 10.93  |   | Unconditional Guaranty  Agreement, dated as of January 8, 2009, between the Company and  PrivateBank. (17)                                                                                        |
|   |   |                                                                                                                                                                                                   |
| 10.94  |   | Amended and Restated  Facility B Loan Note, dated as of January 8, 2009, from ISI in favor of  the PrivateBank in the principal amount of up to $1,100,000. (17)                                  |
|   |   |                                                                                                                                                                                                   |
| 10.95  |   | Severance and  Non-Competition Agreement dated February 1, 2009 between Argyle Security,  Inc. and Matthew A. Kepke. (18)                                                                              |
|   |   |                                                                                                                                                                                                   |
| 10.96  |   | Amendment No.2 to Loan  and Security Amendment, dated as of March 30, 2009, between ISI and  PrivateBank.                                                                                              |
|   |   |                                                                                                                                                                                                   |
| 10.97  |   | Allonge to Third  Amended and Restated Senior Subordinated Promissory Note dated March 30, 2009  from ISI in favor of Blair in the aggregate original principal amount of  $5,951,609, filed herewith. |
|   |   |                                                                                                                                                                                                   |
| 10.98  |   | Allonge to Amended and  Restated Senior Subordinated Promissory Note A dated March 30, 2009 from ISI  in favor of Blair in the aggregate original principal amount of $5,000,000,  filed herewith.     |
|   |   |                                                                                                                                                                                                   |
| 10.99  |   | Seventh Amendment to  Note and Warrant Purchase Agreement, dated as of March 30, 2009, between ISI  and Blair, filed herewith.                                                                         |
|   |   |                                                                                                                                                                                                   |
| 14.1   |   | Code of Business  Conduct. (16)                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                   |
| 21.1   |   | List of Subsidiaries,  filed herewith.                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                   |
| 23.1   |   | Consent of  Ernst & Young LLP, filed herewith.                                                                                                                                                |
|   |   |                                                                                                                                                                                                   |
| 23.2   |   | Consent of Padgett,  Stratemann & Co., LLP, filed herewith.                                                                                                                                   |

 

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| 31.1      |   | Certification of the  Chief Executive Officer (Principal Executive Officer) pursuant to  Rule 13a-14(a) of the Securities Exchange Act, as amended, filed  herewith.                                                                                                                                   |
|-----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                                                                                                                                                                             |
| 31.2      |   | Certification of the  President and Chief Operating Officer (Principal Executive Officer) pursuant  to Rule 13a-14(a) of the Securities Exchange Act, as amended, filed  herewith.                                                                                                                     |
|      |   |                                                                                                                                                                                                                                                                                                             |
| 31.3      |   | Certification of the  Executive Vice President and Chief Financial Officer (Principal Financial  Officer) pursuant to Rule 13a-14(a) of the Securities Exchange Act,  as amended, filed herewith.                                                                                                      |
|      |   |                                                                                                                                                                                                                                                                                                             |
| 31.4      |   | Certification of the  Vice President and Corporate Controller (Principal Accounting Officer)  pursuant to Rule 13a-14(a) of the Securities Exchange Act, as  amended, filed herewith.                                                                                                                  |
|      |   |                                                                                                                                                                                                                                                                                                             |
|  32. |   | Certification of the  Chief Executive Officer, President and Chief Operating Officer, Executive  Vice President and Chief Financial Officer and Vice President and Corporate  Controller pursuant to 18 U.S.C. 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith. |

 

----

| (1)  |   | Incorporated by  reference to the Registrant’s Registration Statement on Form S-1 (File  No. 333-124601).               |
|------|--------|----------------------------------------------------------------------------------------------------------------------------------------|
| (2)  |   | Incorporated by  reference to the Registrant’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2006. |
| (3)  |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  March 14, 2007.                        |
| (4)  |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  December 8, 2006.                      |
| (5)  |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  April 20, 2006.                        |
| (6)  |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  April 16, 2007.                        |
| (7)  |   | Incorporated by  reference to the Registrant’s current report on Form 8-K dated September 13,  2007.                    |
| (8)  |   | Incorporated by  reference to the Registrant’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2007. |
| (9)  |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  January 2, 2008.                       |
| (10) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  February 6, 2008.                      |
| (11) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  March 11, 2008.                        |
| (12) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  April 22, 2008.                        |
| (13) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  June 10, 2008.                         |
| (14) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  July 21, 2008.                         |
| (15) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  September 30, 2008.                    |
| (16) |   | Incorporated by  reference to the Registrant’s Quarterly Report on Form 10-Q for the  quarter ended September 30, 2008. |
| (17) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated  January 8, 2009.                       |
| (18) |   | Incorporated by  reference to the Registrant’s Current Report on Form 8-K dated January 28,  2009.                                |

 

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**SIGNATURES**

 

 Pursuant to therequirements of Section 13 or 15 (d) of the Securities Exchange Actof 1934, the Registrant had duly caused this report to be signed on its behalfby the undersigned, thereunto duly authorized.

 

 
|                | ARGYLE SECURITY, INC. |                                                   |
|---------------------|-----------------------|--------------------------------------------------------|
|                |                  |                                                   |
|                |                  |
| March 30, 2009 | By:                   | /s/ Bob Marbut                                    |
|                |                  | Bob Marbut, Chief  Executive Officer                   |
|                |                  |                                                   |
|                | By:                   | /s/ Sam Youngblood                                |
|                |                  | Sam Youngblood,  President and Chief Operating Officer |
|                     |                       |                                                        |  |

 

 Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the Registrant and in thecapacities and on the dates indicated.

 

 
| March 30, 2009 | By:    | /s/   Bob Marbut                                                |
|---------------------|--------|----------------------------------------------------------------------|
|                |   | Bob Marbut, Chief  Executive Officer (Principal Executive   Officer) |

 

 
| March 30, 2009 | By:    | /s/   Sam  Youngblood                                                             |
|---------------------|--------|----------------------------------------------------------------------------------------|
|                |   | Sam Youngblood,  President and Chief Operating Officer   (Principal Executive Officer) |

 

 
| March 30, 2009 | By:    | /s/   Ron  Chaimovski                       |
|---------------------|--------|--------------------------------------------------|
|                |   | Ron Chaimovski,  Executive Chairman of the Board |

 

 
| March 30, 2009 | By:    | /s/   Wesley Clark |
|---------------------|--------|-------------------------|
|                |   | Wesley Clark, Director  |

 

 
| March 30, 2009 | By:    | /s/   John Smith |
|---------------------|--------|-----------------------|
|                |   | John Smith, Director  |

 

 
| March 30, 2009 | By:    |   /s/    Lloyd Campbell |
|---------------------|--------|----------------------------------------|
|                |   | Lloyd Campbell,  Director              |

 

 
| March 30, 2009 | By:    |     /s/    Walter Klein |
|---------------------|--------|--------------------------------------------------|
|                |   | Walter Klein, Director                           |

 

 
| March 30, 2009 | By:    | /s/     Donald F. Neville                                                                |
|---------------------|--------|---------------------------------------------------------------------------------------------------------|
|                |   | Donald F. Neville, Executive  Vice President and Chief  Financial Officer (Principal Financial Officer) |

 

 
| March 30, 2009 | By:    | /s/     Dean Dresser                                                    |
|---------------------|--------|----------------------------------------------------------------------------------------|
|                |   | Dean Dresser, Vice President  and Corporate Controller  (Principal Accounting Officer) |

 

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**ARGYLESECURITY, INC.**

**INDEXOF FINANCIAL STATEMENTS**

** **
| ** **                                                                   | **Page**   |
|------------------------------------------------------------------------------|------------|
| **Audited  Consolidated Financial Statements of Argyle Security, Inc.** | ** ** |
| ** **                                                                   | ** ** |
| Report  of Independent Registered Public Accounting Firm                     | F-2        |
|                                                                         |       |
| Report  of Independent Registered Public Accounting Firm                     | F-3        |
|                                                                         |       |
| Report  of Management on Internal Controls Over Financial Reporting          | F-4        |
|                                                                         |       |
| Consolidated  Balance Sheets                                                 | F-5        |
|                                                                         |       |
| Consolidated  Statements of Operations                                       | F-6        |
|                                                                         |       |
| Consolidated Statement of Changes in Stockholders’ Equity               | F-8        |
|                                                                         |       |
| Consolidated  Statements of Cash Flows                                       | F-9        |
|                                                                         |       |
| Notes to Consolidated Financial Statements                                   | F-11       |

 

F-1

----

Table of Contents

 

**Report of Independent RegisteredPublic Accounting Firm**

 

The Board of Directorsand Stockholders

 

Argyle Security, Inc.

 

We have audited theaccompanying consolidated balance sheets of Argyle Security, Inc.(formerly Argyle Security Acquisition Corporation) (the Company)  as of December 31,2008 and 2007, and the related consolidated statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2008.  These financial statements are theresponsibility of the Company’s management.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. We were not engaged to perform an audit of theCompany’s internal control over financial reporting. Our audits included considerationof internal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting.  Accordingly, we express no such opinion. Anaudit also includes examining, on a test basis, evidence supporting the amountsand disclosures in the financial statements, assessing the accountingprinciples used and significant estimates made by management, and evaluatingthe overall financial statement presentation. We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the consolidated financial position of Argyle Security, Inc. at December 31,2008 and 2007, and the consolidated results of its operations and its cashflows for each of the three years in the period ended December 31, 2008, inconformity with U.S. generally accepted accounting principles.

 

As discussed in Note 2 tothe financial statements, in 2007 the Company changed its method of accountingfor income taxes.

** **

/s/ Ernst & YoungLLP

 

 

San Antonio, Texas

March 31, 2009

 

F-2

----

Table of Contents

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand Stockholders

ISI Detention ContractingGroup, Inc. and Subsidiaries

 

We have audited ISIDetention Contracting Group, Inc. and Subsidiaries’ consolidated statements ofoperations and cash flows for the seven months ended July 31, 2007 and for theyear ended December 31, 2006.  These consolidatedfinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these consolidated financial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting Oversight Board(United States).  Those standards requirethat we plan and perform the audits to obtain reasonable assurance aboutwhether the consolidated financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe consolidated financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the results of operations and cash flows for the sevenmonths ended July 31, 2007 and for the year ended December 31, 2006, inconformity with accounting principles generally accepted in the United Statesof America.

 

/s/ Padgett, Stratemann &Co., L.L.P.

 

October 30, 2007

 

F-3

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Table of Contents

 

**REPORTOF MANAGEMENT ON INTERNAL CONTROLS OVER FINANCIAL REPORTING**

To the Board of Directorsand Stockholders

 

The management of ArgyleSecurity, Inc. (the “Company”) is responsible for establishing andmaintaining adequate internal control over financial reporting, as defined in Rule 13a-15(f) or15d-15(f) under the Securities Exchange act of 1934. The Company’sinternal control over financial reporting is designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles.

 

Internal control overfinancial reporting, no matter how well designed, has inherent limitations.Therefore, internal controls over financial reporting determined to beeffective can provide only reasonable assurance with respect to financialstatement preparation and presentation. Also, projections of any evaluation ofeffectiveness to future periods are subject to the risk that controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

 

Management assessed theeffectiveness of the Company’s internal control over financial reporting as of December 31,2008. Management has excluded PDI and Com-Tec from itsassessment of internal control over financial reporting as of December 31,2008.  Fire Quest was acquired and its assets fully absorbed by MCS–commercial on January 1, 2008. PDI wasacquired on January 4, 2008, and Com-Tec was acquired on January 31,2008. In making this assessment, it used the criteria set forth in*Internal Control—Integrated Framework* issuedby the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

At December 31, 2008,total assets, total assets less goodwill and net tangible assets, and totalrevenues subject to PDI’s internal control over financial reporting represented6.3%, 9.6%, and 6.6% of Argyle’s consolidated total assets, total assets lessgoodwill and net intangible assets, and total revenues as of and for the yearended December 31, 2008. At December 31, 2008, total assets, total assets lessgoodwill and net tangible assets, and total revenues subject to Com-Tec’sinternal control over financial reporting represented 20.3%, 8.9%, and 14.3% ofArgyle’s consolidated total assets, total assets less goodwill and netintangible assets, and total revenues as of and for the year ended December 31,2008. 

 

Management’s assessmentincluded an evaluation of the design of the Company’s internal controls overfinancial reporting and testing of the operational effectiveness of itsinternal controls over financial reporting.

 

Based on our assessment,management has determined that, as of December 31, 2008, the Companymaintained effective internal control over financial reporting.  Theannual report on internal control over financial reporting does not include anattestation report of the registrant’s registered public accounting firmpursuant to temporary rules of the Securities and Exchange Commission thatpermit the registrant to provide only management’s report in its annual report.

 
| By: /s/ Bob Marbut                                                       |   |
|--------------------------------------------------------------------------|--------|
| Bob Marbut   Chief Executive Officer                                     |   |
| (Principal Executive  Officer)                                           |   |
|                                                                     |   |
| By: /s/ Sam Youngblood                                                   |   |
| Sam Youngblood   President and Chief Operating Officer                   |   |
| (Principal  Executive Officer)                                           |   |
|                                                                     |   |
| By: /s/ Donald F.  Neville                                               |   |
| Donald F. Neville   Executive Vice President and Chief Financial Officer |   |
| (Principal Financial  Officer)                                           |   |
|                                                                     |   |
| By: /s/ Dean Dresser                                                     |   |
| Dean Dresser   Vice President and Corporate Controller                   |   |
| (Principal Accounting  Officer)                                          |   |
|                                                                     |   |
|                                                                     |   |
| Dated: March 30,  2009                                              |   |

 

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Table of Contents

 

**PART I- FINANCIAL INFORMATION**

 

**ITEM 1 -CONSOLIDATED FINANCIAL STATEMENTS (AUDITED)**

 

**ARGYLESECURITY, INC.**

**CONSOLIDATED BALANCE SHEET**S

 

(in thousandsexcept share data)

 
| ** **                                                                                                                                                                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **2008**              | ** ** | **2007** | ** ** |
| **Assets**                                                                                                                                                                                        |       |                  |       |   |   |
| Current assets:                                                                                                                                                                                   |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                                        |       | $                     | 11,142     |   | $ | 3,556 |   |
| Restricted cash                                                                                                                                                                                   |       | 2,500                 |       | — |   |
| Receivables:                                                                                                                                                                                      |       |                  |       |   |   |
| Contract – net  of allowance for doubtful accounts of $777 and $975 at December 31, 2008 and  2007, respectively                                                                             |       | 28,815                |       | 14,459 |   |
| Contract  receivables – related party                                                                                                                                                        |       | 4,685                 |       | 10,887 |   |
| Other  receivables                                                                                                                                                                                |       | 335                   |       | 42 |   |
| Costs and  estimated earnings in excess of billings on incomplete contracts                                                                                                                       |       | 6,475                 |       | 7,665 |   |
| Intangible  assets                                                                                                                                                                                |       | 184                   |       | 2,959 |   |
| Refundable  income taxes                                                                                                                                                                          |       | 168                   |       | 561 |   |
| Inventory                                                                                                                                                                                         |       | 2,146                 |       | 138 |   |
| Other current  assets                                                                                                                                                                             |       | 6                     |       | 78 |   |
| Prepaids                                                                                                                                                                                          |       | 379                   |       | 162 |   |
| Deferred income  taxes, net                                                                                                                                                                       |       | 898                   |       | — |   |
| Total current  assets                                                                                                                                                                             |       | 57,733                |       | 40,507 |   |
| Property and  equipment, net                                                                                                                                                                      |       | 9,033                 |       | 5,227 |   |
| Goodwill                                                                                                                                                                                          |       | 2,844                 |       | 19,937 |   |
| Intangible  assets                                                                                                                                                                                |       | 12,111                |       | 15,146 |   |
| Deposits,  deferred transaction costs, and other assets                                                                                                                                           |       | 591                   |       | 331 |   |
| Total other  assets                                                                                                                                                                               |       | 24,579                |       | 40,641 |   |
| Total assets                                                                                                                                                                                      |       | $                     | 82,312     |   | $ | 81,148 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                    |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                                             |       |                  |       |   |   |
| Accounts payable  and accrued liabilities                                                                                                                                                         |       | $                     | 15,799     |   | $ | 14,318 |   |
| Accounts payable  – related party                                                                                                                                                            |       | 173                   |       | 40 |   |
| Billings in  excess of costs and estimated earnings on incomplete contracts                                                                                                                       |       | 7,633                 |       | 5,733 |   |
| Interest payable  to stockholders                                                                                                                                                                 |       | 49                    |       | 40 |   |
| Current portion  of capitalized lease obligations                                                                                                                                                 |       | 239                   |       | 97 |   |
| Current portion  of long-term debt                                                                                                                                                                |       | 3,235                 |       | 81 |   |
| Deferred income  taxes                                                                                                                                                                            |       | —                |       | 211 |   |
| Total current  liabilities                                                                                                                                                                        |       | 27,128                |       | 20,520 |   |
| Long-Term  Liabilities:                                                                                                                                                                           |       |                  |       |   |   |
| Deferred income taxes                                                                                                                                                                             |       | 1,577                 |       | 6,095 |   |
| Long-term debt –  less current portion                                                                                                                                                       |       | 29,558                |       | 15,965 |   |
| Derivative,  deferred rent and other long term liabilities                                                                                                                                        |       | 635                   |       | — |   |
| Long-term  capitalized lease obligations - less current portion                                                                                                                                   |       | 3,389                 |       | 1,904 |   |
| Total long-term  liabilities                                                                                                                                                                      |       | 35,159                |       | 23,964 |   |
| Total  liabilities                                                                                                                                                                                |       | 62,287                |       | 44,484 |   |
| Stockholders’  Equity                                                                                                                                                                        |       |                  |       |   |   |
| Preferred stock  of Argyle Security, Inc. - $.0001 par value; 1,000,000 shares authorized;  18,750 shares issued and outstanding at December 31, 2008 and 0 shares at December  31, 2007          |       | —                |       | — |   |
| Common stock of  Argyle Security, Inc. - $.0001 par value; 89,000,000 shares authorized;  shares issued and outstanding 5,969,342 at December 31, 2008 and 5,879,342  shares at December 31, 2007 |       | 1                     |       | 1 |   |
| Additional paid  in capital                                                                                                                                                                       |       | 50,925                |       | 36,279 |   |
| Accumulated  other comprehensive income (loss)                                                                                                                                                    |       | (116                  | )          | — |   |
| Accumulated  earnings (deficit)                                                                                                                                                                   |       | (30,785               | )          | 384 |   |
| Total  stockholders’ equity                                                                                                                                                                  |       | 20,025                |       | 36,664 |   |
| Total  liabilities and stockholders' equity                                                                                                                                                       |       | $                     | 82,312     |   | $ | 81,148 |   |

 

See notes to consolidatedfinancial statements.

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF OPERATIONS**

 

(in thousands exceptshare data)

 
| ** **                                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                          | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues:                                                                                                           |       |                                       |       |   |   |   |   |
| Contract  revenues                                                                                                  |       | $                                          | 98,606     |   | $ | 24,341 |   | $ | — |   |
| Contract  revenues - related party                                                                                  |       | 16,782                                     |       | 15,048 |   | — |   |
| Service and  other revenues                                                                                         |       | 19,455                                     |       | 4,664 |   | — |   |
| Total revenues                                                                                                      |       | 134,843                                    |       | 44,053 |   | — |   |
| Cost of  revenues:                                                                                                  |       |                                       |       |   |   |   |   |
| Contract costs                                                                                                      |       | 90,352                                     |       | 29,435 |   | — |   |
| Service and  other costs, including $4,688, $1,400, and $0 of amortization of intangibles,  respectively            |       | 24,102                                     |       | 4,585 |   | — |   |
| Total cost of  revenues                                                                                             |       | 114,454                                    |       | 34,020 |   | — |   |
| Gross profit                                                                                                        |       | 20,389                                     |       | 10,033 |   | — |   |
| Operating  expenses:                                                                                                |       |                                       |       |   |   |   |   |
| Salaries and  related expense, including stock-based compensation of $1,187, $236, and $131,  respectively.         |       | 12,796                                     |       | 3,891 |   | 131 |   |
| Professional  fees and outside services                                                                             |       | 3,436                                      |       | 1,686 |   | 494 |   |
| General and  administrative expenses                                                                                |       | 7,125                                      |       | 2,943 |   | 397 |   |
| Depreciation                                                                                                        |       | 2,002                                      |       | 737 |   | 2 |   |
| Goodwill and  intangible assets impairment charge                                                                   |       | 26,603                                     |       | — |   | — |   |
| Amortization of  intangible assets                                                                                  |       | 1,715                                      |       | 555 |   | — |   |
| Total operating  expenses                                                                                           |       | 53,677                                     |       | 9,812 |   | 1,024 |   |
| Operating income  (loss)                                                                                            |       | (33,288                                    | )          | 221 |   | (1,024 | ) |
| Other income  (expense):                                                                                            |       |                                       |       |   |   |   |   |
| Interest income                                                                                                     |       | 164                                        |       | 1,005 |   | 1,352 |   |
| Interest expense                                                                                                    |       | (3,664                                     | )          | (838 | ) | (64 | ) |
| Total other  income (expense)                                                                                       |       | (3,500                                     | )          | 167 |   | 1,288 |   |
| Income (loss)  before provision for income taxes                                                                    |       | (36,788                                    | )          | 388 |   | 264 |   |
| (Benefit)  Provision for income taxes                                                                               |       | (5,931                                     | )          | 169 |   | 91 |   |
| Net income  (loss)                                                                                                  |       | (30,857                                    | )          | 219 |   | 173 |   |
| Deferred  interest, net of taxes, attributable to common stock subject to possible redemption                       |       | —                                     |       | — |   | (176 | ) |
| Dividends on  redeemable preferred stock                                                                            |       | (312                                       | )          | — |   | — |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                              |       | $                                          | (31,169    | ) | $ | 219 |   | $ | (3 | ) |
|                                                                                                                |       |                                       |       |   |   |   |   |
| Weighted-average  number of shares of common stock outstanding exclusive of shares subject to  possible redemption: |       |                                       |       |   |   |   |   |
| Basic                                                                                                               |       | 5,797,293                                  |       | 5,187,086 |   | 3,773,985 |   |
| Diluted                                                                                                             |       | 5,797,293                                  |       | 6,213,189 |   | 3,773,985 |   |
| Net income  (loss) per share allocable to holders of non-redeemable common stock                                    |       |                                       |       |   |   |   |   |
| Basic                                                                                                               |       | $                                          | (5.38      | ) | $ | 0.04 |   | $ | (0.00 | ) |
| Diluted                                                                                                             |       | $                                          | (5.38      | ) | $ | 0.04 |   | $ | (0.00 | ) |

 

See notes toconsolidated financial statements.

