**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-K**

 

**ANNUALREPORT**

**PURSUANT TOSECTION 13 OR 15(d) OF THE**

**SECURITIESEXCHANGE ACT OF 1934**

 

| **x**                                                | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES AND****EXCHANGE ACT OF 1934**  |
|------------------------------------------------------|-------------------------------------------------------------------------------------------------------------|
|                                                 |                                                                                                        |
| **For the fiscal year ended December 31, 2007** |
|                                                 |                                                                                                        |
| **OR**                                               |
|                                                 |                                                                                                        |
| **o**                                                | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934** |

 

**For the transition period from                                to**

 

**Argyle Security, Inc.**

(Name of issuer as specified in its charter)

 

| **Delaware**                                                       |   | **20-3101079**                      |
|--------------------------------------------------------------------|--------|-------------------------------------|
| (State or other jurisdiction ofincorporation or organization) |   | (I.R.S. EmployerIdentification No.) |
|                                                               |   |                                |
| **200  Concord Plaza Suite 700 San Antonio, TX**              |   | **78216**                           |
| (address of principal executive offices)                           |   | (Zip Code)                          |

 

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

 

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

 

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

 

**Common Stock, $.0001 par value**

(Title of Class)

 

**Common Stock Purchase Warrants**

(Title of Class)

 

**Units consisting of one share ofCommon Stock and one**

**Common Stock Purchase Warrant**

(Title of Class)

 

Indicate by checkmark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.

Yes o   No x

 

Indicate by checkmark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.

Yes x   No o

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x   No o

 

Indicate by checkmark if disclosure of delinquent filers pursuant to item 405 of Regulation S-Kis not contained herein, and will not be contained, to the best of theregistrant’s knowledge in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange. (Check one):

 

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

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes o   No x

 

State theaggregate market value of the voting and non-voting stock held bynon-affiliates of the Issuer as of the last business day of the registrant’smost recently completed second fiscal quarter: $28,860,359.

 

Indicate thenumber of shares outstanding of each of the Registrant’s classes of commonstock, as of the latest practicable date: 5,964,342 at March 31, 2008

 

**DOCUMENTS INCORPORATED BY REFERENCE:**

 

**Part III of this Annual Reporton Form 10-K is incorporated by reference to the proxy statement for theregistrant’s annual meeting of stockholders to be held in 2008.**

 

 

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TABLE OF CONTENTS

 
| Part I   |
|---------------|
| Item 1.       | Business | 1 |
| Item 1A.      | Risk Factors | 21 |
| Item 1B.      | Unresolved Staff  Comments | 27 |
| Item 2.       | Description of  Property | 28 |
| Item 3.       | Legal Proceedings | 28 |
| Item 4.       | Submission of  Matters to a Vote of Security Holders | 28 |
|          |   |   |
| Part II  |
|          |   |   |
| Item 5.       | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 29 |
| Item 6.       | Selected Financial  Data | 31 |
| Item 7.       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 33 |
| Item 7A.      | Quantitative  and Qualitative Disclosures About Market Risk | 50 |
| Item 8.       | Financial  Statements and Supplementary Data | 50 |
| Item 9.       | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure | 51 |
| Item 9A(T).   | Controls and  Procedures | 51 |
| Item 9B.      | Other Information | 52 |
|          |   |   |
| Part III |
|          |   |   |
| Item 10.      | Directors,  Executive Officers and Corporate Governance | 53 |
| Item 11.      | Executive  Compensation | 53 |
| Item 12.      | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters | 53 |
| Item 13.      | Certain  Relationships and Related Transactions and Director Independence | 53 |
| Item 14.      | Principal  Accounting Fees and Services | 53 |
|          |   |   |
| Part IV  |
|          |   |   |
| Item 15.      | Exhibits and  Financial Statement Schedules | 55 |

 

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**PART I**

 

**Item 1. Business**

 

**Background**

 

Argyle Security, Inc.,formerly Argyle Security Acquisition Corporation, is a Delaware corporationincorporated on June 22, 2005 in order to serve as a vehicle for theacquisition of an operating business through a merger, capital stock exchange,asset acquisition or other similar business combination.   Argyle completed its initial public offeringin January 2006.  As provided in itscertificate of incorporation, Argyle was required, by July 30, 2007, toconsummate a business combination or enter a letter of intent, agreement inprinciple or definitive agreement relating to a business combination, in whichcase Argyle would be allowed an additional six months to complete thetransactions contemplated by such agreement.

 

During February 2006,after the Argyle initial public offering was completed, Argyle’s managementdeveloped a list of 15 criteria to be used in screening and evaluating targetcompanies for Argyle to acquire. These criteria were approved by Argyle’s Boardof Directors at its March 6, 2006 meeting and were utilized during theensuing months by Argyle in the search and evaluation process. While managementfelt it would not have been possible to find a target company that fully metall of the criteria, Argyle sought to identify those companies withcharacteristics that were in close alignment with the criteria.

 

Following is a summary ofthe criteria used by the Argyle team in the process:

 

1.   Business Sectors Served: Highest prioritygiven to video surveillance, access control and perimeter/outdoor.

2.   Markets Served: Highest priority given toU.S. and European companies.

3.   Channels Served: Highest priority given tosecurity IT/IP integrators and security value added resellers.

4.   Products Offered to Include One or More ofthe Following: Part of a solutions strategy, competitively positioned,scalable, favorable obsolescence factor, strong brand equity.

5.   Annual Sales: At least $20 million.

6.   Gross Margin: If video or access control -50%, if perimeter/outdoor or if intrusion protection - 40%.

7.   Operating Margin: 10% or more, or thepotential to reach 10% in the next 12-18 months.

8.   Annual Cash Flow: At least $1.5 million.

9.   Relative Competitive Advantage: Clearcompetitive advantage in at least one key area.

10.R&D Capability: Ability to continuously integrate into company’s otherofferings, ability to add value to Argyle’s other targeted sectors andcompanies, in-house R&D leadership or management capability.

11. Management Capabilities:Strong in at least one key functional area.

12. Location: Located so asto be cost effective in interacting/communicating with Argyle management.

13. Relative Attractiveness:To investors and to other targeted companies.

14.Opportunities/Potential: For revenue growth, for improving margin percentages,for synergies with other target sectors/companies, to improve/expand offerings,for channel expansion.

15.Target Company’s Culture: Senior management supportive of Argyle vision andstrategy, customer focused, senior management familiar with and supportive of asolutions strategy.

 

1

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On July 31, 2007,pursuant to the terms of a merger agreement, dated December 8, 2006, asamended on June 29, 2007 and July 11, 2007 the (“Merger Agreement”), Argyle acquired all of the assets and liabilities of ISI-Detention ContractingGroup, Inc. (“ISI”) through the merger of Argyle’s wholly-ownedsubsidiary, ISI Security Group, Inc., into ISI. As a result of the merger,ISI became a wholly owned subsidiary of Argyle. ISI is a provider of physicalsecurity solutions to commercial, governmental and correctional customers.

 

At the closing of themerger, the following consideration was paid by Argyle to thestockholders and debt holders of ISI:

 

· $18.6 millionin cash;

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

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

 

The value of Argyle commonstock issued as merger consideration is based on the average closing price ofArgyle’s common stock for the two days prior to, including the day of, and twodays subsequent to the second amendment to the merger agreement resulting inthe final negotiated purchase price (June 29, 2007) of $7.78 per share.  Based on the cash paid, common stock andconvertible promissory notes issued, and capitalized merger transaction costsof $2.7 million, the transaction was valued for accounting purposes at $32.5million.

 

The ISI acquisition met thepreviously set criteria in terms of; business sectors served (access controland perimeter / outdoor), markets served (US), channels served (IT / IPintegrators), and products offered (solutions strategy and strong brandequity).  ISI had financial metrics ofrevenues, gross margins, operating margins, and cash flows all exceeding thepreviously set acquisition criteria.  Theclose proximately of ISI to the Company’s headquarters in San Antonio, the experienceand expertise of the ISI management team, and the similar corporate culture andphilosophy made the acquisition particularly attractive.

 

**Overviewof ISI**

 

ISI, the wholly owned subsidiary of Argyle, is theparent company of several subsidiaries, including three solution providers inthe physical security industry: ISI Detention Contracting (referred to asISI-Detention), Metroplex Control Systems (referred to as MCS-Detention), andMetroplex Control Fire and Security Alarms (referred to as MCS-Commercial).Metroplex Control Systems (or MCS) was formed in 1988 and was acquired by ISIin 2000. After the acquisition, MCS was restructured into two separatesubsidiary entities (each under its own management): MCS-Detention andMCS-Commercial. MCS-Detention specializes in turnkey installations for publicand privately owned/operated detention facilities. MCS-Commercial has built aparallel business targeting commercial and industrial facilities.

 

***ISI-Detention***

 

ISI-Detentionhas been involved in furnishing and installing detention equipment in more than1,900 correctional facilities since its inception in 1976. ISI-Detentiondesigns, engineers, supplies, installs, and maintains a full array of detentionsystems and equipment, targeting correctional facilities throughout the UnitedStates. Its expertise and track record position ISI-Detention favorably amongthe nation’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-Detentionoffers a complete array of electronic security system solutions revolvingaround electronic 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. More than 60% of the revenue for ISI-Detention and MCS-Detentionduring 2004, 2005, and 2006 has been the result of contracts with repeatcustomers.