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF OPERATIONS**

(in thousands)

 
| ** **                                                         | ** ** | **Predecessor (ISI)**    | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                         | ** ** | **January 1, 2007** | ** ** | **Year Ended** | ** ** |
| ** **                                                         | ** ** | **through**                   | ** ** | **December 31,** | ** ** |
| ** **                                                         | ** ** | **July 31, 2007**   | ** ** | **2006** | ** ** |
| Revenues:                                                          |       |                          |       |   |   |
| Contract  revenues                                                 |       | $                             | 19,948     |   | $ | 30,968 |   |
| Contract  revenues - related party                                 |       | 16,740                        |       | 19,855 |   |
| Service and  other revenues                                        |       | 6,446                         |       | 6,929 |   |
| Total revenues                                                     |       | 43,134                        |       | 57,752 |   |
| Cost of  revenues:                                                 |       |                          |       |   |   |
| Contract costs                                                     |       | 28,626                        |       | 41,130 |   |
| Service and  other costs, including $0 amortization of intangibles |       | 4,890                         |       | 4,839 |   |
| Total cost of  revenues                                            |       | 33,516                        |       | 45,969 |   |
| Gross profit                                                       |       | 9,618                         |       | 11,783 |   |
| Operating  expenses:                                               |       |                          |       |   |   |
| Salaries and  related expenses, including stock-based compensation |       | 4,641                         |       | 4,555 |   |
| Professional  fees and outside services                            |       | 194                           |       | 405 |   |
| Depreciation                                                       |       | 475                           |       | 641 |   |
| General and  administrative expenses                               |       | 2,283                         |       | 2,910 |   |
| Amortization of  intangible assets                                 |       | 203                           |       | 349 |   |
| Total operating  expenses                                          |       | 7,796                         |       | 8,860 |   |
| Operating income  (loss)                                           |       | 1,822                         |       | 2,923 |   |
| Other income  (expense):                                           |       |                          |       |   |   |
| Interest income                                                    |       | 4                             |       | 211 |   |
| Interest expense                                                   |       | (3,010                        | )          | (3,830 | ) |
| Total other  income (expense)                                      |       | (3,006                        | )          | (3,619 | ) |
| Income (loss)  before provision for income taxes                   |       | (1,184                        | )          | (696 | ) |
| Benefit for  income taxes                                          |       | (1,053                        | )          | (8 | ) |
| Net income  (loss)                                                 |       | $                             | (131       | ) | $ | (688 | ) |

 

See notes toconsolidated financial statements.

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF CHANGES INSTOCKHOLDERS’ EQUITY**

**DECEMBER31, 2007 THROUGH DECEMBER 31, 2008**

 

(in thousandsexcept share data)

 
| ** **                                                                                  | ** ** | ** **            | ** ** | ** **               | ** ** | ** **       | ** ** | ** **        | ** ** | ** **          | ** ** | **Accumulated**        | ** ** | ** **      | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------------|------------|------------------|------------|-------------------|------------|---------------------|------------|------------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                  | ** ** | ** **            | ** ** | ** **               | ** ** | ** **       | ** ** | ** **        | ** ** | **Additional**      | ** ** | **Other**              | ** ** | **Accumulated** | ** ** | **Total**  | ** ** |
| ** **                                                                                  | ** ** | **Common Stock** | ** ** | **Preferred Stock** | ** ** | **Paid in** | ** ** | **Comprehensive** | ** ** | **Earnings /** | ** ** | **Stockholders’** | ** ** |
| ** **                                                                                  | ** ** | **Shares**            | ** ** | **Amount**               | ** ** | **Shares**       | ** ** | **Amount**        | ** ** | **Capital**         | ** ** | **Income (Loss)** | ** ** | **(Deficit)**   | ** ** | **Equity** | ** ** |
| **Balance  at December 31, 2005**                                                      |       | 937,500               |       | $                        | —     |             | —     |              | $          | —              |       | $                      | 25         |            | $          | —     |       | $ | (8 | ) | $ | 17 |   |
| Stock issuance at  $8.00 per share                                                          |       | 3,825,046             |       | —                   |       |             |       |              |       | 30,600              |       |                   |       | —          |       | 30,600     |       |
| Expense of  offerings                                                                       |       | —                |       | —                   |       |             |       |              |       | (2,145              | )          |                   |       | —          |       | (2,145     | )          |
| Proceeds subject  to possible redemption of 764,627 shares and associated deferred interest |       | —                |       | —                   |       |             |       |              |       | (5,914              | )          |                   |       | —          |       | (5,914     | )          |
| Stock based  compensation                                                                   |       | —                |       | —                   |       |             |       |              |       | 130                 |       |                   |       | —          |       | 130        |       |
| Officer and  director option exercise                                                       |       | 18,761                |       | —                   |       |             |       |              |       | 1                   |       |                   |       | —          |       | 1          |       |
| Net income                                                                                  |       | —                |       | —                   |       |             |       |              |       | —              |       |                   |       | 173             |       | 173        |       |
| **Balance  at December 31, 2006**                                                      | ** ** | **4,781,307**         | ** ** | **$**                    | **—** | ** **       | **$**      | **—**        | ** ** | **$**               | **—** | ** **             | **$**      | **22,697**      | ** ** | **$**      | **—** | ** ** | **$** | **165** | ** ** | **$** | **22,862** | ** ** |
|                                                                                        |       |                  |       |                     |       |             |       |              |       |                |       |                   |       |            |       |       |       |
| Repayment of  redeeming stockholders                                                        |       | (211,965              | )          | —                   |       | —           |       | —            |       | (1,661              | )          | —                 |       | —          |       | (1,661     | )          |
| Stock issuance at  $7.78 per share                                                          |       | 1,180,000             |       | 1                        |       | —           |       | —            |       | 9,180               |       | —                 |       | —          |       | 9,181      |       |
| Issuance of  restricted stock                                                               |       | 130,000               |       | —                   |       | —           |       | —            |       | —              |       | —                 |       | —          |       | —     |       |
| Deferred  financing costs - warrants                                                        |       | —                |       | —                   |       | —           |       | —            |       | 93                  |       | —                 |       | —          |       | 93         |       |
| Payment of  underwriters fees                                                               |       | —                |       | —                   |       | —           |       | —            |       | (103                | )          | —                 |       | —          |       | (103       | )          |
| Release of  redemptive reserves                                                             |       | —                |       | —                   |       | —           |       | —            |       | 5,736               |       | —                 |       | —          |       | 5,736      |       |
| Recognize  deferred interest                                                                |       | —                |       | —                   |       | —           |       | —            |       | 101                 |       | —                 |       | —          |       | 101        |       |
| Stock-based  compensation                                                                   |       | —                |       | —                   |       | —           |       | —            |       | 236                 |       | —                 |       | —          |       | 236        |       |
| Net income                                                                                  |       | —                |       | —                   |       | —           |       | —            |       | —              |       | —                 |       | 219             |       | 219        |       |
| **Balance  at December 31, 2007**                                                      | ** ** | **5,879,342**         | ** ** | **$**                    | **1**      | ** **       | **—** | ** **        | **$**      | **—**          | ** ** | **$**                  | **36,279** | ** **      | **$**      | **—** | ** ** | **$** | **384** | ** ** | **$** | **36,664** | ** ** |
| ** **                                                                                  | ** ** | ** **            | ** ** | ** **               | ** ** | ** **       | ** ** | ** **        | ** ** | ** **          | ** ** | ** **             | ** ** | ** **      | ** ** | ** ** | ** ** |
| Net income (loss)                                                                           |       | —                |       | —                   |       | —           |       | —            |       | —              |       | —                 |       | (30,857         | )          | (30,857    | )          |
| Deferred loss on  hedging activities, net of tax of $72                                     |       | —                |       | $                        | —     |             | —     |              | $          | —              |       | $                      | —     |            | $          | (116       | )          | $ | — |   | (116 | ) |
| Stock-based  compensation                                                                   |       | 90,000                |       | —                   |       | —           |       | —            |       | 1,187               |       | —                 |       | —          |       | 1,187      |       |
| Issuance of  preferred stock                                                                |       | —                |       | —                   |       | 18,750           |       | 0                 |       | 13,532              |       | —                 |       | —          |       | 13,532     |       |
| Dividends on  preferred stock                                                               |       | —                |       | —                   |       | —           |       | —            |       | —              |       | —                 |       | (312            | )          | (312       | )          |
| Common stock  registration costs                                                            |       | —                |       | —                   |       | —           |       | —            |       | (73                 | )          | —                 |       | —          |       | (73        | )          |
| **Balance  at December 31, 2008**                                                      | ** ** | **5,969,342**         | ** ** | **$**                    | **1**      | ** **       | **18,750** | ** **        | **$**      | **0**               | ** ** | **$**                  | **50,925** | ** **      | **$**      | **(116**   | **)**      | **$** | **(30,785** | **)** | **$** | **20,025** | ** ** |
|                                                                                             |            |                       |            |                          |            |                  |            |                   |            |                     |            |                        |            |                 |            |            |            |  |  |  |  |  |  |  |

 

See notes toconsolidated financial statements.

 

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**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

(in thousands)

** **
| ** **                                                                                          | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Cash  flows from operating activities:**                                                          |       |                                       |       |   |   |   |   |
| Net income  (loss)                                                                                  |       | $                                          | (30,857    | ) | $ | 219 |   | $ | 173 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities |       |                                       |       |   |   |   |   |
| Stock-based  compensation                                                                           |       | 1,187                                      |       | 236 |   | 131 |   |
| Amortization                                                                                        |       | 6,403                                      |       | 2,048 |   | — |   |
| Depreciation                                                                                        |       | 2,106                                      |       | 734 |   | 2 |   |
| Goodwill and  intangible asset impairment                                                           |       | 26,603                                     |       | — |   | — |   |
| Loss on disposal  of asset                                                                          |       | 48                                         |       | — |   | — |   |
| Payment to  ISI*MCS Ltd on behalf of ISI                                                            |       | —                                     |       | (1,919 | ) | — |   |
| Accrued interest  on deferred underwriting costs                                                    |       | —                                     |       | 30 |   | 64 |   |
| Interest earned  on assets held in trust                                                            |       | —                                     |       | (896 | ) | (1,332 | ) |
| Interest income  released from the trust                                                            |       | —                                     |       | — |   | 600 |   |
| Deferred  interest on Merit debt                                                                    |       | 442                                        |       | — |   | — |   |
| Tax payments  relapsed from the trust                                                               |       | —                                     |       | 149 |   | — |   |
| Decrease  (increase) in contract receivables                                                        |       | (9,523                                     | )          | (3,535 | ) | — |   |
| Decrease  (increase) in related party contract receivables                                          |       | 6,202                                      |       | (1,451 | ) | — |   |
| Decrease  (increase) in related party receivables                                                   |       | (293                                       | )          | (3 | ) | — |   |
| Decrease  (increase) in costs and estimated earnings in excess of billings                          |       | 1,967                                      |       | (2,739 | ) | — |   |
| Decrease  (increase) in other assets                                                                |       | (1,124                                     | )          | 500 |   | (10 | ) |
| Increase  (decrease) in accounts payable and accrued expenses                                       |       | (1,121                                     | )          | 5,190 |   | 178 |   |
| Increase  (decrease) in other long-term liabilities                                                 |       | 112                                        |       | — |   | — |   |
| Increase  (decrease) in deferred income taxes and refundable taxes                                  |       | (5,141                                     | )          | (322 | ) | 91 |   |
| Increase  (decrease) in billings in excess of costs and estimated earnings                          |       | 1,382                                      |       | (2,681 | ) | — |   |
| **Net  cash used in operating activities**                                                          | ** ** | **$**                                      | **(1,607** | **)** | **$** | **(4,440** | **)** | **$** | **(103** | **)** |
| ** **                                                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Cash  flows from investing activities:**                                                          |       |                                       |       |   |   |   |   |
| Purchase of  investments held in trust                                                              |       | —                                     |       | (171,372 | ) | (318,720 | ) |
| Maturity of  investments held in trust                                                              |       | —                                     |       | 171,372 |   | 289,999 |   |
| Acquisition of  PDI, Com-Tec, and Fire Quest in 2008 and ISI in 2007, net of cash acquired          |       | (5,264                                     | )          | (17,260 | ) | — |   |
| Purchase of  property and equipment                                                                 |       | (2,960                                     | )          | (841 | ) | (7 | ) |
| Transaction  costs                                                                                  |       | (630                                       | )          | (1,967 | ) | (58 | ) |
| Increase /  (decrease) in other assets                                                              |       | —                                     |       | (16 | ) | — |   |
| **Net  cash used in investing activities**                                                          | ** ** | **$**                                      | **(8,854** | **)** | **$** | **(20,084** | **)** | **$** | **(28,786** | **)** |
| ** **                                                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Cash  flows from financing activities:**                                                          |       |                                       |       |   |   |   |   |
| Gross proceeds  from public offering and private placement                                          |       | —                                     |       | — |   | 30,600 |   |
| Issuance of  preferred stock                                                                        |       | 15,000                                     |       | — |   | — |   |
| Restricted cash                                                                                     |       | (2,500                                     | )          | — |   | — |   |
| Proceeds from  issuance and exercise of options                                                     |       | —                                     |       | — |   | 1 |   |
| Offering costs  and financing costs                                                                 |       | (1,874                                     | )          | (7 | ) | (873 | ) |
| Receipt of funds  held in trust                                                                     |       | —                                     |       | 30,200 |   | — |   |
| Investment  banker fees paid                                                                        |       | —                                     |       | (1,370 | ) | — |   |
| Repayment on  borrowings                                                                            |       | (50,528                                    | )          | (12,942 | ) | — |   |
| Proceeds from  borrowings                                                                           |       | 53,119                                     |       | 13,220 |   | — |   |
| Proceeds from  notes payable                                                                        |       | 5,000                                      |       | — |   | — |   |
| Proceeds from  notes payable and warrants to stockholders                                           |       | —                                     |       | 300 |   | — |   |
| Repayment of  notes payable and warrants to stockholders                                            |       | —                                     |       | (300 | ) | (155 | ) |
| Redemption of  common stock                                                                         |       | —                                     |       | (1,661 | ) | — |   |
| Issuance of  common stock                                                                           |       | —                                     |       | — |   | — |   |
| Payments on  capital lease obligations                                                              |       | (170                                       | )          | (54 | ) | — |   |
| **Net  cash provided by financing activities**                                                      | ** ** | **$**                                      | **18,047** | ** ** | **$** | **27,386** | ** ** | **$** | **29,573** | ** ** |
|                                                                                                |       |                                       |       |   |   |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                                           | ** ** | **$**                                      | **7,586**  | ** ** | **$** | **2,862** | ** ** | **$** | **684** | ** ** |
| Cash and cash  equivalents at beginning of year                                                     | ** ** | **3,556**                                  | ** ** | **694** | ** ** | **10** | ** ** |
| **Cash  and cash equivalents at end of year**                                                       | ** ** | **$**                                      | **11,142** | ** ** | **$** | **3,556** | ** ** | **$** | **694** | ** ** |

 

See notes toconsolidated financial statements.

 

F-9

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**CONSOLIDATED STATEMENT OF CASH FLOWS**

(inthousands)

 
| ** **                                                                                | ** ** | **Predecessor (ISI)**    | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                | ** ** | **January 1, 2007** | ** ** | **Year Ended** | ** ** |
| ** **                                                                                | ** ** | **through**                   | ** ** | **December 31,** | ** ** |
| ** **                                                                                | ** ** | **July 31, 2007**   | ** ** | **2006** | ** ** |
| **Cash  flows from operating activities:**                                                |       |                          |       |   |   |
| Net income  (loss)                                                                        |       | $                             | (131       | ) | $ | (688 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities |       |                          |       |   |   |
| Interest  accretion and fair value adjustment on stock warrrants                          |       | 1,400                         |       | 1,297 |   |
| Depreciation                                                                              |       | 475                           |       | 991 |   |
| Stock  appreciation rights                                                                |       | 1,364                         |       | — |   |
| Loss on disposal  of assets                                                               |       | —                        |       | (5 | ) |
| Deferred income  tax expense (benefit)                                                    |       | (1,190                        | )          | (7 | ) |
| Decrease  (increase) in contract receivables                                              |       | (636                          | )          | (4,181 | ) |
| Decrease  (increase) in related party contract receivables                                |       | (3,174                        | )          | (3,935 | ) |
| Decrease  (increase) in other receivables                                                 |       | (131                          | )          | 215 |   |
| Decrease  (increase) in costs and estimated earnings in excess of billings                |       | (1,055                        | )          | (1,078 | ) |
| Decrease  (increase) in other assets                                                      |       | (368                          | )          | (156 | ) |
| Increase  (decrease) in accounts payable and accrued expenses                             |       | 1,363                         |       | 5,523 |   |
| Increase  (decrease) in related party accounts payable                                    |       | —                        |       | 6 |   |
| Increase  (decrease) in billings in excess of costs and estimated earnings                |       | 2,410                         |       | 2,471 |   |
| **Net  cash provided by (used in) operating activities**                                  | ** ** | **$**                         | **327**    | ** ** | **$** | **453** | ** ** |
|                                                                                      |       |                          |       |   |   |
| **Cash  flows from investing activities:**                                                |       |                          |       |   |   |
| Purchase of  property and equipment                                                       |       | (1,004                        | )          | (764 | ) |
| Proceeds from  sale of property and equipment                                             |       | —                        |       | 7 |   |
| **Net  cash used in investing activities**                                                | ** ** | **$**                         | **(1,004** | **)** | **$** | **(757** | **)** |
| ** **                                                                                | ** ** | ** **                    | ** ** | ** ** | ** ** |
| **Cash  flows from financing activities:**                                                |       |                          |       |   |   |
| Loan origination  fees and other assets                                                   |       | 240                           |       | (98 | ) |
| Line of credit,  net                                                                      |       | 2,686                         |       | 507 |   |
| Proceeds from  Long-term borrowings                                                       |       | —                        |       | — |   |
| Net transaction  costs                                                                    |       | (624                          | )          | — |   |
| Payments on  long-term borrowings and capital lease obligations                           |       | (542                          | )          | (162 | ) |
| **Net  cash provided by financing activities**                                            | ** ** | **$**                         | **1,760**  | ** ** | **$** | **247** | ** ** |
|                                                                                      |       |                          |       |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                                 | ** ** | **$**                         | **1,083**  | ** ** | **$** | **(57** | **)** |
| Cash and cash  equivalents at beginning of year                                           | ** ** | **359**                       | ** ** | **416** | ** ** |
| **Cash  and cash equivalents at end of year**                                             | ** ** | **$**                         | **1,442**  | ** ** | **$** | **359** | ** ** |

 

See notes toconsolidated financial statements.

 

F-10

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**NOTES TO AUDITED CONSOLIDATEDFINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note1 — Basis of Presentation**

 

Argyle Security, Inc.(formerly Argyle Security Acquisition Corporation) (“Argyle”) was incorporatedin Delaware in June 2005 as a blank check company formed to acquire,through merger, capital stock exchange, asset acquisition, or other similarbusiness combination, a business in the security industry. Argyle completed itsinitial public offering in January 2006.  On July 31, 2007,Argyle consummated its initial acquisition through the acquisition of 100% ofthe outstanding capital stock of ISI Security Group, Inc. (f/k/a ISIDetention Contracting Group, Inc., referred to herein as “ISI”) and itssubsidiaries. When used herein, “Argyle”, the “Company”, “we”, “us”, “our”,refers to the pre-acquisition company until July 31, 2007 and thepost-acquisition company after July 31, 2007.

 

Argyle is a comprehensivesecurity solutions provider to our diverse customer base because it addressesthe majority of their physical electronic security requirements.  Argyleis a detention and commercial equipment contractor that specializes indesigning and integrating security solutions, including turnkey installations,design, engineering, supply, and installation of various detention,surveillance and access control equipment and software solutions forcorrectional facilities and commercial institutions. The work is performedunder fixed-price contracts. The projects are located in various citiesthroughout the United States. The length of the contracts varies but istypically less than two years. Argyle also provides turnkey installationscovering the full spectrum of electronic security and low voltage systems,including fire alarm, access control, closed circuit television, intercom,sound/paging and other custom designed systems.

 

In February 2008,we organized our business under the name of “Argyle Security USA” and then, in January 2009,we eliminated the name “Argyle Security USA” and, for the sole purpose of debtcovenant compliance calculation which only considers the operating business’financial condition, organized the operational business of Argyle under thename “Argyle Security Operations”, or “ASO”, through which we provide securitysolutions to commercial, governmental and correctional customers.  Argylehas two reporting segments or business divisions: “Argyle Corrections” and “ArgyleCommercial Security”.

 

Argyle Correctionsspecializes in the design and installation of turnkey security solutions forpublic and privately-owned/operated detention facilities. Argyle Correctionsdesigns, assembles, supplies, installs, and maintains access control, video andintegrated electronic control systems for correctional and governmentfacilities throughout the United States. Argyle Corrections offers a completearray of electronic security system solutions revolving around access control,including: electronic locking systems and hardware and security doors andframes. Argyle Corrections also includes the sale and design of jail furniture,security glazing and other security-based systems. It provides the above goodsand services to detention market integrators, electrical contractors andcompetitors of Argyle that lack their own in-house electronic solutions.Whether acting as prime contractor or as a subcontractor for projects spanningall levels of security, Argyle Corrections’ product offerings include securitylocking systems, security hollow metal doors and wall panels, security windows,security glass and glazing, security furnishings and accessories, designsupport and full installation capabilities.