 

Contracting Structure: Most transactionsin which ISI-Detention becomes involved result in a contract with a customerwho is an owner or construction manager (where ISI-Detention is a primecontractor), an agreement with a general contractor or electrical contractor(where ISI-Detention is a subcontractor). Approximately 70% of the totalrevenues of ISI are derived from work performed for general contractors,whereas approximately 30% comes from work performed directly for the end user.ISI-Detention may seek these projects on its own as a stand-alone vendor or aspart of a team that has been assembled to pursue the project.

 

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Team Contracting: A team is typicallyassembled by a general contractor, architect, engineer, developer, or a privatecorrectional facility operator to submit a proposal to negotiate with acustomer or submit a competitive bid on a correctional project. Within theseteams, ISI-Detention is the ‘‘Security Solutions Principal’’. The members ofthe team negotiate the amount and terms of the contract for their respectiveparts of the project. This means that ISI-Detention and the other constructionrelated members of the team would enter into a contract with a generalcontractor without having to directly participate in a bid competition. Thiscan occur because the members of the team have previously worked together, andthe team members have experience in dealing with most, if not all, of the otherteam members, and know their capabilities. In many instances, ISI-Detention willhave previously developed a relationship with more than one member of the team,which facilitates the contracting process. 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 of 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.

 

Contractswith owners, construction managers, general contractors and electricalcontractors are pursued in both competitively bid situations and negotiatedtransactions. These constitute approximately 90% of ISI-Detention’s annualproject volume. The processes related to competitively bid contracts andnegotiated transactions are as follows:

 

(i)             Competitively bid contract: ISI-Detention, acting alone or asthe Security Solutions Principal for a team, is asked to submit a proposal witha price to a customer (owner, general contractor, construction manager orelectrical subcontractor) for a portion of the work on a corrections project.There are usually other organizations competing with ISI-Detention alsosubmitting proposals with pricing. The customer collects all the bids from thevendors or teams, chooses the best one, and then submits a bid or proposal totheir prospective customer in a bid competition. If ISI-Detention’s customer isan owner or construction manager, and the owner selects ISI-Detention as thewinning bidder, then ISI-Detention enters into an agreement with the owner orconstruction manager. If ISI-Detention’s customer is a general contractor or anelectrical engineer, and that customer is selected as the winning bidder, thenthe customer engages ISI-Detention for that portion of the project for whichISI-Detention submitted a proposal or bid. In many bid competitions, thesuccessful bidder is determined by which party has submitted the ‘‘best’’ bid,not necessarily the ‘‘lowest’’ bid. We believe that the relationships we havedeveloped with architects, engineers, general contractors and others, hasfacilitated ISI-Detention occasionally 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 ISI-Detention has not been thesuccessful bidder when it was, in fact, the lowest bidder.

 

(ii)          Negotiated transaction: ISI-Detention, acting alone or as theSecurity Solutions Principal for a team, prepares a proposal for a portion ofthe work on a correctional project that is being submitted to a prospectivecustomer for a negotiated transaction. The parties negotiate the terms of theagreements without competitive bidding. Many of these negotiated transactionsare with repeat customers of ISI-Detention. This arrangement allowsISI-Detention to enter into a contract with a customer without the pricepressure and elimination of value-added services that is common incompetitively bid transactions.

 

Product solutions for ISI-Detentionprimarily include detention hardware (prison bars, locks and locking systems),security glass, security furniture (metal furniture), detention grade hollowmetal doors, frames and windows and labor to install these items. All of theseitems are purchased from third-party vendors and sold through ISI-Detention toits customer. ISI-Detention does not manufacture the hardware installed as partof its security solutions. Hardware is purchased from third parties andinstalled as required by the plans and specifications for each project. All ofthese products are sold to general contractors that are building, expanding orrenovating a jail or prison, or they are sold to the owner (governmental orprivate entity) of a jail or prison that is being built, expanded or renovated.In either situation, these products are installed in city lockups, countyjails, state prisons and federal prisons.

 

Thesecurity solution created by ISI for each customer is a unique combination ofdifferent security devices, made by many different manufacturers. These devicesinclude access controls (keypads, card swipe readers, and key fob proximityreaders at doorways), electric locks, closed circuit television equipment, firealarm systems and smoke detectors, etc. These many different devices were notoriginally manufactured to work together in an integrated system. Eachmanufacturer developed its product to work in a ‘‘typical’’ environment, andeach manufacturer determined what ‘‘typical’’ would be.