 

Argyle Correctionsconsists of all of our businesses in the corrections sector, includingMetroplex Control Systems, Inc. (“MCS”), ISI-Detention, as well as Com-Tecand PDI.  Com-Tec and PDI were acquired in January 2008.  ArgyleCorrections includes:

 

·                  MCS (also referred to asMCS-Detention), which designs, engineers, supplies, installs and maintainscomplex, customized physical and software security solutions, access control,video and electronic security control system solutions at correctional and governmentfacilities;

 

·                  ISI -Detention, which designs,engineers, supplies, installs and maintains a full array of detention systemsand equipment, targeting correctional facilities throughout the United States;

 

·                  PDI, which is a full-service, turnkeysolutions provider that manufactures high-security metal barriers,high-security observation window systems, detention furniture and accessories;and

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note1 — Basis of Presentation (continued)**

 

·                  Com-Tec, which is an industry leaderin the custom design and manufacture of electronic security and communicationssystems.

 

Argyle CommercialSecurity has built a parallel business to Argyle Corrections, targetingcommercial and industrial facilities. Argyle Commercial Security focuses on thecommercial security sector and provides turnkey, electronic security systems tothe commercial market. Currently, MCS Commercial Fire & Security,referred to as MCS-Commercial, operates out of its own San Antonio headquartersand five regional offices in Texas and Colorado. The offices in Austin, Houstonand Denver resulted from acquisitions made by ISI before it was acquired byArgyle. Its security systems cover access control, video systems, intrusiondetection systems, proximity and smart cards, biometric technology, photoidentification (ID) printers and supplies among others. It also secures thecommunity by levering leading edge technology through installation ofintelligent perimeter security, wireless video, IP video and intelligent videosurveillance. Its industry-leading fire detection systems include QuickStart,EST2 & EST3, integrated life support systems, control panels,detectors, and audible and visible signals. Argyle Federal Systems is currentlya newly operational business unit which focuses on providing security solutionsand services targeted at the federal government. In ****November 2008****,Argyle Commercial Security was awarded a supply contract through the U.S.General Services Administration (“GSA”) to provide integrated securitysolutions and products to the various departments in the United States federalgovernment and any other entity that purchases off the GSA contract. Thesesolutions and products consist of Access Control, Video, Perimeter Security andID Credentials that have been very successful in the commercial marketplace,and now will be available to all governmental entities with access to the GSAcontracts.

 

On January 1, 2008,MCFSA, Ltd. (“MCS Commercial”) and all of the partnership interests which aredirectly or indirectly wholly owned by ISI, acquired substantially all of thebusiness assets and liabilities of FireQuest Inc. (“Fire Quest”). Fire Quest isengaged in the business of alarm system sales and service.

 

On January 4, 2008, ISIacquired substantially all of the business assets and liabilities of PDI. PDI is a full-service, turnkey solutions provider that manufactures highsecurity metal barriers, high security observation window systems, detentionfurniture and accessories.

 

On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI, which inturn is a wholly owned subsidiary of the Company, closed a transaction,pursuant to which ISI-Controls acquired 100% of the outstanding units ofCom-Tec, resulting in Com-Tec becoming a wholly owned subsidiary ofISI-Controls. Com-Tec is engaged in the business of custom design, manufactureand installation of electronic security and communications systems.

 

Prior to the acquisitionof ISI, Argyle had no operations and was considered a developmental stageenterprise. ISI is deemed to be a “predecessor” to the Company.   Asa result, the statements of operations and statements of cash flows of ISI forseven months ended July 31, 2007 are presented for comparative purposesonly. The results of operations and cash flows on a consolidated basissubsequent to the acquisition of ISI are not comparative to the predecessor ISIresults of operations and cash flows because the basis for the acquired assetsand liabilities of ISI have been adjusted to fair value pursuant to Statementof Financial Accounting Standards (“SFAS”) No. 141,*  Business Combinations* .

 

The audited consolidatedfinancial statements of Argyle, as of December 31, 2008 and 2007, includethe accounts of the Company and all wholly-owned subsidiaries. All significantintercompany transactions and balances have been eliminated inconsolidation.  In the opinion of management, all normal recurringadjustments considered necessary for a fair presentation have beenincluded. 

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note1 — Basis of Presentation (continued)**

 

*ProForma Results of Operations*

 

Following are pro formaunaudited results of operations for the Company for the years ended December 31,2008 and 2007, assuming the Fire Quest, PDI and Com-Tec acquisitions occurredon January 1, 2008 and 2007, respectively and the ISI acquisition occurredon January 1, 2007.

 

The Company derived theunaudited pro forma results of operations from (i) the unauditedconsolidated financial statements of ISI from January 1, 2007 to July 31,2007, (ii) the unaudited consolidated financial statements of Com-Tec forthe one month ended January 31, 2008 and the audited  consolidated financial statements of Com-Tec forthe year ended December 31, 2007, (iii) the audited financial statementsof PDI for the year ended December 31, 2007, (iv) the unauditedfinancial statements of Fire Quest for the year ended December 31, 2007and (v) the audited consolidated financial statements of the Company forthe year ended December 31, 2008 and 2007. The unaudited pro forma resultsof operations are not necessarily indicative of results of operations that mayhave actually occurred had the acquisitions taken place on the dates noted, orthe future financial position or operating results of the Company. The proforma adjustments are based upon available information and assumptions that theCompany believes are reasonable. The pro forma adjustments include adjustmentsfor interest expense and increased depreciation and amortization expense as aresult of the application of the purchase method of accounting based on thefair values of the tangible and intangible assets.

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**ProForma Consolidated Statements of Operations**

**(unaudited)**

 

(in thousands,except share data)

 
| ** **                                                                                                           | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2008**                                   | ** ** | **2007** | ** ** |
| Revenues:                                                                                                            |       |                                       |       |   |   |
| Contract  revenues                                                                                                   |       | $                                          | 100,324    |   | $ | 54,712 |   |
| Contract  revenues - related party                                                                                   |       | 16,782                                     |       | 31,788 |   |
| Service and  other revenues                                                                                          |       | 19,455                                     |       | 19,541 |   |
| Total revenues                                                                                                       |       | 136,561                                    |       | 106,041 |   |
| Cost of  revenues:                                                                                                   |       |                                       |       |   |   |
| Contract costs                                                                                                       |       | 91,722                                     |       | 66,079 |   |
| Service and other  costs, including amortization of intangibles ($4,725 for 2008 and $5,127 for 2007)           |       | 24,139                                     |       | 19,452 |   |
| Total cost of  revenues                                                                                              |       | 115,861                                    |       | 85,531 |   |
| Gross profit                                                                                                         |       | 20,700                                     |       | 20,510 |   |
| Operating  expenses:                                                                                                 |       |                                       |       |   |   |
| Salaries and  related expense, including stock-based compensation of $1,187 and $236,  respectively.                 |       | 13,004                                     |       | 9,860 |   |
| Professional  fees and outside services                                                                              |       | 3,439                                      |       | 2,176 |   |
| General and  administrative expenses                                                                                 |       | 7,205                                      |       | 6,291 |   |
| Depreciation                                                                                                         |       | 2,004                                      |       | 1,408 |   |
| Goodwill and  intangible assets impairment charge                                                                    |       | 26,603                                     |       | — |   |
| Amortization of  intangible assets                                                                                   |       | 1,735                                      |       | 1,735 |   |
| Total operating  expenses                                                                                            |       | 53,990                                     |       | 21,470 |   |
| Operating loss                                                                                                       |       | (33,290                                    | )          | (960 | ) |
| Other income  (expense):                                                                                             |       |                                       |       |   |   |
| Interest income                                                                                                      |       | 164                                        |       | 230 |   |
| Interest expense                                                                                                     |       | (3,708                                     | )          | (2,891 | ) |
| Total other  income (expense)                                                                                        |       | (3,544                                     | )          | (2,661 | ) |
| Income (loss)  before provision for income taxes                                                                     |       | (36,834                                    | )          | (3,621 | ) |
| Provision  (benefit) for income taxes                                                                                |       | (5,965                                     | )          | (2,320 | ) |
| Net income  (loss)                                                                                                   |       | $                                          | (30,869    | ) | $ | (1,301 | ) |
| Deferred  interest, net of taxes, subject to possible redemption                                                     |       | —                                     |       | — |   |
| Dividends on  convertible preferred stockholders                                                                     |       | (312                                       | )          | — |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                               |       | $                                          | (31,181    | ) | $ | (1,301 | ) |
|                                                                                                                 |       |                                       |       |   |   |
| Weighted-average  number of shares of commomn stock outstanding exclusive of shares subject to  possible redemption: |       |                                       |       |   |   |
| Basic                                                                                                                |       | 5,797,293                                  |       | 5,195,415 |   |
| Diluted                                                                                                              |       | 5,797,293                                  |       | 5,195,415 |   |
| Net income  (loss) per share allocable to holders of                                                                 |       |                                       |       |   |   |
| non-redeemable  common stock:                                                                                        |       |                                       |       |   |   |
| Basic                                                                                                                |       | $                                          | (5.38      | ) | $ | (0.25 | ) |
| Diluted                                                                                                              |       | $                                          | (5.38      | ) | $ | (0.25 | ) |

 

F-14

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies**

 

Argyle completed aprivate placement (the “Private Placement”) in January 2006 and receivednet proceeds of approximately $0.9 million. Also in January 2006, theregistration statement for Argyle’s initial public offering (the “PublicOffering”) was declared effective, and the net proceeds from the sale of Argyle’sunits, after deducting certain offering expenses of approximately $2.4 million,including underwriting discounts of approximately $1.8 million, wereapproximately $28.2 million. Approximately $27.3 million of the proceeds fromthe Public Offering and the Private Placement were placed in a trust accountfor Argyle’s benefit. Except for $0.6 million in interest that was earned onthe funds contained in the trust account and that was released to Argyle to beused as working capital, and the amounts released to Argyle for the payment oftaxes, Argyle was not able to access the amounts held in the trust until itconsummated a business combination. The amounts held outside of the trustaccount were used by Argyle to provide for business, legal and accounting duediligence on prospective acquisitions and continuing general and administrativeexpenses. Prior to releasing the funds held in trust, the trust accountcontained $1.4 million reserved for the compensation of Argyle’s underwritersin its Public Offering, which was paid to them upon completion of the businesscombination. All amounts held in trust were released on July 31, 2007 tofund the acquisition of ISI.

 

On March 14, 2007,the underwriters from the Public Offering agreed to forfeit any and all rightsor claims to a pro-rata portion of the deferred underwriting costs andassociated interest with respect to any shares of common stock redeemed inconnection with any acquisition (see Note 17). In connection with the PublicOffering and the Private Placement, Argyle’s officers and directors placed allthe shares owned by them before the Private Placement and the Public Offeringinto an escrow account. Except in certain circumstances, the shares held inescrow were not able to be released prior to January 24, 2009.

 

As part of theacquisition of ISI, stockholders holding 211,965 of the aggregate number ofshares sold in the Public Offering elected to redeem such shares (see Note 15).The per-share redemption price was equal to $7.80 per share including interestearned thereon in the trust account, less taxes payable, $0.6 million ofinterest income, which was released from the trust account in September 2006to fund our working capital, and amounts owed to the underwriter for thePrivate Placement (approximately $45,000 plus interest). Approximately $1.7million was paid to redemptive shareholders in August of 2007.

 

***Cash and Cash Equivalents***

 

The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents, and the carrying amounts approximate fair value.

 

***Restricted Cash***

 

Represents depositsrequired by the Company’s commercial bank letter of credit.

 

***Contract Receivables***

 

Contract receivables arerecorded at the invoiced amount and do not bear interest. The allowance fordoubtful accounts is established as losses are estimated to have occurredthrough a provision for bad debts charged to earnings. Losses are chargedagainst the allowance when management believes the inability to collect areceivable is confirmed. Subsequent recoveries, if any, are credited to theallowance. The allowance for doubtful accounts is evaluated on a regular basisby management and is based on historical experience and specifically identifiedquestionable receivables. The evaluation is inherently subjective, as itrequires estimates that are susceptible to significant revision as moreinformation becomes available.

 

The amount recognized forbad debt expense for fiscal years ended December 31, 2008 and 2007 was $0.9million and $0.8 million, respectively, and is reflected in the general andadministrative expenses of the Statement of Operations.

 

***Revenue Recognition***

 

A majority of the Company’srevenues are generated under fixed-price construction contacts.  Revenuesunder fixed-price contracts are recognized under the percentage-of-completionmethodology.  Service revenues are recognized when the services havebeen delivered to and accepted by the customer. Other revenues consists ofproduct sales and are recognized upon shipment, or later if required byshipping terms, provided title is transferred, prices are fixed and collectionis deemed probable.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

 

***Construction Contracts***

 

Construction Contractsare those as defined in the American Institute of Certified Public Accountants’Statement of Position 81-1 (SOP 81-1),*  Accounting for Performance of Construction-Type and CertainProduction-Type Contracts*  .

 

Most of the Company’scontracts extend over a period of 6 to 14 months (6 to 9 months for ArgyleCommercial Security and 9 to 14 months for Argyle Corrections), which is theperiod the Company considers to be its operating cycle. Such contractsgenerally provide that the customers accept completion of progress to date andcompensate the Company for services rendered measured in terms of unitsinstalled, hours expended or some other measure of progress. Revenues fromConstruction Contracts are recognized on the percentage-of-completion method inaccordance with SOP 81-1. The Company recognizes revenues on signed letters ofintent, contracts and change orders. Percentage-of-completion for ConstructionContracts is measured principally by the percentage of costs incurred andaccrued to date for each contract to the estimated total costs for eachcontract at completion. The Company generally considers contracts to besubstantially complete upon departure from the work site and acceptance by thecustomer. Contract costs include all direct material, labor, subcontract,equipment costs, related payroll taxes and insurance costs, and any otherindirect costs related to contract performance. Changes in job performance, jobconditions, estimated contract costs, profitability and final contractsettlements may result in revisions to costs and income, and the effects ofthese revisions are recognized in the period in which the revisions aredetermined. Provisions for total estimated losses on incomplete contracts aremade in the period in which such losses are determined.

 

Pre-contract costs arecosts that are incurred for a specific anticipated contract and that willresult in no future benefits unless the contract is obtained. Such costs areexpensed as incurred.

 

The balances billed butnot paid by customers pursuant to retainage provisions in constructioncontracts will be due upon completion of the contracts and acceptance by thecustomer. Based on the Company’s experience with similar contracts in recentyears, the retention balance at each balance sheet date will be collectedwithin the subsequent fiscal year.

 

The current asset, “costsand estimated earnings in excess of billings on incomplete contracts,”represents revenues recognized in excess of amounts billed which managementbelieves will be billed and collected within the subsequent year. The currentliability, “billings in excess of costs and estimated earnings on incompletecontracts,” represents billings in excess of revenues recognized.

 

***Service Sales***

 

Service Sales Revenuesare recognized when the services have been delivered to and accepted by thecustomer.  These are generally short-term projects which are evidenced bysigned service agreements or customer work orders or purchase orders. These sales agreements/customer orders generally provide for billing tocustomers based on time at quoted hourly or project rates plus costs ofmaterials and supplies furnished by the Company.

 

***Shipped Products***

 

Revenues are recognizedby PDI when the product is shipped to the customer in accordance with thecontractual shipping terms. In almost all cases the shipping of products to PDI’scustomers is FOB Origin, whereby title passes to the purchaser when the productleaves the PDI premises under the bail of a common carrier.  In only rare instances (less than 2% of allshipments) are products shipped to PDI customers as FOB Destination, wherebytitle passes to the purchaser when the product reaches its destination. Whendelivery to the customer’s delivery site has occurred, the customer takes titleand assumes the risks and rewards of ownership.

 

The Company incurred $1.4million in shipping and handling costs which are reflected in the service andother costs in the Statement of Operations. 

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

 

***Inventory***

 

Inventory is valued atthe lower of cost or market and consists of raw materials, work in process (WIP)and finished goods in the fiscal year ended 2008 where it was only finishedgoods as of the fiscal year ended 2007. Costs of inventory are determined using the average cost method for allof the business units. Inventory that was acquired by Argyle from ISI has beenstated at fair value at July 31, 2007; all subsequent purchases have beenrecorded based on cost. The $1.0 million of inventory that was acquired fromthe Fire Quest, Com-Tec and PDI acquisitions has been stated at fair value atthe date of acquisition (see Note 3).  The Company performs quarterlyreview of its inventory holdings to determine appropriate reserves forobsolescence.  At December 31, 2008and December 31, 2007, the Company’s inventory balance (net of reserves)was $2.1 million and $138,000, respectively, which is included in other currentassets on the consolidated balance sheet.  The composition of the year ended inventory was as follows:

 
| ** **     | ** ** | **2008** | ** ** | **2007** | ** ** |
|----------------|------------|----------|------------|----------|------------|
|           |       |     |       |     |       |
| Raw materials  |       | $        | 191,000    |     | $          | 0 |   |
| WIP            |       | $        | 993,000    |     | $          | 0 |   |
| Finished goods |       | $        | 962,000    |     | $          | 138,000 |   |

 

***Property and Equipment***

 

Property and equipment isstated at cost less accumulated depreciation, except for the plant andequipment acquired by Argyle in connection with the acquisition of ISI whichwas recorded at fair value at July 31, 2007; all subsequent purchases arerecorded based on cost. The $1.2 million of property and equipment fromthe Fire Quest, Com-Tec, and PDI acquisitions have been stated at fair value atthe date of acquisition (see Note 3).  Depreciation is calculated on thestraight-line method.

 

The Company reviews thecarrying value of property and equipment for impairment whenever events andcircumstances indicate that the carrying value of the asset may not berecoverable from the estimated future cash flows expected to result from itsuse and eventual disposition. In cases where undiscounted expected future cashflows are less than the carrying value, an impairment loss is recognized equalto an amount by which the carrying value exceeds the fair value of assets. Thefactors considered by management in performing this assessment include currentoperating results, trends, and prospects, and the effects of obsolescence,demand, competition and other economic factors.

 

***Assets Held Under Capital Leases***

 

Assets held under capitalleases are classified under property and equipment on the Company’s balancesheet and are recorded at the lower of the net present value of the minimumlease payments or the fair value of the asset at the inception of the lease.Amortization expense is computed using the straight-line method over theshorter of the estimated useful life of the asset or the lease term. Assetsheld under capital leases that were acquired from ISI have been stated at fairvalue as of July 31, 2007.

 

***Goodwill and Other Intangible Assets***

 

Goodwill represents theexcess of the purchase price over the fair value of net assets acquired,including the amount assigned to identifiable intangible assets.  Goodwillis reviewed for impairment annually, or more frequently if impairmentindicators arise.  Our annual impairment review requires extensive use ofaccounting judgment and financial estimates.   The analysis ofpotential impairment of goodwill requires a two-step process.   The first step is to identify if a potentialimpairment exists by comparing the fair value of a reporting unit with itscarrying amount, including goodwill. If the fair value of a reporting unitexceeds its carrying amount, goodwill of the reporting unit is not consideredto have a potential impairment, and the second step of the impairment test isnot necessary. However, if the carrying amount of a reporting unit exceeds itsfair value, the second step is performed to determine if goodwill is impairedand to measure the amount of impairment loss to recognize, if any.

 

The second step comparesthe implied fair-value of goodwill with the carrying amount of goodwill. If theimplied fair value of goodwill exceeds the carrying amount, then goodwill isnot considered impaired. However, if the carrying amount of goodwill exceedsthe implied fair value, an impairment loss is recognized in an amount equal tothat excess.

 

The implied fair value ofgoodwill is determined in the same manner as the amount of goodwill recognizedin a business combination (i.e., the fair value of the reporting unit isallocated to all the assets and liabilities, including any unrecognizedintangible assets, as if the reporting unit had been acquired in a businesscombination and the fair value of the reporting unit were the purchase pricepaid to acquire the reporting unit).

 

We have elected to makethe first day of the third quarter the annual impairment assessment date forgoodwill and other intangible 

 

F-17

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

assets. However, we couldbe required to evaluate the recoverability of goodwill and other intangibleassets prior to the required annual assessment if we experience disruptions tothe business, unexpected significant declines in operating results, divestitureof a significant component of the business or a sustained decline in marketcapitalization.

 

The Company identifiedits reporting units under the guidance of SFAS 142 *Goodwill andOther Intangible Assets* (FAS 142) and EITF Topic D-101, *Clarification of Reporting Unit Guidance in Paragraph 30 of FASBStatement No. 142*. The Company’s reporting units are ISI-Detention,MCS-Detention, PDI, Com-Tec (which comprise the Argyle Corrections segment),and MCS-Commercial which comprises the Argyle Commercial segment.

 

During the quarter ended September 30,2008, the Company began an analysis of Goodwill Impairment in accordance withFAS 142, for the ISI acquisition completed July 31, 2007, the acquisitionof Fire Quest on January 1, 2008, the acquisition of PDI on January 4,2008 and the acquisition of Com-Tec on January 31, 2008.   Theinitial analysis (first step) was performed by the Company’s management teamand a valuation firm after the conclusion of the quarter.  Based on acombination of factors, including the current economic environment, ouroperating results and a sustained decline in our market capitalization, weconcluded that there were a number of indicators which required us to perform anon-cash, goodwill impairment analysis as of September 30, 2008. For thepurposes of this analysis, our estimates of fair value were based on a combinationof the income approach, which estimates the fair value of our reporting unitsbased on the future discounted cash flows, and the market approach, whichestimates the fair value of our reporting units based on comparable marketprices.  Accordingly, we recorded a $16.9million non-cash goodwill impairment charge, representing our best estimate ofthe impairment loss, during the third quarter of fiscal year 2008.

 

We estimate the fairvalue of our reporting units, using various valuation techniques, with theprimary technique being a discounted cash flow analysis. A discounted cash flowanalysis requires us to make various judgmental assumptions about sales,operating margins, growth rates and discount rates. Assumptions about sales,operating margins and growth rates are based on our budgets, business plans,economic projections, anticipated future cash flows and marketplace data.Assumptions are also made for varying perpetual growth rates for periods beyondthe long-term business plan period.

 

Other intangible assetfair values have been calculated for trademarks using a relief from royaltyrate method and using the present value of future cash flows for patents andin-process technology. Assumptions about royalty rates are based on the ratesat which similar brands and trademarks are licensed in the marketplace.

 

Our impairment analysiscontains uncertainties due to uncontrollable events that could positively ornegatively impact the anticipated future economic and operatingconditions.  We have not made anymaterial changes in the accounting methodology used to evaluate impairment ofgoodwill and other intangible assets during the last two years.

 

While we believe we havemade reasonable estimates and assumptions to calculate the fair value of thereporting units and other intangible assets, it is possible a material changecould occur. If our actual results are not consistent with our estimates andassumptions used to calculate fair value, we may be required to perform thesecond step in future periods which could result in further impairments of ourremaining goodwill.

 

During the fourth quarterof fiscal year 2008, the management team and a valuation firm began thetwo-step valuation process of the impairment to our goodwill and intangibleassets.  During the latter part of thesecond half of fiscal year 2008 and continuing into December 2008, ourmarket capitalization was below book value. We considered this information, aswell as our discount rate and Weighted Average Cost of Capital (“WACC”) of 14% andoverall revenue and operating growth rate assumptions for fiscal years 2009through 2012.   We considered the marketcapitalization decline in our evaluation of fair value of goodwill and believethe decline to be primarily attributed to the negative market conditions as aresult of the credit crisis, indications of a possible recession and currentissues within the overall economy in the United States and globally.

 

Our fiscal 2008 goodwilland intangible asset impairment analysis resulted in a December 31, 2008charge of $9.7 million in addition to the estimate made as of September 30,2008 of $16.9 million.  The non-cash,total impairment charges for goodwill and intangible assets for the year ended December 31,2008 were $26.6 million.

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

 

A summary of the activityin goodwill by business segment is as follows (in thousands):

 
| ** **                                                  | ** ** | **Corrections** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------|------------|-----------------|------------|----------------|------------|-----------|------------|
| Balance December  31, 2007                                  |       | $               | 13,275     |           | $          | 6,662     |       | $ | 19,937 |   |
| ISI Adjustments                                             |       | 91              |       | (33            | )          | 58        |       |
| Com-Tec  Acquisition                                        |       | 2,844           |       | —         |       | 2,844     |       |
| PDI Acquisition  (Net of $1.4 million of Impairment)        |       | —          |       | —         |       | —    |       |
| Fire Quest  Acquisition (Net of $0.7 million of Impairment) |       | —          |       | —         |       | —    |       |
| ISI Goodwill  Impairment                                    |       | (13,366         | )          | (6,629         | )          | (19,995   | )          |
| Balance December  31, 2008                                  |       | $               | 2,844      |           | $          | —    |       | $ | 2,844 |   |

 

During the year ended December 31,2008, the Company increased goodwill from the acquisition of ISI by $58,000 asa result of $34,000 of additional transaction costs ($4,000 accounting fees,$9,000 in insurance costs and $21,000 in legal fees), a $13,000 write-down ofstale checks outstanding (decrease in cash), a $29,000 reduction in refundabletaxes (current tax asset) and an $5,000 increase to intangible assets. The non-cash goodwill impairment charge attributable to the originalacquisition amounted to $20.0 million.

 

During the year ended December 31,2008, the Company increased goodwill from the acquisition of Com-Tec by$467,000 (over the original valuation amount of $2.4 million), as a result of$26,000 of additional transaction costs, $171,000 in inventory and warrantyreserves and a $270,000 adjustment to intangible assets due to a change in thevaluation inputs associated with the discount rate applied to the cash flowsassociated with those intangible assets.

 

During the year ended December 31,2008, the Company wrote off the entire amount of goodwill from the acquisitionof PDI from the original valuation amount of $1.2 million.  During the year there additions to goodwillof $57,000 from additional transaction costs, $65,000 in inventory reservesand a $110,000 adjustment to intangible assets (due to a change in thevaluation inputs associated with the discount rate applied to the cash flowsassociated with those intangible assets) and a $20,000 increase in currentliabilities for the PDI Promissory Note derivative (see Note 8) that werewritten off  as a result of the valuationanalysis performed in the fourth quarter of 2008.

 

During the year ended December 31,2008, the Company had $18,000 of additional transaction costs to the $0.7million in the originally booked goodwill from the acquisition of Fire Quest.

 

F-19

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

** **

**Note2 — Background, Formation, and Summary of Significant Accounting Policies(continued)**

** **

***Software Costs***

*** ***

Software costs representinternally-developed software that is proprietary to the Company and assists inits operations. According to Statement of Position 98-1,*Accounting for the Costs of Computer SoftwareDeveloped or Obtained for Internal Use*, the costs of computersoftware developed or obtained for internal use are to be amortized on astraight-line basis, unless another systematic and rational basis is morerepresentative of the software’s use. Management does not believe there isanother more rational basis and, therefore, the assets are amortized on thestraight-line basis over a 36-month period.

 

***Self Insurance***

*** ***

ISI, PDI and Com-Tec areself-insured to certain limits under their respective group health and dentalplans.  On a quarterly basis, the Company estimates its health insurancecost, for its self-insured employee base at ISI, based upon expected healthinsurance claims for the current year. The insurance company which providesboth the stop loss and total aggregate insurance coverages also provides theaverage, or expected, and maximum, claims for each class. The average andmaximum claims are based on the Company’s demographics and prior claim history.The Company uses the average claims history for the trailing 12 months as itsbasis for accruing health care cost.

 

***Warranty Reserve***

*** ***

The Company warrants itsproducts against defects in design, materials and workmanship generally forperiods ranging from one to two years.  A provision for estimated futurecosts related to warranty expense is recorded when products are sold. Management estimates the provision based primarily on historical warranty claimexperience.  As of December 31, 2008, the warranty reserve was$204,000 and is included in accounts payable and accrued expenses on theaudited consolidated balance sheet.

 

***Fair Value of Financial Instruments***

*** ***

The recorded fair valueof financial instruments, including contracts receivable, other assets andaccounts payable, approximate the fair value amount due to their shortmaturity. The carrying value of the revolving line of credit approximates fairvalue due to its variable interest rate. The recorded value of the long-termdebt approximates fair value based on borrowing rates currently available tothe Company for financing arrangements with similar terms and averagematurities.

 

***Income Taxes***

*** ***

The Company accounts forincome taxes under the liability method in accordance with SFAS No. 109, *Accounting for Income Taxes*. Deferred income taxes arerecorded based on enacted statutory rates to reflect the tax consequences infuture years of the differences between the tax bases of assets and liabilitiesand their financial reporting amounts. Deferred tax assets which will generatefuture tax benefits are recognized to the extent that realization of suchbenefits through future taxable earnings or alternative tax strategies in theforeseeable short-term future is more likely than not. A valuation allowance isestablished when necessary to reduce deferred tax assets to the amount expectedto be realized.

 

The Company adopted FASBInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes, an interpretation of FASB Statement No. 109* (FIN48) on January 1, 2007. FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in financial statements and requires the impact of atax position to be recognized in the financial statements if that position ismore likely than not of being sustained by the taxing authority. The adoptionof FIN 48 did not have an effect on our consolidated financial position orresults of operations.  The Company hasapplied the accounting provisions of FIN 48 to its tax positions and determinedthat no uncertain tax positions presently exist.

 

The Company would recordany interest and penalties related to unrecognized tax benefits in income taxexpense.

 

***Salesand Use Taxes***

 

The Company collects andremits taxes on behalf of various state and local tax authorities.  For the year ended 2008, the Companycollected $0.7 million and remitted $0.5 million in taxes.

 

***Reclassifications***

*** ***

Prior-year balances havebeen reclassified to conform to current-year presentation.  The balancesheet includes a reclassification of website development costs that was inother assets to property, plant and equipment.

 

***Recently Issued Accounting Pronouncements***

*** ***

In September 2006,the FASB issued SFAS No. 157,*FairValue Measurements*. SFAS No. 157 defines Fair Value,establishes a framework for measuring Fair Value and expands disclosures aboutFair Value measurements, but does not change existing guidance as to whether ornot an instrument is carried at Fair Value.  In February 2008, theFASB released a FASB Staff Position, which delayed the effective date of SFAS No. 157for all non-financial assets and liabilities, except those that are recognizedor disclosed at fair value in the condensed consolidated financial statementson a recurring basis.

 

The Company adopted SFAS No. 157as of January 1, 2008, which, among other things, requires enhanceddisclosures about financial assets and liabilities that are measured andreported at fair value. SFAS No. 157 establishes a fair value hierarchythat distinguishes between market participant assumptions developed based onmarket data obtained from sources independent of the entity (observable inputs)and the entity’s own assumptions about market participant assumptionsdeveloped based on the best information available in the circumstances(unobservable inputs).

 

The fair value hierarchyin SFAS 157 prioritizes the inputs to valuation techniques used to measure fairvalue into three broad levels, giving the highest priority to Level 1 inputsand the lowest priority to Level 3 inputs. Level 1 inputs to a fair valuemeasurement are quoted market prices (unadjusted) in active markets foridentical assets or liabilities that the reporting entity has the ability toaccess at the measurement date. Level 2 inputs are inputs other than quotedmarket prices included within Level 1 that are observable for the asset orliability, either directly or indirectly. Level 3 inputs are unobservableinputs for the asset or liability.

 

The Company measures itsderivative financial instruments at fair value on a recurring basis. As of December 31,2008, the Company had in place an interest rate swap agreement, which wasentered into on December 1, 2008, to partially hedge the Company’svariable rate debt.

 

The Company has optionsto convert or extend the PDI Promissory Notes which resulted in the creation ofcompound embedded derivatives for which the Company has performed valuations ona regular basis. The Company currently and will continue to mark to market thisderivative for which any changes in fair value are recognized in the statementof operations, in all the subsequent quarters until they are exercised or haveexpired.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Recently Issued Accounting Pronouncements (continued)***

*** ***

In February 2007,the FASB issued SFAS No. 159,*The FairValue Option for Financial Assets and Liabilities*. SFAS No. 159permits all entities to choose to elect to measure eligible financialinstruments at fair value. SFAS No. 159 applies to fiscal years beginningafter November 15, 2007, with early adoption permitted for an entity thathas also elected to apply the provisions of SFAS No. 157. The Companyelected not to adopt the fair value option for valuation of those assets andliabilities which are eligible; therefore, there is no impact on our financialposition or results of operations.

 

In December 2007,the FASB issued SFAS No. 141(R),*Business Combinations—a replacement of FASB Statement No. 141*,which significantly changes the principles and requirements for how theacquirer of a business recognizes and measures in its financial statements theidentifiable assets acquired, the liabilities assumed and any non-controllinginterest in the acquiree. The statement also provides guidance for recognizingand measuring the goodwill acquired in the business combination and determineswhich information to disclose to enable users of the financial statements toevaluate the nature and financial effects of the business combination. Thisstatement is effective prospectively, except for certain retrospectiveadjustments to deferred tax balances, for fiscal years beginning after December 15,2008. We are currently evaluating the impact that SFAS No. 141(R) willhave on our accounting for acquisitions prior to the effective date of thefirst fiscal year beginning after December 31, 2008.

 

In March 2008, theFASB issued SFAS No. 161 *Disclosures aboutDerivative Instruments and Hedging Activities an amendment of FASB Statement No. 133*.The new standard requires additional disclosures regarding a company’sderivative instruments and hedging activities by requiring disclosure of thefair values of derivative instruments and their gains and losses in a tabularformat. It also requires disclosure of derivative features that are creditrisk-related as well as cross-referencing within the notes to the financialstatements to enable financial statement users to locate important informationabout derivative instruments, financial performance and cash flows. Thestandard is effective for our fiscal year and interim periods beginning January 1,2009, with early application encouraged. The principal impact from thisstandard will be to require us to have disclosures regarding our derivativeinstruments that will be held starting in December 2008, pursuant to theterms of the new senior credit facility described below (see Note 24).

 

In April 2008, theFASB issued Staff Position No. FAS 142-3, *Determinationof Useful Life of Intangible Assets* (“FSP FAS 142-3”).  FSP FAS142-3 amends the factors that should be considered in developing renewal orextension assumptions used to determine the useful life of a recognizedintangible asset under FASB Statement No. 142, “Goodwill and OtherIntangible Assets.” FSP FAS 142-3 also requires expanded disclosures related tothe determination of intangible asset useful lives. This standard appliesprospectively to intangible assets acquired and/or recognized on or after January 1,2009. We do not believe that the adoption of this standard will have a materialeffect on our financial condition or results of operations.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

** **

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

In May 2008, theFASB issued FASB Staff Position No. APB 14-1, *Accountingfor Convertible Debt Instruments That May Be Settled in Cash uponConversion (Including Partial Cash Settlement)* (FSP APB 14-1). FSPAPB 14-1 specifies that issuers of convertible debt instruments that may besettled in cash upon conversion (including partial cash settlement) shouldseparately account for the liability and equity components in a manner thatwill reflect the entity’s nonconvertible debt borrowing rate when interest costis recognized in subsequent periods. The amount allocated to the equitycomponent represents a discount to the debt, which is amortized into interestexpense using the effective interest method over the life of the debt. FSP APB14-1 is effective for financial statements issued for fiscal years beginningafter December 15, 2008, and interim periods within those fiscal years.Early adoption is not permitted. Therefore, we expect to adopt the provisionsof FSP APB 14-1 beginning in the first quarter of fiscal 2009. The provisionsof FSP APB 14-1 are required to be applied retrospectively to all periodspresented. Upon retrospective adoption, we anticipate our effective interestrate on our 5.00% Convertible ISI Seller Notes due 2012 will range from 14.0%to 15.0%, which would result in the recognition of a discount to these noteswith the offsetting after tax amount recorded to capital in excess of parvalue. This discount will be accreted until the maturity date at the effectiveinterest rate, which will result in an estimated $0.3 million increase to ourfiscal 2008 interest expense.  The impactto the 2009 interest expense will be minimal as the debt was converted tocommon stock on January 12, 2009. (See Note 24)

 

In June 2008, theFinancial Accounting Standards Board (“FASB”) issued FASB Staff Position (“FSP”)No. EITF 03-6-1,*  Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities*  (“EITF 03-6-1”). EITF 03-6-1 addresseswhether instruments granted in share-based payment transactions areparticipating securities prior to vesting and, therefore, need to be includedin the earnings allocation under the two-class method of calculating earningsper share. EITF 03-6-1, which is applied retrospectively. This regulation iseffective for the Company beginning January 1, 2009. The Company iscurrently evaluating the potential impact of EITF 03-6-1 on its earnings pershare.

 

***Use of Estimates***

*** ***

The preparation offinancial statements in conformity with U.S. GAAP requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements. Actual results coulddiffer from those estimates.

 

Although estimating is acontinuous and normal process for companies in the construction industry,material revisions in estimates of the percentage of completion requiredisclosure under FASB Statement No. 154,*Accounting Changes and Error Corrections*  (“SFAS No 154”). The effect on income fromcontinuing operations, net income and any related per-share amounts of thecurrent period shall be disclosed for a change in estimate that affects futureperiods. Additionally, the Statement requires that, if a change in estimatedoes not have a material effect in the period of change but is reasonablycertain to have a material effect in later periods, a description of thatchange in estimate shall be disclosed whenever the financial statements of theperiod of change are presented.

 

During the year ended December 31,2008, the Company conducted regular reviews and evaluations for the costestimates associated with all of the approximately 1,200 active ConstructionContracts in the Company’s Work—in-Process. Changes in cost estimates come as the result of customer-ordered changeorders, changes in material or labor costs and issues associated with managingthe projects.  As a result of the reviewthe cost estimates for the in-process Construction Contracts (that existed asof year-ended December 31, 2007) increased by a net $6.1 million. Of theaforementioned net estimated cost increases of $6.1 million, 41 contracts hadcost estimate changes of approximately $100,000 or greater resulting in $7.1million of the net increase.  30 of the41 contracts resulted in cost estimate increases totaling $9.5 million while 11contracts had estimated cost decreases totaling $2.4 million.  Approximately 1,150 of the remainingcontracts with variances of less than $100,000 resulted in a net decrease incost estimates of $1.0 million. In a few cases, the reviews resulted in a totalof $46,000 ($0.01 basic and diluted earnings per share) in contract lossaccruals that have been have been included in the Contract Costs in the Statementof Operations for the year ended December 31, 2008.

 

***Contingencies***

*** ***

Certain conditions mayexist as of the date of the consolidated balance sheet, which may result in aloss to the Company but which will only be resolved when one or more futureevents occur or fail to occur. The Company’s management and its legal counselassess such contingent liabilities, and such assessment inherently involves anexercise of judgment. In assessing loss contingencies related to legalproceedings that are pending against the Company or its subsidiaries orunasserted claims that may result in such proceedings, the Company’s legalcounsel evaluates the perceived merits of any legal proceedings or unassertedclaims, as well as the perceived merits of the amount of relief sought orexpected to be sought therein.

 

If the assessment of acontingency indicates that it is probable that a material loss has beenincurred and the amount of the liability can be estimated, then the estimatedliability would be accrued in the Company’s consolidated financial statements.If the assessment indicates that a potentially material loss contingency is notprobable, but is reasonably possible or is probable but cannot be estimated,then the nature of the contingent liability, together with an estimate of therange of possible loss if determinable and material, would be disclosed in thenotes to the consolidated financial statements.

 

Loss contingencies thatare considered remote are generally not disclosed unless they involveguarantees, in which case the guarantees would be disclosed.  As of December 31,2008, the Company did not have any loss contingencies requiring disclosures oraccruals.

 

During the fourth quarterof fiscal year 2008 the management team and a valuation firm began the two-stepvaluation process of analyzing the non-cash, impairment of goodwill andintangible assets.  During the latterpart of the second half of fiscal year 2008 and continuing into December 2008,our market capitalization was below book value. We considered this information,as well as our discount rate and WACC of 14% and overall revenue and operatinggrowth rate assumptions for fiscal years 2009 through 2012.   We considered the market capitalizationdecline in our evaluation of fair value of goodwill and believe the decline tobe primarily attributed to the negative market conditions as a result of thecredit crisis, indications of a possible recession and current issues withinthe overall U.S. and global economy.

 

Our impairment analysiscontains uncertainties due to uncontrollable events that could positively ornegatively impact the anticipated future economic and operatingconditions.  We have not made anymaterial changes in the accounting methodology used to evaluate impairment ofgoodwill and other intangible assets during the last two years.

 

Our fiscal year 2008goodwill and intangible asset impairment analysis resulted in a quarter ended December 31,2008 non-cash charge of $9.7 million in addition to the estimate made for thenine months ended September 30 2008 of $16.9 million.  The total non-cash impairment charges forgoodwill and intangible assets for the year ended December 31, 2008 was$26.6 million.

 

While we believe we havemade reasonable estimates and assumptions to calculate the fair value of thereporting business units and other intangible assets, it is possible a materialchange could occur. If our actual results are not consistent with our estimatesand assumptions used to calculate fair value, we may be required to perform thesecond step again in future periods, which could result in further impairmentsof our remaining goodwill.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note2 — Background, Formation, and Summary of Significant AccountingPolicies (continued)**

** **

***Concentrations of Credit Risk***

*** ***

Financial instrumentsthat potentially expose the Company to concentrations of credit risk, asdefined by SFAS No. 105,*Disclosure ofInformation about Financial Instruments with Off-Balance Sheet Risk andFinancial Instruments with Concentrations of Credit Risk* , consistprimarily of contract receivables.  During the year ended December 31,2008, Revenues from our top three customers (all from Argyle Corrections)represented 27% of total Company revenues, respectively.  During the yearended December 31, 2008, the Company had revenues from our top two customers(all from Argyle Corrections), which represented 19% of total Company revenues.These concentrations are up from the year ended December 31, 2007 but downfrom the year ended December 31, 2006, when the top three customersrepresented 20% and 33% of total Company revenues, respectively.  SeeRelated-Party Transactions footnote (see Note 19) for discussion oftransactions with ISI*MCS, Ltd.

 

***Net Income/(Loss) Per Share***

*** ***

Net income/(loss) pershare (basic) is calculated in accordance with the provisions of SFAS No. 128,*Earnings Per Share*, by dividing netincome/(loss) by the weighted average number of common shares outstandingduring the period. Our convertible preferred stock is considered aparticipating security, because the preferred stockholders are entitled toreceive dividends when dividends are paid to common stockholders. We includethe participating convertible preferred stock in the computation of earningsper share, using the two-class method in accordance with EITF No. 03-06,*  Participating Securities and the Two-Class Methodunder FASB Statement No. 128*. Net income/(loss) per share(diluted) is calculated by adjusting the number of shares of common stockoutstanding using the “treasury stock” method for options and warrants and the“if converted” method for convertible preferred stock and convertible debt, tothe extent the effect of the converted portion on EPS is dilutive. Because weincurred a net loss for all periods, the diluted EPS calculation is the same asthe basic EPS calculation.

 

As of December 31,2008, the Company had granted 220,000 shares of restricted stock, of which106,667 shares have vested.

 

As of the years endedDecember 31, 2008, 2007, and 2006 the shares used to calculate earnings pershare the shown below.

 
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Weighted average  common shares outstanding - basic   |       | 5,797,293                                  |       | 5,187,086 |   | 4,477,861 |   |
| Effect of  convertible securities                     |       | —                                     |       | 1,026,103 |   | — |   |
| Weighted average  common shares outstanding - diluted |       | 5,797,293                                  |       | 6,213,189 |   | 4,477,861 |   |

 

As of December 31, 2008there were 170,000 shares of restricted stock, 192,500 shares of common stockfrom the ISI convertible debt and 18,750 preferred shares outstandingconvertible into a weighted average 1,296,107 common shares that were excludedfrom the earnings per share calculation as they were anti-dilutive.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

** **

**Note3 — Acquisitions**

** **

***Fire Quest***

*** ***

On January 1, 2008,MCFSA, all of the partnership interests of which are directly or indirectlywholly owned by ISI, acquired substantially all of the business assets andliabilities of Fire Quest for a total purchase price of $1.1 million. Thepurchase price was comprised of the following:

 
| Fire Quest  Consideration: |   |   |   |
|----------------------------|--------|--------|--------|
| Cash                       |   | $      | 764    |   |
| Promissory note            |   | 250    |   |
| Transaction  costs         |   | 121    |   |
| Net purchase  price        |   | $      | 1,135  |   |

 

***PDI***

*** ***

On January 4, 2008,ISI acquired substantially all of the business assets and liabilities ofPeterson Detention, Inc. (“PDI”) for a total purchase price of $4.8million. The purchase price was comprised of the following:

 
| PDI  Consideration: |   |   |   |
|---------------------|--------|--------|--------|
| Cash                |   | $      | 1,500  |   |
| Promissory note     |   | 3,000  |   |
| Transaction  costs  |   | 313    |   |
| Net purchase  price |   | $      | 4,813  |   |

 

***Com-Tec***

*** ***

On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI, closed atransaction, pursuant to which ISI-Controls acquired 100% of the outstandingunits of Com-Tec Security, LLC (“Com-Tec”), resulting in Com-Tec becoming awholly owned subsidiary of ISI-Controls. The total purchase price for theCom-Tec acquisition was $6.7 million. The purchase price was comprised of thefollowing:

 
| Com-Tec  Consideration: |   |   |   |
|-------------------------|--------|--------|--------|
| Cash                    |   | $      | 3,000  |   |
| Promissory note         |   | 3,515  | (1)    |
| Transaction  costs      |   | 199    |   |
| Net purchase  price     |   | $      | 6,714  |   |

 

----

(1)   Does not reflect $14,000 adjustment made toprincipal on March 2, 2009.

 

F-24

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

** **

**Note3 — Acquisitions (continued)**

** **

The acquisitions of FireQuest, PDI and Com-Tec were accounted for as business combinations inaccordance with SFAS No. 141.  Under the purchase method ofaccounting, the assets and liabilities acquired were recorded as of theacquisition date at their respective fair values.  We have obtainedthird-party valuations, and the values of certain assets and liabilities arebased on these valuations.  The followingtable summarizes the estimated fair value of assets acquired and liabilitiesassumed at the date of the acquisition, adjusted for the goodwill impairmentcharges recorded during third and fourth quarters of 2008 (in thousands):

 
| ** **                    | ** ** | **Fire Quest** | ** ** | **PDI** | ** ** | **Com-Tec** | ** ** | **Total** | ** ** |
|-------------------------------|------------|---------------------|------------|---------|------------|-------------|------------|-----------|------------|
| Current assets                |       | $                   | 140        |    | $          | 2,162       |       | $         | 4,490      |   | $ | 6,792 |   |
| Property and  equipment       |       | 37                  |       | 1,126   |       | 72          |       | 1,235     |       |
| Goodwill (net of  impairment) |       | —              |       | —  |       | 2,844       |       | 2,844     |       |
| Customer  relationships       |       | 90                  |       | 470     |       | 730         |       | 1,290     |       |
| Customer backlog              |       | 84                  |       | 1,240   |       | 590         |       | 1,914     |       |
| Trade name                    |       | —              |       | —  |       | 1,080       |       | 1,080     |       |
| Software                      |       | —              |       | —  |       | 240         |       | 240       |       |
| Non-compete  agreements       |       | 70                  |       | 200     |       | 180         |       | 450       |       |
| Total assets  acquired        |       | 421                 |       | 5,198   |       | 10,226      |       | 15,845    |       |
|                          |       |                |       |    |       |        |       |      |       |
| Current  liabilities          |       | (19                 | )          | (755    | )          | (2,652      | )          | (3,426    | )          |
| Debt                          |       | —              |       | (1,110  | )          | (860        | )          | (1,970    | )          |
| Total  liabilities assumed    |       | (19                 | )          | (1,865  | )          | (3,512      | )          | (5,396    | )          |
|                          |       |                |       |    |       |        |       |      |       |
| Carrying value                |       | $                   | 402        |    | $          | 3,333       |       | $         | 6,714      |   | $ | 10,449 |   |
| Goodwill  impairment          |       | 733                 |       | 1,480   |       | —      |       | 2,478     |       |
| Net purchase  price           |       | $                   | 1,135      |    | $          | 4,813       |       | $         | 6,714      |   | $ | 12,662 |   |

 

As of December 31,2008, all final adjustments for Fire Quest, PDI and Com-Tec have been includedin the financial statements and no further adjustments will be made.  All remaining goodwill is deductible for taxpurposes.  See Note 2 regarding thenon-cash goodwill impairment charge and Note 7 regarding other intangiblesimpairment.

 

**Note4 — Contract Receivables**

** **

Contract receivablesconsist of the following (in thousands):

** **
| ** **                                                        | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2008**              | ** ** | **2007**              | ** ** |
| Completed  contracts and contracts in progress (net of allowance) |       | $                     | 24,494     |                  | $          | 12,126 |   |
| Retainage                                                         |       | 4,321                 |       | 2,333                 |       |
| Completed  contracts and contracts in progress - related parties  |       | 2,938                 |       | 8,468                 |       |
| Retainage -  related parties                                      |       | 1,747                 |       | 2,419                 |       |
| Contract  receivables                                             |       | $                     | 33,500     |                  | $          | 25,346 |   |

 

F-25

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

** **

**Note5 — Costs and Estimated Earnings on Incomplete Contracts and BacklogInformation**

** **

Costs and estimatedearnings on incomplete contracts and backlog information are as follows (inthousands):

 
| ** **                                                                  | ** ** | **Total**             | ** ** | **Corrections**       | ** ** | **Commercial**        | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                  | ** ** | **2008**              | ** ** | **2008**              | ** ** | **2008**              | ** ** |
| Amended contract  amount                                                    |       | $                     | 310,588    |                  | $          | 237,456               |       | $ | 73,132 |   |
| Revenues  recognized to date                                                |       | 237,126               |       | 178,388               |       | 58,738                |       |
| Unearned  contract amount - backlog                                         |       | $                     | 73,462     |                  | $          | 59,068                |       | $ | 14,394 |   |
| Costs incurred  to date                                                     |       | $                     | 196,576    |                  | $          | 151,107               |       | $ | 45,469 |   |
| Estimated costs  to complete                                                |       | 60,737                |       | 48,923                |       | 11,814                |       |
| Estimated total  cost                                                       |       | $                     | 257,313    |                  | $          | 200,030               |       | $ | 57,283 |   |
| Billings to date                                                            |       | $                     | 238,450    |                  | $          | 179,999               |       | $ | 58,451 |   |
| Costs and  estimated earnings in excess of billings on incomplete contracts |       | $                     | 6,475      |                  | $          | 4,277                 |       | $ | 2,198 |   |
| Billing in  excess of costs and estimated earnings on incomplete contracts  |       | $                     | 7,633      |                  | $          | 5,605                 |       | $ | 2,028 |   |

 
| ** **                                                                  | ** ** | **Total**             | ** ** | **Corrections**       | ** ** | **Commercial**        | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                  | ** ** | **2007**              | ** ** | **2007**              | ** ** | **2007**              | ** ** |
| Amended contract  amount                                                    |       | $                     | 196,030    |                  | $          | 147,996               |       | $ | 48,034 |   |
| Revenues  recognized to date                                                |       | 109,179               |       | 72,978                |       | 36,201                |       |
| Unearned  contract amount - backlog                                         |       | $                     | 86,851     |                  | $          | 75,018                |       | $ | 11,833 |   |
| Costs incurred  to date                                                     |       | $                     | 89,863     |                  | $          | 60,583                |       | $ | 29,280 |   |
| Estimated costs  to complete                                                |       | 70,496                |       | 61,364                |       | 9,132                 |       |
| Estimated total  cost                                                       |       | $                     | 160,359    |                  | $          | 121,947               |       | $ | 38,412 |   |
| Billings to date                                                            |       | $                     | 109,658    |                  | $          | 72,372                |       | $ | 37,286 |   |
| Costs and  estimated earnings in excess of billings on incomplete contracts |       | $                     | 7,665      |                  | $          | 5,751                 |       | $ | 1,914 |   |
| Billing in  excess of costs and estimated earnings on incomplete contracts  |       | $                     | 5,733      |                  | $          | 3,217                 |       | $ | 2,517 |   |

 

----

* Backlog associated withPDI is not included in the table above for Total Company and CorrectionsSegment, as the associated Revenues are not accounted for under the Percentageof Completion Method as defined in SOP 81-1.

 

Backlog is the result ofthe aggregate contract amount less revenues recognized to date usingpercentage-of-completion accounting (as described in Note 2 of theseconsolidated financial statements). The Company recognizes as backlog onlythose contracts for which it has received signed contracts and executed lettersof intent to award a contract from its customers.  As of the year ended December 31,2008 backlog from 31 letters of intent amounted to $23.2 million. The Companyalso verifies that funding is in place on the contracts prior to inclusion inbacklog.

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note 6 —Property and Equipment**

 

Property and equipmentconsists of the following (in thousands):

 
| ** **                         | ** ** | **Estimated**         | ** ** | ** **            | ** ** | ** ** | ** ** |
|------------------------------------|------------|-----------------------|------------|-----------------------|------------|------------|------------|
| ** **                         | ** ** | **Useful Lives** | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **In Years**     | ** ** | **2008**              | ** ** | **2007**   | ** ** |
| Buildings                          |       | 10 - 40               |       | $                     | 3,622      |       | $          | 1,888 |   |
| Leasehold  improvements            |       | 7 - 12                |       | 1,408                 |       | 593        |       |
| Furniture,  fixtures and equipment |       | 3 - 10                |       | 3,816                 |       | 1,254      |       |
| Vehicles                           |       | 3 - 7                 |       | 2,962                 |       | 2,189      |       |
| Website costs                      |       | 3                     |       | 59                    |       | 39         |       |
|                               |       |                  |       | 11,867                |       | 5,963      |       |
| Less -  accumulated depreciation   |       |                  |       | 2,834                 |       | 736        |       |
| Property and  equipment, net       |       |                  |       | $                     | 9,033      |       | $          | 5,227 |   |

 

Depreciation expenserelating to property and equipment was $2.1 million and $0.7 million for yearsended December 31, 2008 and 2007, respectively. Depreciation expense was$0.5 million and $0.6 million for the Predecessor (ISI) for seven months ended July 31,2007 and year ended December 31, 2006.

 

**Note 7 —Intangible Assets and Other Assets**

 

At December 31,2008, intangible assets consisted of the following (in thousands):

 
| ** **                                | ** ** | **Gross Carrying** | ** ** | ** **     | ** ** | ** **         | ** ** | ** **       | ** ** | ** **       | ** ** | ** **              | ** ** |
|-------------------------------------------|------------|--------------------|------------|----------------|------------|--------------------|------------|------------------|------------|------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **Amount Before**  | ** ** | **Impairment** | ** ** | **Gross Carrying** | ** ** | **Accumulated**  | ** ** | **Net Carrying** | ** ** | **Weighted Average**    | ** ** |
| **Amortizable Intangible Assets:**        | ** ** | **Impairment**     | ** ** | **Charges**    | ** ** | **Amount**         | ** ** | **Amortization** | ** ** | **Amount**       | ** ** | **Amortization Period** | ** ** |
| Customer  relationships                   |       | $                  | 12,916     |           | $          | 1,864              |       | $                | 11,052     |             | $          | 1,883                   |       | $ | 9,169 |   | 113 months |   |
| Customer backlog                          |       | 6,273              |       | —         |       | 6,273              |       | 6,089            |       | 184              |       | 15 months               |       |
| Software                                  |       | 540                |       | —         |       | 540                |       | 215              |       | 325              |       | 36 months               |       |
| Non-compete                               |       | 451                |       | 141            |       | 310                |       | 173              |       | 137              |       | 30 months               |       |
|                                      |       | $                  | 20,180     |           | $          | 2,005              |       | $                | 18,175     |             | $          | 8,360                   |       | $ | 9,815 |   |   |   |
| **Unamortizable  Intangible Assets****:** |       |               |       |           |       |               |       |             |       |             |       |                    |       |
| Trade name                                |       | $                  | 4,856      |           | $          | 2,376              |       | $                | 2,480      |             | $          | —                  |       | $ | 2,480 |   |   |   |

 

At December 31,2007, intangible assets consisted of the following (in thousands):

 
| ** **                                   | ** ** | **Gross Carrying** | ** ** | ** **     | ** ** | ** **              | ** ** | ** **       | ** ** | ** **            | ** ** | ** **                   | ** ** |
|----------------------------------------------|------------|-------------------------|------------|----------------|------------|-------------------------|------------|------------------|------------|-----------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **Amount Before**  | ** ** | **Impairment** | ** ** | **Gross Carrying** | ** ** | **Accumulated**  | ** ** | **Net Carrying** | ** ** | **Weighted Average**    | ** ** |
| ** **                                   | ** ** | **Impairment**          | ** ** | **Charges**    | ** ** | **Amount**              | ** ** | **Amortization** | ** ** | **Amount**            | ** ** | **Amortization Period** | ** ** |
| **Amortizable Intangible Assets:** |       |                    |       |           |       |                    |       |             |       |                  |       |                         |       |
| Customer  relationships                      |       | $                       | 11,625     |           | $          | —                  |       | $                | 11,625     |                  | $          | 513                          |       | $ | 11,112 |   | 114 months |   |
| Customer backlog                             |       | 4,359                   |       | —         |       | 4,359                   |       | 1,400            |       | 2,959                 |       | 16 months                    |       |
| Software                                     |       | 300                     |       | —         |       | 300                     |       | 42               |       | 258                   |       | 36 months                    |       |
| Non-compete                                  |       | —                  |       | —         |       | —                  |       | —           |       | —                |       | N/A                          |       |
|                                         |       | $                       | 16,284     |           | $          | —                  |       | $                | 16,284     |                  | $          | 1,955                        |       | $ | 14,329 |   |   |   |
| **Unamortizable  Intangible Assets:**        |       |                    |       |           |       |                    |       |             |       |                  |       |                         |       |
| Trade name                                   |       | $                       | 3,776      |           | $          | —                  |       | $                | 3,776      |                  | $          | —                       |       | $ | 3,776 |   |   |   |

 

Amortization expense was$6.4 million and $2.0 million for the years ended December 31, 2008 and2007, respectively.  As of December 31,2008 and 2007, intangible assets not subject to amortization included tradenames of $2.5 million and $3.8 million, respectively.

 

Estimated amortizationexpense for the next five years and thereafter is as follows (in thousands):

 
| **Years ending December 31:** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2009                                         |       | $          | 1,546      |   |
| 2010                                         |       | 1,278      |       |
| 2011                                         |       | 1,099      |       |
| 2012                                         |       | 1,092      |       |
| 2013                                         |       | 1,092      |       |
| Thereafter                                   |       | 3,708      |       |
|                                         |       | $          | 9,815      |   |

 

F-27

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note8 — Long-Term Debt**

 

Notes payable andlong-term debt consist of the following (in thousands):

 
| ** **                                 | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|
| **Collateral**                             | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Notes payable:                             |       |                  |       |   |   |
| Vehicles and  equipment                    |       | $                     | 418        |   | $ | 190 |   |
| Unsecured debt -  related party            |       | 11,393                |       | 5,952 |   |
| Unsecured  convertible debt - stockholders |       | 1,925                 |       | 1,925 |   |
| Seller notes                               |       | 6,106                 |       | — |   |
| Line of credit  and senior term debt       |       | 12,951                |       | 7,979 |   |
|                                       |       | $                     | 32,793     |   | $ | 16,046 |   |
| Less - current  maturities                 |       | 3,235                 |       | 81 |   |
| Long term debt                             |       | $                     | 29,558     |   | $ | 15,965 |   |

 

***Vehicles and Equipment***

 

Amounts attributed tovehicles and equipment in the above table include notes in favor of The FrostNational Bank related to vehicles and various equipment lines. Vehicle andequipment notes are staggered with regard to their maturities, each amortizingover 36 — 48 month periods.  Interest rates on the individualnotes range from prime plus 1.0% to a fixed rate of 9.6%. The weighted averageinterest rate for these borrowings was 9.4% and 8.2% at December 31, 2008and December 31, 2007, respectively. Argyle has agreed to guarantee the obligations of ISI under the notes upto $1 million.

 

***Unsecured Debt — Related Parties***

 

On January 2, 2008an additional $5.0 million in unsecured debt was funded by the same relatedparty for which $6.0 million was outstanding at December 31, 2007. All notes are unsecured and subordinated to the line of credit facility. Theunsecured note agreements contain prepayment options with prepayment penalties.Interest on the additional $5.0 million of debt accrues at 11.58% per annum andis payable quarterly in arrears, deferred interest at the rate of 8.42% perannum, and default interest of an additional 2% per annum. The total debt of$11.0 million plus accrued and unpaid interest is due and payable in one singlepayment on January 31, 2011. Argyle has agreed to guarantee the payment ofup to $5.0 million of the outstanding unsecured debt. There are both financialand restrictive covenants associated with the note agreements.  As of December 31,2008, the Company was in compliance or had received a waiver of non-compliancewith all covenants. In addition, the Company modified future covenants (SeeNote 24), and expects to be in compliance with the modified covenants for thenext year.

 

On October 28, 2008,the Board approved the Company’s providing guarantees to ISI and itssubsidiaries as an alternative to bonding, in an aggregate amount of up to$15.0 million, in order to allow us the ability to bid projects withoutobtaining bonding.

 

***Unsecured Convertible Debt — Stockholders***

 

As part of the mergerconsideration paid to acquire ISI, we issued unsecured convertible debt to thestockholders of ISI in the amount of $1.9 million, at a rate of interest of 5%per annum, paid semiannually. The notes were able to be converted in whole orin part into shares of the Company’s common stock at the election of the noteholder at a share price of $10.00 any time after January 1, 2008 orredeemed at the same price by the Company after January 1, 2009. On January 12,2009, the notes were redeemed in full by the Company at $10.00 per share for anaggregate of 192,763 shares of common stock.

 

In April 2007, ourofficers and directors, an affiliate of our Executive Chairman and ChiefExecutive Officer, and certain of our consultants, pursuant to a note andwarrant acquisition agreement, loaned us an aggregate of $300,000 and, inexchange, received promissory notes in the aggregate principal amount of$300,000 and warrants to purchase an aggregate of up to 37,500 shares of commonstock. The warrants are exercisable at $5.50 per share of common stock andexpire on January 24, 2011. The warrants also may be exercised on anet-share basis by the holders of the warrants. We have estimated, based upon aBlack-Scholes model, that the fair value of the warrants on the date of issuewas approximately $2.48 per warrant (a total value of approximately $93,000,using an expected life of two years, volatility of 2.39% and a risk-free rateof 5%). However, because the warrants have a limited trading history, thevolatility assumption was based on information then available to management. Thepromissory notes had an interest at a rate of 4% per year and were repayable 30days after the consummation of a business combination. The notes and theassociated accrued interest were paid in full in August 2007.

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note8 — Long-Term Debt (continued)**

 

***Seller Notes***

 

In connection with thePDI acquisition, ISI issued convertible promissory notes (the “PDI PromissoryNotes”) in the aggregate principal amount of $3.0 million. The aggregateprincipal amount of the PDI Promissory Notes may be reduced, depending on theoccurrence of certain events described in the Asset Purchase Agreement. Thepayment of the PDI Promissory Notes is guaranteed by and secured by the assetsof ISI and its subsidiaries, and they bear interest at 6% paid quarterlythrough December 2009.  Argyle provided a guaranty of payment andperformance of ISI’s obligations under the PDI Promissory Notes. After December 2009,principal and interest payments of $133,000 are due monthly with final paymentoccurring on December 31, 2012.  From June 1, 2009 through November 15,2009, we have the option to (i) convert $500,000 of the outstandingprincipal into common stock of Argyle based on 95% of the closing price of thecommon stock for a 20-day trading period preceding notice of the Company’sintent to convert; or (ii) extend the $500,000 principal due in 2010 to January 3,2011 for an additional payment of $15,000 plus accrued interest.  Theaforementioned options to convert or extend the PDI Promissory Notes resultedin the creation of compound embedded derivatives for which the Company hasperformed valuations at the end of each fiscal quarter.  The Company willmark to market the derivatives, for which any changes in fair value will berecognized in the statement of operations, in all the subsequent quarters untilthey are exercised or have expired.  The valuation of these derivativesheld a value of $23,000 as of December 31, 2008.

 

 

In connection with theCom-Tec acquisition, ISI issued a secured subordinated promissory note in theaggregate principal amount of $3.5 million (the “Com-Tec Promissory Note”). TheCom-Tec Promissory Note is guaranteed by and secured by the assets of ISI andits subsidiaries, bears interest at 7% per year and have a maturity date of April 1,2011.  Argyle provided a guaranty of payment and performance of ISI’sobligations under the Com-Tec Promissory Note. Interest only payments were madefor each three-month period beginning on May 2008 and August 2008; a single principal payment of $100,000 was due and paid on December 15,2008; and level principal and interest payments in the cumulative amount of$128,058 are due monthly beginning on August 1, 2008 and continuingmonthly thereafter on the first day of each month for consecutive monthsthrough December 2008; then level principal and interest payments in thecumulative amount of $123,748 due monthly beginning on January 1, 2009,and continuing monthly thereafter on the first day of each month through December 2009,then for 25 consecutive months until the maturity date. On March 2, 2009, theprincipal of the Com-Tec Promissory Note was reduced to $3,491,290.80 as aresult of adjustments made because of uncollected accounts receivable.

 

In connection with theFire Quest acquisition, the Company issued a promissory note in the aggregateprincipal amount of $250,000 (the “Fire Quest Promissory Note”). The Fire QuestPromissory Note, was guaranteed by and secured by the assets of ISI and itssubsidiaries and bears interest at the rate of 7.25% per year and became dueand payable on January 1, 2009. Argyle had provided a guaranty ofpayment and performance of ISI’s obligations under the Fire Quest PromissoryNote.  The Company has paid quarterlypayments of accrued and unpaid interest of $4,531.25 until the maturity dateand made a final payment on the maturity date equal to the unpaid principalamount together with any then unpaid and accrued interest and other amountspayable thereunder. As a result, the Fire Quest Promissory Note is no longer anoutstanding obligation of ISI or its subsidiaries.

 

Collectively, the FireQuest Promissory Note, the PDI Promissory Notes and the Com-Tec Promissory Noteare hereinafter collectively referred to as the “Seller Notes”.

 

***Senior Secured Credit Facility***

 

At December 31 2008,ISI had a line of credit facility for (i) a secured revolving line ofcredit in the maximum amount of $10.0 million with a $5.0 million sublimit forthe issuance of letters of credit, (ii) a secured revolving line of creditin the maximum amount of $5.0 million, to be used solely for the issuance ofletters of credit and (iii) a term loan in the maximum amount of $10.0million (collectively, the “Loans”).  The Loans have a three-year maturityand, upon closing, the proceeds were used to pay off existing indebtedness,with the remaining availability to be used for working capital and othergeneral corporate purposes. The Loans are secured by liens on and securityinterests in the personal property of ISI and guaranteed by the subsidiaries ofISI.

 

The interest rates of theLoans are, at ISI’s option from time to time, (i) a floating per annumrate of interest equal to the prime rate plus the Applicable Margin, or (ii) theLIBOR Rate plus the Applicable Margin. The “Applicable Margin” means the rateper annum added to the prime rate and LIBOR as determined by the ratio of totaldebt to EBITDA of ISI and its subsidiaries for the prior fiscal quarter. Theweighted average interest rate for these borrowings was 5.9% and 6.9% at December 31,2008 and December 31, 2007, respectively. The intercompany loan, with a principal amount of $2.0 million advancedon September 30, 2008 at an interest rate of 5%, was repaid in full uponthe closing of the Loans with the Bank on October 3, 2008.

 

In connection with theLoans, the holders of each Seller Note agreed to be subordinated to the lenderwith respect to payment and perfection. In addition, the maturity dates of eachSeller Note was effectively extended to be no earlier than the date on whichall of the outstanding obligations of ISI to repay the outstanding principaland accrued and unpaid interest relating to the Loans are satisfied.

 

The agreement containsboth financial and restrictive covenants, including a restriction on thepayment of dividends by ISI. Under the terms of the credit facility, enteredinto as of October 3, 2008, the Company is indebted for $9.5 million interm debt and $3.5 million through the line of credit.  As of December 31,2008, the Company was in compliance or had received a waiver of non-compliancewith all covenants. In addition, the Company modified future covenants (seeNote 24), and expects to be in compliance with the modified covenants for thenext year.

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note8 — Long-Term Debt (continued)**

 

Aggregate maturitiesrequired on all debt at December 31, 2008 are as follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2009                                        |       | $          | 3,235      |   |
| 2010                                        |       | 4,936      |       |
| 2011                                        |       | 24,485     |       |
| 2012                                        |       | 66         |       |
| 2013                                        |       | 71         |       |
| Thereafter                                  |       | —     |       |
|                                        |       | $          | 32,793     |   |

 

As a result of a reviewof anticipated capital expenditures for the remainder of the 2008 fiscal year,on November 12, 2008, the Company discovered that it was in excess of thelimit of $2.5 million provided for in its loan agreement with its subordinateddebt lender and, accordingly, on November 12, 2008, the Company requestedand received a waiver to increase the limit to $3 million in exchange for a$25,000 fee.   As of December 31,2008, the Company was in compliance with or had received waiver of compliancewith of all the loan covenants.

 

On January 8, 2009,ISI amended certain covenants related to the senior line of credit facility andits subordinated debt, among other amendments. In connection with the amendment of the senior line of credit facility,Argyle agreed to provide a guaranty of the obligations of ISI under thefacility (See Note 24 for a summary of the amended terms.).

 

***InterestRate Risk Management***

 

The Company usesderivative instruments to protect against the risk of changes in prevailinginterest rates adversely affecting future cash flows associated with changes inthe London Inter-bank Offer Rate (“LIBOR”) applicable to its variable rate debtdiscussed above. The Company utilizes interest rate swap agreement to convert aportion of the variable rate debt to a fixed rate obligation. The Companyaccounts for its interest rate swaps in accordance with SFAS No. 133, *Accounting for Derivative Instruments and Hedging Activities*.

 

During the fourth quarterof 2008, the Company entered into a US dollar amortizing interest rate swapagreement, which became effective on December 1, 2008, with a notionalamount starting at $10.0 million. The notional amount of the swap is set todecrease periodically as set forth in the swap agreement. The Company presentsthe fair value of the interest rate swap agreement at the end of the period inother long-term liabilities, as applicable, on its consolidated balance sheet.

 

At December 31,2008, the interest rate swap had a fair value (net of taxes) of approximately ($116,000).During the year ended December 31, 2008, the Company recognized interest(expense) income from hedging activities relating to interest rate swaps of ($3,062).There were no ineffective amounts recognized during the period ended December 31,2008, and the Company does not expect the hedging activities to result in anineffectiveness being recognized in the earnings.

 

At December 31,2008, accumulated other comprehensive income included a deferred pre-tax netloss of $188,000 related to the interest rate swap. For the year ended December 31,2008, the Company did not reclassify any pre-tax expense into interest expensefrom accumulated other comprehensive income as adjustments to interest paymentson variable rate debt.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note9 — Capital Leases**

 

ISI sold itsowner-occupied real estate to a partnership owned by ISI’s stockholders during2004 and entered into a leaseback of the properties with the partnership. ISIentered into a second lease on another property owned by the same partnershipin 2006. ISI entered into a third lease on another property owned by the samepartnership in June 2008.  All three leases are triple net leases. Atriple net lease is a lease agreement on a property whereby the tenant orlessee agrees to pay all real estate taxes, building insurance and maintenance(the three ‘Nets’) on the property in addition to any normal fees that areexpected under the agreement (rent, etc.). In such a lease, the tenant orlessee is responsible for all costs associated with repairs or replacement ofthe structural building elements of the property.

 

The terms of theaforementioned leases were modified on July 31, 2007 to extend theexpiration date from 2018 to 2019. The modification did not materially affectthe carrying value of the assets or related liabilities recorded in theaccompanying consolidated balance sheet.

 

In December 1, 2008,the Company entered into a 36-month capital lease totaling $64,000 forTele-Trac equipment to be installed in its fleet of service vehicles to enablemanagement to better monitor and manage productivity for the installation andfield-service workforce.

 

The following is asummary of leased property, included in property and equipment, in theaccompanying consolidated financial statements (in thousands):

 
| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| **Collateral**                     | ** ** | **2008**              | ** ** | **2007** | ** ** |
| Buildings                          |       | $                     | 3,622      |   | $ | 1,888 |   |
| Furniture,  fixtures and equipment |       | $                     | 64         |   | — |   |
| Less -  accumulated depreciation   |       | 323                   |       | 69 |   |
| Net                                |       | $                     | 3,363      |   | $ | 1,819 |   |

 

The following is aschedule by years of future minimum lease payments under capital leases,together with the present value of net minimum lease payments at December 31,2008 (in thousands):

 
| **Year Ending December 31:**                       | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|
| 2009                                                              |       | $          | 516        |   |
| 2010                                                              |       | 516        |       |
| 2011                                                              |       | 514        |       |
| 2012                                                              |       | 493        |       |
| 2013                                                              |       | 493        |       |
| Thereafter                                                        |       | 2,845      |       |
| Future minimum  lease payments                                    |       | $          | 5,377      |   |
| Less - amount of  minimum lease payments attributable to interest |       | 1,749      |       |
| Present value of  net minimum lease payments                      |       | $          | 3,628      |   |
| Current portion  of capitalized lease obligations                 |       | 239        |       |
| Long-term  portion of capitalized lease obligations               |       | 3,389      |       |
|                                                              |       | $          | 3,628      |   |

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note10 — Commitments**

 

The Company leases officespace and equipment under operating leases expiring through 2012.  The corporate office lease space in San Antonio, TX expired as of July 31,2007, and the Company operated under a month-to-month lease arrangement untilit was renewed in January 2008.  The new lease expanded the spacefrom approximately 2,500 square feet to 5,500 square feet for a total expensein 2008 of $121,000. The lease expires in January 2013.

 

As part of theacquisition of PDI on January 4, 2008, ISI assumed PDI’s existing leasesin California and Arizona.  On September 5, 2008, ISI entered into alease relating to approximately 29,709 square feet of property located at 577and 583 North Batavia Street, Orange, California. The term of the new lease isfor two years commencing September 1, 2008 and ending August 31,2010. The aggregate monthly base rent is $16,934.  In connection withthe lease, on September 5, 2008, Argyle entered into a guaranty pursuantto which Argyle has agreed to guarantee the payment and performance obligationsof ISI under the lease. The PDI lease in Arizona is a four-year lease. Thethree facilities occupy a total of 55,709 square feet (26,000-square footfacility in Arizona and the 29,709-square foot facilities in California) withaggregate monthly payments of $32,934.

 

As part of the Com-Tecacquisition that occurred at January 31, 2008, ISI signed a new lease forthe existing facility.  The Com-Tec lease is a five year lease, for the33,000-square foot facility, with aggregate monthly payments of $14,000beginning in year three with the total rent expense being recognized on astraight-line basis over the life of the lease.

 

Rental expense was $1.2million and $193,000 for the years ended December 31, 2008 and 2007,respectively.  Total deferred rent as reflected on the Statement of FinancialCondition as of December 31, 2008 amounted to $112,000. Rental expense was$266,000 for the seven months ended July 31, 2007 and 190,000 for the yearended December 31, 2006 (Predecessor).

 

Minimum rentalcommitments at December 31, 2008 are as follows (in thousands):

 
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|
| 2009                                        |       | $          | 895        |   |
| 2010                                        |       | 878        |       |
| 2011                                        |       | 728        |       |
| 2012                                        |       | 615        |       |
| 2013                                        |       | 323        |       |
| Thereafter                                  |       | 106        |       |
| Total commitment  outstanding               |       | $          | 3,545      |   |

 

In August 2007, weentered into a letter of credit facility with a financial institution. Theletter of credit may not exceed $500,000. The facility requires a 1% annualcommitment fee on the unused portion of the letter of credit facility and ispaid quarterly.

 

In May 2008, weentered into a letter of credit facility with a financial institutioncollateralized by $2.5 million of restricted cash for bonding. The letter ofcredit may not exceed $2.5 million. The facility does not have a fee on theunused portion of the letter of credit facility.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note11 — Self Insurance**

 

ISI, PDI and Com-Tec areself-insured to certain limits under their respective group health and dentalplans. Stop-loss coverage is provided for claims above $75,000 per employee upto a lifetime maximum of $3 million for ISI and above $30,000 per employee upto a maximum of $2.0 million for Com-Tec. Operations are charged with the costof claims reported and an estimate of claims incurred but not reported based onprior experience. The determination of such claims and expenses and theappropriateness of the related liability are continually reviewed and updated.Total claims payable and claims incurred but not reported were $399,000 at December 31,2008 and $300,000 at December 31, 2007. ISI has had one individual who hasmet the stop-loss limit of $75,000 for 2008. Com-Tec has not had anyone meet thestop-loss limit for 2008.

 

**Note12 — Derivative Instruments**

 

TheCompany adopted the provisions of SFAS No. 157, effective January 1,2008, for financial assets and liabilities. SFAS No. 157 defines fair value, thereby eliminatinginconsistencies in guidance found in various prior accounting pronouncements,and increases disclosures surrounding fair value calculations.

 

SFAS No. 157establishes a three-tiered fair value hierarchy that prioritizes inputs tovaluation techniques used in fair value calculations. The three levels ofinputs are defined as follows:

 

Level 1 —unadjusted quoted prices for identical assets or liabilities in active marketsaccessible by the Company

 

Level 2 —inputs that are observable in the marketplace other than those inputs classifiedas Level 1

 

Level 3 —inputs that are unobservable in the marketplace and significant to thevaluation

 

SFAS No. 157requires the Company to maximize the use of observable inputs and minimize theuse of unobservable inputs. If a financial instrument uses inputs that fall indifferent levels of the hierarchy, the instrument will be categorized basedupon the lowest level of input that is significant to the fair valuecalculation.

 

**FairValue measurement as of December 31, 2008**

 
| ** **                                                                                  | ** ** | **Significant Other** | ** ** |
|---------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                  | ** ** | **Observable Inputs** | ** ** |
| **($ in thousands)**                                                              | ** ** | **(Level 2)**         | ** ** |
| **Liability**                                                                               |       |                       |       |
|                                                                                        |       |                       |       |
| Interest Rate  Swap (included in Derivative, deferred rent and other long-term liabilities) |       | $                          | 116        |   |
|                                                                                             |            |                            |            |  |

** **

**Note13 — Pre-initial Public Offering Financing and Public Offering**

 

***Public Offering***

 

In January 2006,Argyle sold 3,700,046 units (which included 75,046 units sold by theunderwriters pursuant to a partial exercise of their over-allotment option) tothe public at a price of $8.00 per unit. Each unit consists of one share of theCompany’s common stock, $0.0001 par value, and one redeemable common stockpurchase warrant (warrant). Each warrant entitles the holder to purchase fromthe Company one share of common stock at an exercise price of $5.50 until theirexpiration date of January 24, 2011. The warrants are redeemable by theCompany at a price of $.01 per warrant upon 30 days’ notice, but only in theevent that the last sale price of the common stock is at least $11.50 per sharefor any 20 trading days within a 30-trading-day period ending three businessdays before a notice of redemption is delivered.

 

***Private Placement***

 

In January 2006,Argyle sold to its officers an aggregate of 125,000 units identical to theunits sold in the Public Offering at a price of $8.00 per unit.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note14 — Common Stock Reserved for Issuance**

 

As of December 31,2008, 4,185,046 shares of common stock were reserved for issuance upon exerciseof redeemable warrants and options, 375,000 shares of common stock werereserved for issuance pursuant to the underwriters’ unit purchase optiondescribed in Note 17, and 1,875,000 shares of common stock were reserved forissuance pursuant to the preferred stock conversion option described in Note16. This includes the warrants that were issued in connection with the April 2007notes to stockholders which entitled the holder to exercise the warrants for atotal of 37,500 shares of stock. In 2007, the Company granted certain employeesincentive stock options (ISOs) and non-qualified stock options entitling theholders to exercise options for a total of 125,000 shares of stock and 130,000shares of restricted stock (see Note 18). In 2008, the Company granted certainemployees incentive stock options (ISOs) and non-qualified stock optionsentitling the holders to exercise options for a total of 100,000 shares ofstock and 90,000 shares of restricted stock (see Note 18). Lastly, in April 2008,the Company issued warrants for a total of up to 112,500 shares of stockexercisable at $8.00 per share to Rodman & Renshaw as partialconsideration in connection with the $15.0 million Preferred Stock issuancecompleted in April 2008 (see Note 16).

 

**Note15 — Redemptive Status of Common Stock**

 

The registrationstatement for Argyle’s initial public offering indicated that, after signing adefinitive agreement for the acquisition of a target business, Argyle wouldsubmit such transaction for stockholder approval. Based on the votes submitted,211,965 shares voted against the proposed ISI business combination and soughtto be redeemed for cash. As a result, $1.7 million of net proceeds from theinitial public offering (which included interest) was redeemed to stockholdersin August 2007. The 211,965 shares of common stock were cancelled as of August 2007.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note16 — Preferred Stock**

 

The Company is authorizedto issue 1,000,000 shares of preferred stock with such designations, voting,and other rights and preferences, as may be determined from time to time by theBoard of Directors. 18,750 shares of preferred stock were issued andoutstanding as of December 31, 2008.

 

In April 2008, theCompany issued 18,750 shares of $0.0001 par value Series A ConvertiblePreferred Stock pursuant to a $15.0 million private placement. Each share ofthe Series A Convertible Preferred Stock accrues dividends at a rategreater of the declared dividend of the Company’s common stock, or 3% perannum.  Such shares are convertible into100 shares of the Company’s common stock at any time at the option of theholder at a conversion price of $8.00 per share.  Upon liquidation(voluntary or otherwise), dissolution, winding up or a change of control of theCompany (to the extent approved by the Company’s Board of Directors), holdersof the Series A Preferred Stock will be entitled to receive, from theassets of the Company available for distribution, the greater of the originalissue price plus accrued but unpaid dividends or the amount the holder wouldreceive if all the Series A Preferred Stock were converted into shares ofCommon Stock.  Series A Convertible Preferred Stock holders have novoting rights.

 

**Note17 — Agreement with Underwriters**

 

In March 2007, theunderwriters of the Public Offering agreed to forfeit any and all rights orclaims to a pro rata portion of the deferred underwriting costs and associatedaccrued interest with respect to any shares of common stock that are redeemedin connection with the proposed acquisition. This fee was charged againstadditional paid-in capital and was payable upon a successful businesscombination. Based on the redemption of 211,965 shares, $80,000 related to thesewaived underwriter fees were paid to redemptive stockholders. Upon closing ofthe purchase of ISI, Argyle paid approximately $1.4 million for servicesperformed related to the Public Offering.

 

**Note18 — Stockholders’ Equity and Stock-Based Compensation**

 

On January 1, 2006,the Company adopted SFAS No. 123 (revised 2004),*Share Based Payment*. SFAS No. 123(R) requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values.Following is a description of the various grants made and the impact on thefinancial statements.

 

***2005 — 2006 Options***

 

In July 2005, Argylegranted to its officers, directors, and their respective affiliates certainoptions, which were exercisable only in the event the underwriters exercisedthe over-allotment option, to purchase that number of shares enabling them tomaintain their 20% ownership interest in the Company (without taking intoaccount the units they purchased in the private placement). The measurementdate was deemed to be January 30, 2006, the date the over-allotment wasexercised because the number of options to be issued was not known until thatdate.

 

In January 2006, theunderwriters exercised a portion of the over-allotment option in the amount of75,046 units. In February 2006, the officers and directors exercised theiroptions and purchased 18,761 units for an aggregate cost of $507 (or $0.027 pershare). The compensation cost, recorded in operating expenses, resulting fromthese share-based payments was $130,632 at January 30, 2006, using theBlack-Scholes pricing model. This model was developed for use in estimating thefair value of traded options that have no vesting restrictions and are fullytransferable. The fair value of the options was estimated at the measurementdate using the assumptions of weighted-average volatility factor of 0.10, noexpected dividend payments, weighted-average risk-free interest rate of 5%, anda weighted-average expected life of 0.13 years.

 

The fair value of eachoption was $6.99 per share. All options vested immediately at the measurementdate, and no further options may be exercised. Compensation expense wasrecognized immediately and recorded as an operating expense for the year ended December 31,2006.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note18 — Stockholders’ Equity and Stock-Based Compensation (continued)**

 

***Underwriter Options***

 

Argyle sold to itsunderwriters options to purchase up to an aggregate of 187,500 units for $100.The Units issuable upon exercise of these options are identical to those soldin the Public Offering. These options are exercisable at $8.80 per unit andexpire January 24, 2011. The options to purchase up to 187,500 Units andthe Securities underlying such units were deemed to be compensation by theNational Association of Securities Dealers (“NASD”) and, therefore, weresubject to a 180-day lock-up pursuant to Rule 2710(g) (1) of theNASD Conduct Rules.

 

Argyle accounted forthese purchase options as a cost of raising capital and included the instrumentas equity in its consolidated balance sheet. Accordingly, there is no netimpact on Argyle’s financial position or results of operations, except for therecording of the $100 proceeds from the sale. Argyle has estimated, based upona Black-Scholes model, that the fair value of the purchase options on the dateof sale was approximately $3.40 per unit, (a total value of approximately $0.6million) using an expected life of five years, volatility of 44% and arisk-free rate of 5%. However, because Argyle’s Units did not have a tradinghistory, the volatility assumption was based on information then available tomanagement. The volatility estimate was derived using historical data ofcomparable public companies in the proposed industry. Argyle believes thevolatility estimate calculated from such comparable companies was a reasonablebenchmark to use in estimating the expected volatility of our Units; however,the use of an index to estimate volatility may not necessarily berepresentative of the volatility of the underlying securities.

 

***2007 Incentive Plan***

 

The 2007 OmnibusSecurities and Incentive Plan provides for the grant of distribution equivalentrights, incentive stock options, nonqualified stock options, performance shareawards, performance unit awards, restricted stock awards, stock appreciationrights, tandem stock appreciation rights and unrestricted stock awards for anaggregate of not more than 1,000,000 shares of Argyle’s common stock, todirectors, officers, employees and consultants of Argyle or its affiliates. Ifany award expires, is cancelled, or terminates unexercised or is forfeited, thenumber of shares subject thereto, if any, is again available for grant underthe 2007 Incentive Plan. The number of shares of common stock, with respect towhich stock options or stock appreciation rights may be granted to aparticipant under the 2007 Incentive Plan in any calendar year, cannot exceed150,000.

 

Except as provided in the2007 Incentive Plan, awards granted under the 2007 Incentive Plan are nottransferable and may be exercised only by the participant or by the participant’sguardian or legal representative. Each award agreement will specify, amongother things, the effect on an award of the disability, death, retirement,authorized leave of absence or other termination of employment of theparticipant. Argyle may require a participant to pay Argyle the amount of anyrequired withholding in connection with the grant, vesting, exercise ordisposition of an award. A participant is not considered a stockholder withrespect to the shares underlying an award until the shares are issued to theparticipant.

 

**RestrictedStock**

 

On January 25, 2008and August 25, 2008, the Company granted an aggregate of 85,000 shares and5,000 shares, respectively, of the Company’s restricted common stock to certainof its executive officers and directors. Shares granted to the directors vestedimmediately and shares granted to the executive officers vest in three equaltranches on each of December 31, 2008, 2009 and 2010.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note18 — Stockholders’ Equity and Stock-Based Compensation (continued)**

 

**RestrictedStock (continued)**

 

The following tablesummarizes the restricted stock activity under the 2007 Incentive Plan:

 
| ** **                                                                                          | ** ** | ** **         | ** ** | ** **            | ** ** | **Average**   | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------|------------|
| ** **                                                                                          | ** ** | ** **         | ** ** | **Weighted**          | ** ** | **Remaining** | ** ** |
| ** **                                                                                          | ** ** | ** **         | ** ** | **Average Fair** | ** ** | **Vesting**   | ** ** |
| ** **                                                                                          | ** ** | **Number of** | ** ** | **Value**             | ** ** | **Term**      | ** ** |
| **Restricted Stock**                                                                           | ** ** | **Shares**         | ** ** | **Per Share**    | ** ** | **(Years)**   | ** ** |
| Nonvested at  December 31, 2007                                                                |       | 130,000            |       | $                     | 7.39       |          |       |   |
| Granted  January 2008                                                                          |       | 85,000             |       | 7.55                  |       |          |       |
| Granted  August 2008                                                                           |       | 5,000              |       | 4.46                  |       |          |       |
| Vested                                                                                              |       | 106,667            |       | 7.55                  |       |          |       |
| Forfeited                                                                                           |       | —             |       | —                |       |          |       |
| Nonvested at  December 31, 2008                                                                |       | 113,333            |       | $                     | 7.34       |          | 2.00       |   |
| Expected to vest  according to their respective vesting schedules as of December 31, 2008 |       | 113,333            |       | $                     | 7.34       |          | 2.00       |   |
| Vested at  December 31, 2008                                                                   |       | —             |       | $                     | —     |          | —     |   |

 

During the year ended December 31,2008, the Company recognized $996,000 in compensation expense, net of deferred taxbenefit of $339,000, related to the Company’s issuance of restricted stock. Asof December 31, 2008, there was $441,000 of unrecognized compensationcosts, net of estimated forfeitures, related to the Company’s non-vestedrestricted stock, which is expected to be recognized over a weighted averageperiod of 2.00 years.

 

**PerformanceUnit Awards**

 

On January 25, 2008and August 25, 2008, the Company granted an aggregate of 55,000 performanceunit awards and 5,000 performance unit awards, respectively, to certain of itsofficers, subject to terms and conditions to be set forth in a performance unitaward agreement and in accordance with the Company’s 2007 Incentive Plan. Theseawards vest on December 31, 2010, and a cash payment is made to theholders only if certain performance goals to be determined by the Board ofDirectors are achieved. The Company recognizes compensation expense on theperformance unit awards based on the fair value of the Company’s underlyingcommon stock at the end of each quarter over the remaining vesting period. Thefinal plan metrics for determination of the award was not approved by the Boardof Directors until March 25, 2008. As of the year ended December 31,2008 it is unlikely those metrics will be met and, therefore, the Companyrecognized no compensation expense related to the performance unitawards.  Additionally, no compensation expense was recognized during theyear ended December 31, 2007.

 

The following tablesummarizes the performance unit activity under the 2007 Incentive Plan:

 
| ** **                                                                                     | ** ** | ** **         | ** ** | ** **            | ** ** | **Average**   | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|---------------|------------|
| ** **                                                                                     | ** ** | ** **         | ** ** | **Weighted**          | ** ** | **Remaining** | ** ** |
| ** **                                                                                     | ** ** | ** **         | ** ** | **Average Fair** | ** ** | **Vesting**   | ** ** |
| ** **                                                                                     | ** ** | **Number of** | ** ** | **Value**             | ** ** | **Term**      | ** ** |
| **Performance Units**                                                                     | ** ** | **Units**          | ** ** | **Per Unit**     | ** ** | **(Years)**   | ** ** |
| Nonvested at  December 31, 2007                                                           |       | 115,000            |       | $                     | —     |          |       |   |
| Granted  January 2008                                                                     |       | 55,000             |       | —                |       |          |       |
| Granted  August 2008                                                                      |       | 5,000              |       | —                |       |          |       |
| Vested                                                                                         |       | —             |       | —                |       |          |       |
| Forfeited                                                                                      |       | —             |       | —                |       |          |       |
| Nonvested at  December 31, 2008                                                           |       | 175,000            |       | $                     | —     |          | 2.00       |   |
| Expected to vest  according to their respective vesting schedules as of December 31, 2008 |       | 175,000            |       | $                     | —     |          | 2.00       |   |
| Vested at  December 31, 2008                                                              |       | —             |       | $                     | —     |          | —     |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note18 — Stockholders’ Equity and Stock-Based Compensation (continued)**

 

**Incentiveand Nonqualified Stock Options**

 

On January 25, 2008,the Company granted stock options to purchase an aggregate of 100,000 shares ofthe Company’s common stock to various employees, of which all were ISO. Theoptions have a strike price of $7.55 and vest in three equal tranches on eachof December 31, 2008, 2009 and 2010.

 

The following table summarizesthe stock option activity under the 2007 Incentive Plan:

 
| ** **                                                                                                 | ** ** | ** **         | ** ** | ** **                | ** ** | **Average**   | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------------|------------|---------------|------------|
| ** **                                                                                                 | ** ** | ** **         | ** ** | **Weighted**              | ** ** | **Remaining** | ** ** |
| ** **                                                                                                 | ** ** | ** **         | ** ** | **Average Exercise** | ** ** | **Vesting**   | ** ** |
| ** **                                                                                                 | ** ** | **Number of** | ** ** | **Price**                 | ** ** | **Term**      | ** ** |
| **Stock Options**                                                                                     | ** ** | **Shares**         | ** ** | **Per Share**        | ** ** | **(Years)**   | ** ** |
| Outstanding at  December 31, 2007                                                                     |       | 125,000            |       | $                         | 7.80       |          |       |   |
| Granted  January 2008                                                                                 |       | 100,000            |       | 7.55                      |       |          |       |
| Exercised                                                                                                  |       | —             |       | —                    |       |          |       |
| Forfeited                                                                                                  |       | 15,000             |       | 7.72                      |       |          |       |
| Outstanding at  December 31, 2008                                                                     |       | 210,000            |       | $                         | 7.69       |          | 2.00       |   |
| Vested and  expected to vest according to their respective vesting schedules as of December 31,  2008 |       | 210,000            |       | $                         | 7.69       |          | 2.00       |   |
| Exercisable at  December 31, 2008                                                                     |       | 70,000             |       | $                         | —     |          | —     |   |

 

The Company hasestimated, based upon a Black-Scholes model, that the fair value of the stockoptions granted on January 25, 2008 was approximately $1.78 per option, (atotal value of approximately $178,000), using an expected life of three years,volatility of 40%, and a risk-free rate of 2.5%. However, because the sharesdid not have a trading history, the volatility assumption was based oninformation then available to management. The volatility estimate was derivedusing historical data of public companies in the related industry. The Companybelieves that the volatility estimate calculated from these companies was areasonable benchmark to use in estimating the expected volatility of our units;however, the use of an index to estimate volatility may not necessarily berepresentative of the volatility of the underlying securities.

 

During the year ended December 31,2008, the Company recognized $196,000 in compensation expense, net of deferred taxbenefit of $67,000, related to the Company’s stock options. As of December 31,2008, there was $212,000 of unrecognized compensation costs, net of estimatedforfeitures, related to the Company’s non-vested stock options, which isexpected to be recognized over a weighted average period of 2.00 years.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note19 — Income Taxes**

 

A reconciliation ofincome taxes at the U.S. federal statutory rate to the effective tax ratefollows (in thousands):

 
| ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | **Predecessor (ISI)** | ** ** |
|-----------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | **January 1,**        | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | **Through**           | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **July 31,**          | ** ** | **December 31,** | ** ** |
| ** **                                    | ** ** | **2008**         | ** ** | **2007**         | ** ** | **2006**         | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Taxes at federal  statutory rate              |       | $                | (12,508    | )                | $          | 132              |       | $                     | 90         |   | (402 | ) | $ | (234 | ) |
| Increase  (decrease) resulting from:          |       |             |       |             |       |             |       |                  |       |   |   |
| Permanent  differences                        |       | 20               |       | (2               | )          | —           |       | (609                  | )          | 213 |   |
| Goodwill  impairment charge                   |       | 6,755            |       | —           |       | —           |       | —                |       | — |   |
| State income  tax, net of federal tax benefit |       | (388             | )          | 39               |       | —           |       | 52                    |       | — |   |
| Other                                         |       | 190              |       | —           |       | 1                |       | (94                   | )          | 14 |   |
| Tax expense  (benefit)                        |       | $                | (5,931     | )                | $          | 169              |       | $                     | 91         |   | $ | (1,053 | ) | $ | (7 | ) |
|                                               |            |                  |            |                  |            |                  |            |                       |            |  |  |  |  |  |  |  |

 

The provision for incometax is comprised of the following (in thousands):

 
| ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | **Predecessor (ISI)** | ** ** |
|-----------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|-----------------------|------------|
| ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | **January 1,**        | ** ** | ** ** | ** ** |
| ** **                        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | **Through**           | ** ** | ** ** | ** ** |
| ** **                        | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **July 31,**          | ** ** | **December 31,** | ** ** |
| ** **                        | ** ** | **2008**         | ** ** | **2007**         | ** ** | **2006**         | ** ** | **2007**              | ** ** | **2006** | ** ** |
| Federal:                          |       |             |       |             |       |             |       |                  |       |   |   |
| Current                           |       | $                | (343       | )                | $          | 308              |       | $                     | 119        |   | $ | 53 |   | $ | — |   |
| Deferred                          |       | (5,326           | )          | (215             | )          | (28              | )          | (1,065                | )          | (7 | ) |
| Total                             |       | $                | (5,669     | )                | $          | 93               |       | $                     | 91         |   | $ | (1,012 | ) | $ | (7 | ) |
| State:                            |       |             |       |             |       |             |       |                  |       |   |   |
| Current                           |       | $                | 204        |             | $          | 97               |       | $                     | —     |   | $ | 84 |   | $ | — |   |
| Deferred                          |       | (466             | )          | (21              | )          | —           |       | (125                  | )          | — |   |
| Total                             |       | $                | (262       | )                | $          | 76               |       | $                     | —     |   | $ | (41 | ) | $ | — |   |
| Total provision  for income taxes |       | $                | (5,931     | )                | $          | 169              |       | $                     | 91         |   | $ | (1,053 | ) | $ | (7 | ) |

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note19 — Income Taxes (continued)**

 

Deferred income taxprovisions result from temporary differences in the recognition of income andexpenses for financial reporting purposes and for income tax purposes.  The income tax effect of these temporarydifferences, representing deferred income tax assets and liabilities resultfrom the following (in thousands):

 
| ** **                             | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                             | ** ** | **2008**              | ** ** | **2007**              | ** ** | **2006**              | ** ** |
| Deferred tax  liabilities:             |       |                  |       |                  |       |                  |       |
| Intangibles  (non-amortizable)         |       | $                     | 1,988      |                  | $          | 6,880                 |       | $ | — |   |
| Property and  equipment                |       | 664                   |       | 419                   |       | —                |       |
| Contract  receivables                  |       | 180                   |       | 168                   |       | —                |       |
| Other                                  |       | 14                    |       | 38                    |       | 16                    |       |
| Total deferred  tax liabilities        |       | 2,846                 |       | 7,505                 |       | 16                    |       |
| Deferred tax  assets:                  |       |                  |       |                  |       |                  |       |
| Net operating  loss                    |       | 1,412                 |       | 558                   |       | —                |       |
| Allowance for  doubtful accounts       |       | 298                   |       | 371                   |       | —                |       |
| Capital leases                         |       | 103                   |       | —                |       | —                |       |
| Stock-based  compensation              |       | 255                   |       | 139                   |       | 44                    |       |
| Other                                  |       | 100                   |       | 131                   |       | —                |       |
| Total deferred  tax assets             |       | 2,168                 |       | 1,199                 |       | 44                    |       |
| Net deferred tax  liabilities (assets) |       | $                     | 678        |                  | $          | 6,306                 |       | $ | (28 | ) |

 

At December 31, 2008,2007 and 2006, net deferred tax liabilities include a deferred tax asset of$255,000, $139,000 and $44,000 relating to stock-based compensation expenseunder FAS 123(R), respectively.  Fullrealization of this deferred tax asset requires stock options to be exercisedat a price equaling or exceeding the sum of the strike price plus the fairvalue of the option at the grant date. The provisions of FAS 123(R) do notallow a valuation allowance to be recorded unless the Company’s future taxableincome is expected to be insufficient to recover the asset. Accordingly, therecan be no assurance that the price of our common shares will rise to levelssufficient to realize the entire tax benefit currently reflected in our balancesheet. However, to the extent that additional tax benefits are generated inexcess of the deferred taxes associated with compensation expense previouslyrecognized, the potential future impact on income would be reduced.  The restricted stock that vested during 2008had a fair value that was less than the fair value at the grant date and as aresult, the tax deduction is less than the book compensation costs.  Therefore, Argyle reduced the related deferredtax asset by $134,000.

 

At December 31, 2008and 2007, the Company had net operating loss carryovers of $5.1 million and$1.5 million, respectively that expire July 31, 2028.  The Company will carry-back $1.1 million ofthe net operation loss to prior tax years.

 

The Company adopted FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes, aninterpretation of FASB Statement No. 109 (FIN 48) on January 1, 2007.FIN 48 clarifies the accounting for uncertainty in income taxes recognized infinancial statements and requires the impact of a tax position to be recognizedin the financial statements if that position is more likely than not of beingsustained by the taxing authority. The adoption of FIN 48 did not have aneffect on our consolidated financial position or results of operations.  The Company has applied the accountingprovisions of FIN 48 to its tax positions and determined that no uncertain taxpositions presently exist.

 

Argyle and ISI filed aconsolidated U.S. Federal income tax return for the period after July 31,2007.  All prior tax returns filed byArgyle are open to examination by federal, state and local taxingauthorities.  ISI is no longer subject toU.S. Federal income tax examinations for years before 2005 and is no longer subjectto state and local income tax examinations by authorities for years before2004.  To date, there are no federal orstate tax returns under examination by a taxing authority.

 

The provision for incometaxes decreased $6.1 million for the year ended December 31, 2008 comparedto the same period in 2007. The decrease in income taxes was primarily due tothe decrease in income before income taxes of $37.2 million.  Oureffective tax rate (benefit rate) was 16.1% in the year ended December 31,2008 and 43.3% for the same period in 2007.  The decrease in our effectivetax rate was primarily due to a decrease in income before income taxes and thenon-deductibility for tax purposes of certain goodwill impairments recordedduring the year ended December 31, 2008.

 

**Note20 — Related-Party Transactions**

 

During the first quarterof 2008, the Company entered into a Board-approved agreement with Sec-TecGlobal, Inc. (“Sec-Tec”) to share certain expenses related to commonoffice space in New York, New York as well as administrative related expensesin the New York office. These expenses are being borne by the Company toreflect realistic expenses associated with the Company’s conduct of business inNew York. The Company has agreed to share expenses totaling $175,000 on anannual basis that are to be paid in quarterly payments of $43,750. During theyear ended December 31, 2008, the Company recognized $175,000 in expensesrelated to this agreement. Sec-Tec is a wholly-owned subsidiary of ElectronicsLine 3000 of which the Company’s Executive Chairman and CEO are stockholdersand board members.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note20 — Related-Party Transactions (continued)**

 

At December 31, 2008and 2007, other receivables include $24,000 and $42,000, respectively, ofreceivables from related parties, all of which is attributable to ISI. Amountstypically represent monies or other assets advanced to employees.  The amounts in these employee receivableshave been regularly paid, and management believes they are fully collectible.

 

The Company leasesvarious properties from Green Wing Management, Ltd., an entity owned andcontrolled by the Chief Operating Officer and President of ISI, under capitalleases. The leases on these properties include two that were amended as part ofthe acquisition of ISI to reflect a term of 12 years ending in 2019 and a newlease executed in June 2008. All leases require that an appraisal becompleted by a qualified appraiser to determine the market rate of the leases.The rental rate to be paid on these properties, after the acquisition of ISI,is limited to no more than 90% of the market rate determined by the third-partyappraiser. Additional appraisals by a third-party appraiser are to be conductedevery three years during the 12-year terms, and the annual lease rate in theleases can increase at the time of these appraisals, but only to a level thatdoes not to exceed 90% of the market rate determined by the third-partyappraiser. Argyle has the right to purchase these three properties at any time,at the then current market value; however, the purchase price cannot be lessthan the value determined in the last appraisal preceding the effective date ofthe acquisition of ISI. During the year ended December 31, 2008, theCompany made lease payments of $407,000 under these leases. See Note 9 for theremaining payments due under these leases.

 

In conjunction with themajor refinancing of ISI in 2004, the majority stockholders formed a newcompany in 2004 (ISI*MCS, Ltd.) which was used as the contracting entity on allfuture bonded contracts. ISI transferred certain existing bonded contracts attheir remaining contract values, and no gain or loss was recognized on thetransfers to ISI*MCS, Ltd. at the time of its formation. All contracts ofISI*MCS, Ltd. were subcontracted to ISI for the full contract amount, less a 2%fee. ISI recorded contract revenues based on the ISI*MCS, Ltd.’s contractamount, net of the 2% fee. Contract receivables from ISI*MCS, Ltd. at December 31,2008 and December 31, 2007 totaled $4.7 million and $10.9 million,respectively, which is disclosed as Contract Receivables - Related Party on theface of the consolidated balance sheet since ISI*MCS, Ltd. is not consolidatedin the balance sheet. Contract revenues reported by the Company from ISI*MCS,Ltd. were $16.8 million for the year ended December 31, 2008. ISI*MCS,Ltd. Argyle has agreed to indemnify the shareholders of ISI*MCS, Ltd. fromclaims brought by the bonding company against their personal guarantees forthose contracts that had not been paid in full as of the closing of the mergerbetween Argyle and ISI. The merger agreement setting forth the agreements ofArgyle and ISI provides that these indemnification obligations will survive fora period of four years after the closing date of the merger and the obligationsare not subject to cap, or maximum amount.

 

ISI will receive 100% ofthe remaining contract amounts and ISI*MCS, Ltd. will forego its 2% fee.Remaining amounts to be billed on these contracts as of December 31, 2008totaled $2.9 million.  Beginning July 31,2007, all future contracts, bonded and un-bonded, are being contracted directlyby the Company without involvement by ISI*MCS, Ltd.

 

**UnsecuredDebt — Related Parties**

 

As part of the merger ofArgyle and ISI, debt totaling $16.0 million was owed to a shareholder of ISI,of which $10.0 million was paid prior to its scheduled payment terms. As a partof the merger, the shareholder of ISI became a shareholder of Argyle, holding486,237 shares of Argyle common stock as of July 31, 2007 and, as such,also becoming a related party. At December 31, 2008 and December 31,2007, the remaining debt to the shareholder (see Note 8) totaled $11.2 millionand $6.0 million, respectively.

 

On October 28, 2008,the Board approved the Company’s providing guarantees to ISI and itssubsidiaries as an alternative to bonding, in an aggregate amount of up to$15.0 million, in order to allow ISI the ability to bid projects withoutobtaining bonding.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note21 — Segment Information**

 

Argyle has tworeporting segments: “Argyle Corrections” and “Argyle Commercial Security”.

 

Argyle Correctionsspecializes in the design and installation of turnkey security solutions forpublic and privately-owned/operated detention facilities. Argyle Correctionsdesigns, assembles, supplies, installs, and maintains access control, video andintegrated electronic control systems for correctional and governmentfacilities throughout the United States. Argyle Corrections offers a completearray of electronic security system solutions revolving around command andcontrol and access control, including: electronic locking systems and hardwareand security doors and frames. Argyle Corrections also includes the sale anddesign of jail furniture, security glazing and other security-based systems. Italso provides the above goods and services to detention market integrators,electrical contractors and competitors of Argyle that lack their own in-houseelectronic solutions capabilities. Whether acting as prime contractor or as asubcontractor for projects spanning all levels of security, Argyle Corrections’product offerings include security locking systems, security hollow metal doorsand wall panels, security windows, security glass and glazing, securityfurnishings and accessories, design-support and full-installation capabilities.

 

Argyle Correctionsconsists of all of our businesses in the corrections sector, including MCS-Detention,ISI-Detention, as well as Com-Tec and PDI.  Com-Tec and PDI were acquiredin January 2008.  Argyle Corrections includes:

 

·                  MCS-Detention, which designs,engineers, supplies, installs and maintains complex, customized physical andsoftware security solutions, access control, video and electronic securitycontrol system solutions at correctional and government facilities;

 

·                  ISI -Detention, which designs,engineers, supplies, installs and maintains a full array of detention systemsand equipment, targeting correctional facilities throughout the United States;

 

·                  PDI, which is a full-service, turnkeysolutions provider that manufactures high security metal barriers, highsecurity observation window systems, detention furniture and accessories; and

 

·                  Com-Tec, which is an industry leaderin the custom design and manufacture of electronic security and communicationssystems.

 

Argyle CommercialSecurity has built a parallel business to Argyle Corrections, targetingcommercial and industrial facilities. Argyle Commercial Security focuses on thecommercial security sector and provides turnkey, electronic security systems tothe commercial market. Currently, MCS Commercial Fire & Security,referred to historically as MCS-Commercial, operates out of its own San Antonioheadquarters and five regional offices. The offices in Austin, Houston andDenver resulted from acquisitions made by ISI before it was acquired by Argyle.Argyle Federal Systems is currently a newly operational business unit whichfocuses on providing security solutions and services targeted at the federalgovernment.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note21 — Segment Information (continued)**

 

**SummarySegment Information**

(in thousands)

 
| ** **                           | ** ** | ** **            | ** ** | ** **            | ** ** | **Predecessor (ISI)**   | ** ** |
|--------------------------------------|------------|-----------------------|------------|-----------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **Year Ended**   | ** ** | **Year Ended**   | ** ** | **Seven Months**        | ** ** | **Year Ended** | ** ** |
| ** **                           | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **Ended July 31,** | ** ** | **December 31,** | ** ** |
| **Industry  Segment (in thousands)** | ** ** | **2008**              | ** ** | **2007**              | ** ** | **2007**                     | ** ** | **2006** | ** ** |
| ** **                           |       |                  |       |                  |       |                         |       |   |   |
| Revenues:                            |       |                  |       |                  |       |                         |       |   |   |
| Corrections                          |       | $                     | 107,184    |                  | $          | 37,307                       |       | $ | 24,887 |   | $ | 45,702 |   |
| Commercial                           |       | 33,525                |       | 12,516                |       | 18,246                       |       | 22,538 |   |
| Corporate                            |       | —                |       | —                |       | —                       |       | — |   |
| Eliminations                         |       | (5,866                | )     | (5,770                | )          | —                       |       | (10,488 | ) |
| Total                                |       | $                     | 134,843    |                  | $          | 44,053                       |       | $ | 43,133 |   | $ | 57,752 |   |
| Operating income  (loss):            |       |                  |       |                  |       |                         |       |   |   |
| Corrections                          |       | $                     | (18,848    | )                     | $          | 1,786                        |       | $ | 540 |   | $ | 1,929 |   |
| Commercial                           |       | (8,962                | )          | 214                   |       | 1,281                        |       | 994 |   |
| Corporate                            |       | (5,478                | )          | (2,505                | )          | —                       |       | — |   |
| Eliminations                         |       | —                |       | 726                   |       | —                       |       | — |   |
| Total                                |       | $                     | (33,288    | )                     | $          | 221                          |       | $ | 1,821 |   | $ | 2,923 |   |
| Capital  expenditures:               |       |                  |       |                  |       |                         |       |   |   |
| Corrections                          |       | $                     | 3,964      |                  | $          | 774                          |       | $ | 775 |   | $ | 583 |   |
| Commercial                           |       | 631                   |       | 229                   |       | 229                          |       | 181 |   |
| Corporate                            |       | 160                   |       | 25                    |       | —                       |       | — |   |
| Total                                |       | $                     | 4,755      |                  | $          | 1,028                        |       | $ | 1,004 |   | $ | 764 |   |
| Total assets:                        |       |                  |       |                  |       |                         |       |   |   |
| Corrections                          |       | $                     | 70,143     |                  | $          | 75,430                       |       | $ | 20,295 |   | $ | 25,857 |   |
| Commercial                           |       | (2,142                | )          | 5,519                 |       | 12,484                       |       | 5,171 |   |
| Corporate                            |       | 48,020                |       | 3,570                 |       | —                       |       | — |   |
| Eliminations                         |       | (33,709               | )          | (3,371                | )          | —                       |       | 589 |   |
| Total                                |       | $                     | 82,312     |                  | $          | 81,148                       |       | $ | 32,779 |   | $ | 31,617 |   |

 

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**Note22 — Supplemental Disclosures of Cash Flow Information (in thousands)**

 
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                                   | ** ** | **2007** | ** ** | **2006** | ** ** |
| Cash paid for  interest                                                  |       | $                                          | 3,059      |   | $ | 912 |   | $ | 3 |   |
| Cash paid for  income taxes                                              |       | 544                                        |       | 149 |   | — |   |
| **Supplemental  schedule of non-cash investing activities:**             |       |                                       |       |   |   |   |   |
| Financed  purchases of property and equipment                            |       | $                                          | —     |   | $ | 161 |   | $ | — |   |
| Accrual for  deferred transaction costs                                  |       | —                                     |       | 45 |   | 435 |   |
| Issuance of  warrants associated with notes to related parties           |       | —                                     |       | 93 |   | — |   |
| **Supplemental  schedule of non-cash financing activities:**             |       |                                       |       |   |   |   |   |
| Notes issued for  acquisitions                                           |       | $                                          | 6,765      |   | $ | — |   | $ | — |   |
| Dividends  accrued                                                       |       | 312                                        |       | — |   | — |   |
| Reduction in  deferred interest liability                                |       | —                                     |       | 101 |   | — |   |
| Reduction in  deferred underwriter liability                             |       | —                                     |       | 185 |   | — |   |
| Reduction in  common stock subject to redemption                         |       | —                                     |       | 5,736 |   | — |   |
| Accrual of  offering costs                                               |       | —                                     |       | — |   | 7 |   |
| Accrual of  deferred underwriting costs                                  |       | —                                     |       | — |   | 1,098 |   |
| Write-off of  deferred transaction costs                                 |       | 10                                         |       | — |   | — |   |
|                                                                     |       |                                       |       |   |   |   |   |
| ** **                                                               | ** ** | **Predecessor (ISI)**                      | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **January 1, 2007**                   | ** ** | **Year Ended** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **through**                                | ** ** | **December 31,** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                               | ** ** | **July 31, 2007**                     | ** ** | **2006** | ** ** | ** ** | ** ** | ** ** |
|                                                                     |       |                                       |       |   |   |   |   |   |
| Cash paid for  interest                                                  |       | $                                          | 1,846      |   | $ | 2,563 |   |   |   |   |
| Cash paid for  income taxes                                              |       | —                                     |       | 30 |   |   |   |   |
| **Supplemental  schedule of non-cash investing activities:**             |       |                                       |       |   |   |   |   |   |
| Financed  purchases of property and equipment                            |       | $                                          | 416        |   | $ | — |   |   |   |   |
| Assets acquired  through capital lease                                   |       | —                                     |       | 680 |   |   |   |   |
| Accrual for  deferred transaction costs                                  |       | 45                                         |       | 435 |   |   |   |   |
| Goodwill and  identified net intangible assets from push down accoutning |       | 38,210                                     |       | — |   |   |   |   |
| Reallocation of  acquisition costs to goodwill                           |       | 110                                        |       | — |   |   |   |   |
| **Supplemental  schedule of non-cash financing activities:**             |       |                                       |       |   |   |   |   |   |
| Accrual of  stockholder distributions                                    |       | $                                          | —     |   | $ | 229 |   |   |   |   |
| Write-off of  deferred transaction costs                                 |       | 732                                        |       | — |   |   |   |   |
| Conversion of  warrants to common stock                                  |       | 6,033                                      |       | — |   |   |   |   |
| Settlement of  debt and related accretion                                |       | 7,822                                      |       | — |   |   |   |   |

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note 23 — QuarterlyFinancial Data (Unaudited)**

** **
| ** **                                                                                                       | ** ** | **Year Ended December 31, 2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                                                                                         |       | $                                                    | 37,597     |   | $ | 36,506 |   | $ | 31,700 |   | $ | 29,040 |   |
| Cost of revenues                                                                                                 |       | 31,193                                               |       | 30,442 |   | 28,182 |   | 24,637 |   |
| Gross profit                                                                                                     |       | 6,404                                                |       | 6,064 |   | 3,518 |   | 4,403 |   |
| Net income  (loss)                                                                                               |       | (734                                                 | )          | (1,020 | ) | (18,367 | ) | (10,736 | ) |
| Net income  (loss) allocable to holders of non-redeemable common stock                                           |       | (734                                                 | )          | (1,106 | ) | (18,481 | ) | (10,848 | ) |
| Net income  (loss) per share - basic                                                                             |       | $                                                    | (0.13      | ) | $ | (0.18 | ) | $ | (3.17 | ) | $ | (1.84 | ) |
| Net income  (loss) per share - diluted                                                                           |       | $                                                    | (0.13      | ) | $ | (0.18 | ) | $ | (3.17 | ) | $ | (1.84 | ) |
| Net income  (loss) per share exclusive of shares and related interest subject to  potential redemption - basic   |       | $                                                    | (0.13      | ) | $ | (0.19 | ) | $ | (3.19 | ) | $ | (1.87 | ) |
| Net income  (loss) per share exclusive of shares and related interest subject to  potential redemption - diluted |       | $                                                    | (0.13      | ) | $ | (0.19 | ) | $ | (3.19 | ) | $ | (1.87 | ) |

 
| ** **                                                                                                       | ** ** | **Year Ended December 31, 2007** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                                                                                         |       | $                                                    | —     |   | $ | — |   | $ | 17,092 |   | $ | 26,961 |   |
| Cost of revenues                                                                                                 |       | —                                               |       | — |   | 13,426 |   | 20,594 |   |
| Gross profit                                                                                                     |       | —                                               |       | — |   | 3,666 |   | 6,367 |   |
| Net income  (loss)                                                                                               |       | 51                                                   |       | 50 |   | (116 | ) | 234 |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                           |       | 51                                                   |       | 50 |   | (116 | ) | 234 |   |
| Net income  (loss) per share - basic                                                                             |       | $                                                    | 0.01       |   | $ | 0.01 |   | $ | (0.02 | ) | $ | 0.04 |   |
| Net income  (loss) per share - diluted                                                                           |       | $                                                    | 0.01       |   | $ | 0.01 |   | $ | (0.02 | ) | $ | 0.04 |   |
| Net income  (loss) per share exclusive of shares and related interest subject to  potential redemption - basic   |       | $                                                    | 0.01       |   | $ | 0.01 |   | $ | (0.02 | ) | $ | 0.04 |   |
| Net income  (loss) per share exclusive of shares and related interest subject to  potential redemption - diluted |       | $                                                    | 0.00       |   | $ | 0.00 |   | $ | (0.02 | ) | $ | 0.04 |   |

 
| ** **                                                                                                                 | ** ** | **Year Ended December 31, 2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                 | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Revenues                                                                                                                   |       | $                                                    | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Cost of revenues                                                                                                           |       | —                                               |       | — |   | — |   | — |   |
| Gross profit                                                                                                               |       | —                                               |       | — |   | — |   | — |   |
| Net income  (loss)                                                                                                         |       | $                                                    | (105       | ) | $ | 74 |   | $ | 102 |   | $ | 102 |   |
| Net income  (loss) allocable to holders of non-redeemable common stock                                                     |       | (148                                                 | )          | 3 |   | 63 |   | 79 |   |
| Net income  (loss) per share - basic                                                                                       |       | $                                                    | (0.03      | ) | $ | 0.02 |   | $ | 0.02 |   | $ | 0.02 |   |
| Net income  (loss) per share exclusive of shares and related interest subject to  potential redemption - basic and diluted |       | $                                                    | (0.05      | ) | $ | — |   | $ | 0.02 |   | $ | 0.02 |   |

 
| ** **        | ** ** | **Predecessor**                                                         | ** ** | ** **          | ** ** | ** **         |
|-------------------|------------|-------------------------------------------------------------------------|------------|---------------------|------------|--------------------|
| ** **        | ** ** | **January 1, 2007 through July 31, 2007** | ** ** | ** **          | ** ** | ** **         |
| ** **        | ** ** | **First  Quarter**                                                      | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | ** ** | ** ** | ** ** |
| Net revenues      |       | $                                                                       | 18,852     |                | $          | 17,787             |   | $ | 6,495 |   |   |   |   |
| Cost of revenues  |       | 15,097                                                                  |       | 13,357              |       | 5,062              |   |   |   |   |
| Gross profit      | ** ** | 3,755                                                                   |       | 4,430               |       | 1,433              |   |   |   |   |
| Net income (loss) |       | 123                                                                     |       | (619                | )          | 365                |   |   |   |   |
|                   |            |                                                                         |            |                     |            |                    |  |  |  |  |  |  |  |

 
| ** **         | ** ** | **Predecessor**                                      | ** ** |
|--------------------|------------|------------------------------------------------------|------------|
| ** **         | ** ** | **Year Ended December 31, 2006** | ** ** |
| ** **         | ** ** | **First  Quarter**                                   | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
| Net revenues       |       | $                                                    | 13,391     |   | $ | 12,389 |   | $ | 15,454 |   | $ | 16,518 |   |
| Cost of revenues   |       | 10,858                                               |       | 9,566 |   | 12,149 |   | 13,396 |   |
| Gross profit       |       | 2,533                                                |       | 2,823 |   | 3,305 |   | 3,122 |   |
| Net income  (loss) |       | (386                                                 | )          | (48 | ) | 70 |   | (324 | ) |
|                    |            |                                                      |            |  |  |  |  |  |  |  |  |  |  |

 

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Tableof Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note24— Subsequent Events – Unaudited**

 

*Series BPurchase Agreement*

 

On January 8, 2009,Argyle entered into a Securities Purchase Agreement (the “Purchase Agreement”)with Mezzanine Management Fund IV A, L.P. and Mezzanine Management Fund IVCoinvest A, L.P. (the “Purchasers”), and Sam Youngblood, Ron Chaimovski and BobMarbut (together, with their affiliates, the “Stockholders”), pursuant to whichthe Purchasers purchased 27,273 shares of a newly created series of ourpreferred stock, designated “Series B Convertible Preferred Stock”, parvalue $0.0001 per share (the “Series B Preferred Shares”) for $110 pershare, for an aggregate purchase price of $3,000,030 (the “Series BFinancing”).

 

Each Series BPreferred Share is convertible into 100 shares of common stock, at any time, atthe option of the holder, initially at a conversion price of $1.10 per share ofCommon Stock, subject to adjustment for stock dividends, stock splits orsimilar capital reorganizations, and weighted average price protection forcertain issuances below the conversion price.

 

The Series BPreferred Shares have voting rights equal to the number of shares of commonstock the holder would receive if all Series B Preferred Shares had beenconverted into common stock. The holders of the Series B Preferred Sharesmay also designate one individual to serve on the Company’s Board of Directors.

 

The holders of the Series BPreferred Shares shall be entitled to receive, on a cumulative basis, cashdividends, when, as and if declared by the our Board of Directors, at thegreater of (i) 4% per annum or (ii) the dividend payable on theequivalent amount of common stock into which the Series B Preferred Sharescould be converted; provided, however, that such cash dividend must be paid atthe earliest any of the following occur:  (A) we pay a dividend onthe common stock, (B) we liquidate or there is a change in control, or (C) uponconversion of the Series B Preferred Shares, but only with respect tothose Series B Preferred Shares so converted.

 

The Series BPreferred Shares have a liquidation preference as to both our Series AConvertible Preferred Stock, par value $0.0001 per share (“Series APreferred Shares”) and our common stock equal to the greater of (i) thesum of the original issue price (subject to adjustment for stock dividends,stock splits or similar capital reorganizations) plus all accrued but unpaiddividends, or (ii) the amount the holder would receive if all Series BPreferred Shares had been converted into common stock.

 

For as long as any sharesof Series B Preferred Shares remain outstanding, we will be prohibitedfrom (i) amending, waiving, altering or repealing in a way that adverselyaffects the rights, powers, preferences, or other special rights or privilegesof the holders of the Series B Preferred Shares, whether by amendment tothe Certificate of Incorporation, Bylaws, Certificate of Designation or otherorganization documents, or by merger, consolidation, reorganization orotherwise, (ii) increasing or decreasing (other than by redemption orconversion) the authorized number of shares of preferred stock or Series BPreferred Shares, (iii) creating, issuing or authorizing the issuance ofany equity securities senior to the Series B Preferred Shares, or (iv) repurchasing,redeeming or reissuing any equity securities of the Company to which the Series BPreferred Shares rank senior and prior (whether with respect to dividends,redemption, or upon liquidation or otherwise), including the Series APreferred Shares and the Common Stock, and any rights or options exercisable orconvertible thereof, other than repurchases of shares of Common Stock fromemployees, officers, directors or consultants under agreements providing forsuch repurchase under certain conditions.

 

Under the PurchaseAgreement, we also granted piggyback registration rights to the Purchasers.

 

We granted a preemptiveright to the Purchasers with respect to future financings and a right of firstoffer to provide financing for certain transactions. In addition, theStockholders have granted a right of first refusal to the Purchasers until January 31,2010 as to any transfers of our securities held by the Stockholders.

 

The gross proceeds of theSeries B Financing were used to reduce a portion of the outstandingbalance of the PrivateBank Loans (see below).

 

Neither the Series BPreferred Shares nor the shares of common stock issuable upon conversion of theSeries B Preferred Shares have been registered under the Securities Act,and may not be offered or sold in the United States absent registration or anapplicable exemption from such registration requirement.

 

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**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note24— Subsequent Events – Unaudited (continued)**

 

*Amendment toBlair Purchase Agreement*

 

On January 8, 2009,ISI entered into a Sixth Amendment (the “Blair Amendment”) to the Note andWarrant Purchase Agreement dated as of October 22, 2004 (as amended)between ISI and William Blair Mezzanine Capital Fund III, L.P. (“Blair”), afund managed by Merit Capital Partners. Pursuant to the terms of the BlairAmendment, Blair has agreed to amend its existing covenants to have a 10%cushion to Private Bank’s amended covenants and has agreed to an extension ofthe maturity of its debt for one year, until January 31,2011.  The senior debt—to-EBITDA covenant was increased to 2.50x at March 31,2009 and June 30, 2009.  The senior debt to EBITDA covenant willbecome 2.20x at September 30, 2009. A total debt-to-EBITDA ratio covenantwas created whereby the ratio at the end of the fiscal quarter must be nogreater than to 5.94 to 1.00 at March 31, 2008, 5.78 to 1.00 at June 30,2009, 4.40 to 1.00 at September 30, 2009 and, thereafter, it will be 3.85to 1.00.  The maximum capital expenditures covenant has beenincreased to $330,000 per each fiscal quarter ending March 31, 2009, June 30,2009 and September 30, 2009, respectively. The fixed-charge-coverage ratiohas been amended to take into account payments made to subordinated debtholders. The interest rate on all outstanding notes will increase by 4.0% ifthe outstanding notes are not repaid by September 30, 2010.

 

*Amendmentto PrivateBank Loan Agreement*

 

On January 8, 2009,ISI entered into Amendment No. 1 dated January 8, 2009 (the “LoanAmendment”) to the Loan Agreement dated October 3, 2008 with ThePrivateBank and Trust Company, an Illinois banking corporation (the “Bank”).Pursuant to and subject to the terms and conditions of the Loan Agreement, theBank had made available to ISI (a) a secured revolving line of credit inthe maximum amount of $10,000,000, with a $5,000,000 sublimit for the issuanceof letters of credit, (b) a secured revolving line of credit in themaximum amount of $5,000,000, to be used solely for the issuance of letters ofcredit, and (c) a term loan in the maximum amount of $10,000,000(collectively, the “PrivateBank Loans”).

 

Pursuant to the terms ofthe Loan Amendment, ISI paid down the existing term loan by $3.0 million(effectively paying down the term loan by $2.5 million and pre-paying the March 31,2009 principal payment of $500,000).  All debt covenants were waived at December 31,2008.  The applicable margin for LIBOR rate loans under the revolvinglines of credit between January 1, 2009 through September 30, 2009was increased to 3.5%, the applicable margin for Prime rate loans under therevolving lines of credit between January 1, 2009 and September 30,2009 was increased to 1.50%, the applicable margin for LIBOR rate loans underthe term loan was increased to 4.0%, and the applicable margin for Prime rateloans under the term loan was increased to 2.0%.  The letter ofcredit fee was also increased to 3.5%.  The senior debt-to-EBITDAcovenant was increased from 2.00x to 2.25x at March 31, 2009 and June 30,2009.  The senior debt to EBITDA covenant will return to 2.00x at September 30,2009. The total debt-to-EBITDA covenant was increased from 4.00x to 5.40x at March 31,2008 and 5.25x at June 30, 2009 and will return to 4.00 at September 30,2009 and thereafter it will be 3.50.  There is a new maximum capitalexpenditures covenant of $300,000 per quarter in Q1 2009, Q2 2009, and Q3 2009and the fixed charge coverage ratio has been amended to take into accountpayments made to subordinated debt holders.

 

Argyle agreed to providea guaranty of the PrivateBank Loans up to $18.1 million, until the completionof an audit for the fiscal year ended 2009 (the “Guaranty Agreement”); provided,however that the Guaranty Agreement will terminate on the earlier of (a) thepayment in full of all obligations under the Loan Agreement or (b) at thetime the Bank determines in its sole judgment that ISI’s financial statementsissued pursuant to the Loan Agreement for the fiscal year ended December 31,2009 establish that ISI is in compliance with the amended financial covenantsof the Loan Agreement.  The line of credit that is used solely forletters of credit was decreased from $5.0 million to $1.1 million and thepromissory note evidencing the line of credit was amended and restated toreflect the principal amount reduction. The Loans will continue to be securedby liens on and security interests in the personal property of ISI andguaranteed by the subsidiaries of ISI.

 

*Conversion of ISI Seller Debt*

 

As part of the mergerconsideration paid to acquire ISI, the Company issued unsecured convertibledebt to the stockholders in the amount of $1.9 million, which bears interest at5% per annum, paid semiannually. The notes may be converted in whole or in partinto shares of the Company’s common stock at the election of the note holder ata share price of $10.00 any time after January 1, 2008 or redeemed at thesame price by the Company after January 1, 2009. On January 12, 2009,the notes were redeemed in full by the Company at $10.00 per share for anaggregate of 192,763 shares of common stock.

 

*Line of Credit Facility*

 

In February 2009,Argyle entered into a letter of credit facility with the PrivateBank. Theletter of credit may not exceed $2.5 million. The facility does not have a feeon the unused portion of the letter of credit facility.

 

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Table of Contents

 

**ARGYLESECURITY, INC.**

**NOTESTO AUDITED CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31,2008**

 

**Note24— Subsequent Events – Unaudited (continued)**

 

On February 1, 2009,Argyle granted 90,000 unregistered shares of our common stock to Officers andkey employees listed below. Ability to sell, transfer or assign these sharesvest December 31 in three equal tranches on each of 2009, 2010, and 2011.The holders have the right to vote all shares, regardless of the vestingschedule.

 
| **Stockholders**   | ** ** | **Number of Shares** | ** ** |
|--------------------|------------|--------------------------------|------------|
| Bob Marbut         |       | 25,000                         |       |
| Ron Chaimovski     |       | 25,000                         |       |
| Donald F.  Neville |       | 15,000                         |       |
| Matthew A. Kepke   |       | 15,000                         |       |
| Dean Dresser       |       | 10,000                         |       |

 

Also, on February 1,2009, Argyle granted options to purchase an aggregate of up to 300,000 sharesof common stock to Officers and key employees of the listed below. The exercise price of the options is $1.10 pershare and the options vest December 31 in three equal annual tranches oneach of 2009, 2010 and 2011.

 
| **Stockholders**   | ** ** | **Number of Options** | ** ** |
|--------------------|------------|---------------------------------|------------|
| Bob Marbut         |       | 50,000                          |       |
| Ron Chaimovski     |       | 50,000                          |       |
| Sam Youngblood     |       | 50,000                          |       |
| Donald F.  Neville |       | 30,000                          |       |
| Matthew A. Kepke   |       | 25,000                          |       |
| Dean Dresser       |       | 10,000                          |       |
| Robert Roller      |       | 25,000                          |       |
| Brian LaBad        |       | 10,000                          |       |
| Jeff Paulik        |       | 10,000                          |       |
| Mike Peterson      |       | 10,000                          |       |
| Wally Wallace      |       | 25,000                          |       |
| Tim Moxon          |       | 10,000                          |       |

 

In addition, on February 1,2009, Argyle granted 110,000 performance unit awards to Officers and keyemployees listed below. The awards vest fully on December 31, 2012 atwhich time a cash payment amount per unit award shall be determined by theBoard based on the Company achieving or exceeding performance goals set by theCompensation Committee of the Board.

 
| **Stockholders**   | ** ** | **Number of Unit Awards** | ** ** |
|--------------------|------------|------------------------------------------|------------|
| Bob Marbut         |       | 25,000                                   |       |
| Ron Chaimovski     |       | 25,000                                   |       |
| Donald F.  Neville |       | 15,000                                   |       |
| Matthew A. Kepke   |       | 15,000                                   |       |
| Dean Dresser       |       | 10,000                                   |       |

 

On March 19, 2009,Argyle granted 45,000 unregistered shares of our common stock to the Directorslisted below. These shares vest in full seven (7) days after the Directoris no longer serving on the Board.

 
| **Stockholders** | ** ** | **Number of Shares** | ** ** |
|------------------|------------|--------------------------------|------------|
| Lloyd Campbell   |       | 15,000                         |       |
| Wesley Clark     |       | 15,000                         |       |
| John Smith       |       | 15,000                         |       |

 

Such shares, options andperformance unit awards were issued pursuant to the exemption from registrationcontained in Section 4(2) of the Securities Act as they were issuedto Officers and directors of Argyle.

 

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