 

3

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At the beginning of a project (the designphase), ISI-Detention works with architects, engineers and contractors to helpdesign the project by writing specifications, developing schedules (detailedlists) of doors, windows, door hardware and glazing for the customer. Duringthis stage of development, ISI-Detention writes specifications for specificlocking systems, analyzes particular conditions and requirements and recommendsproducts that correspond to the needs of that correctional facility, dependingon the type of security that is required and the underlying budget. The designprocess provides all the vendors and contractors with a clear outline of whatis needed for the project, without drawing every detailed plan that will beneeded for construction. This provides the customer with a detailed list of theprecise items that ISI-Detention will supply to the customer, and the cost forthose items.

 

Todetermine the pricing of a project, ISI-Detention will obtain the designdrawings of the project in question (which are basically the buildingconstruction drawings) and determine the precise quantity of each item neededfor the project. (For example, a list will be prepared showing exactly how manyleft-swinging 3ftx7ft doors and frames, as well as how many right-handed doorsand frames of the same size, are required on a project. A similar list isprepared for each type of door, window, lock, hinge, light fixture, toilet andevery other detention product that will be required in the project.)ISI-Detention provides these lists of required items to the appropriatevendors. Some vendors perform their own quantity determinations (‘‘takeoffs’’)rather than relying upon the take-offs prepared by ISI-Detention. The vendorthen provides ISI-Detention with the price for the items required. Once all thecosts are received from vendors, and ISI-Detention determines the cost of theservices that it will provide, ISI-Detention then adds profit and overhead,depending on many factors, including but not limited to what other competitorsare known to be bidding on the project, local labor and other conditions, sizeof the project, complexity of the project, schedule for completion, etc.ISI-Detention then determines a sales price. This price is given toISI-Detention’s customer. That customer may be a general contractor or theowner of the project — a city, county, state or federal agency.

 

Inmany cases, ISI 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 is invited to be part ofthis team because of its repeat customer relationship. The team then competesfor the contract as a group. This type of repeat customer relationship allowsISI-Detention the ability to negotiate most of the work sold to repeatcustomers.

 

Typically, when ISI-Detention creates aninitial budget for a project (before the detailed formal estimating of all jobcosts is completed), ISI-Detention typically estimates that 13% of theconstruction dollars will be allocated to ISI-Detention’s scope of work on thatproject, including the security electronics portion. This is an initialestimate that ISI-Detention uses in the early stages of a project before finaldesign is completed. While the final amount of the ISI-Detention scope of workchanges from project to project, depending on many factors relating to thedesign and the intended use of the facility being built or renovated,management has found that an initial budget of 13% of the estimated totalconstruction amount for a project has proven to be a reliable basis forestimating the size of ISI’s portion of the project.

 

Most governmental agencies require thattheir significant contracts be competitively bid. Typically, they utilize the ‘‘Requestfor Proposal’’ (RFP) method where several competitors submit their sealedproposals for a particular project, or the ‘‘Request for Qualifications’’ (RFQ)process where competitors submit their Qualifications for consideration by thecustomer. Some contracts are let upon the standard ‘‘Straight Bid’’ processwhere the detailed plans and specifications for a project are published andcontractors submit a ‘‘Bid’’ or fixed price, for the contract to build theproject. Other competitive bidding processes may also be utilized, such as theConstruction Manager at Risk model, where a Construction Manager is hired for afee to build the project for a fixed price, or ‘‘cost plus profit and overhead’’basis. When ISI-Detention responds to an RFP, RFQ, Straight Bid, or othercompetitive bidding process, it typically provides the response to a generalcontractor (where ISI-Detention is one of several contractors in differentdisciplines that are part of the total design/bid team providing a proposalwith prices) or directly to the owner (governmental agency or private entity)of a correctional project. The quality of ISI-Detention’s estimating process,knowledge of the industry, knowledge of its customers and other issuesrequiring significant judgment and expertise are key factors in determiningwhether ISI-Detention will ‘win’ the competitive bid process and be offered thecontract for the project.

 

When the customer sends ISI-Detention acontract, it contains typical construction contract terms and conditions, suchas provision for retainage, certification of completion for progress payments,fixed markup on change orders, coordination responsibility, and similarprovisions. Most contracts allow for progress payments on a monthly basis, andmost contracts are fixed price.

 

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Progresspayments and retainage 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’s certificationof its percentage of completion, then ISI-Detention is entitled to receive thatpercentage of the entire contract amount, less the amount of retainage(typically 5% to 10%). (For example, if ISI-Detention claims that 60% of itswork under its contract has been completed, then ISI-Detention is entitled tobe paid 60% of the contract amount, less the retainage amount). At theconclusion of the project, assuming no other changes or charges, ISI-Detentionshould have been paid the full contract amount less the retainage. When theowner of the project, ISI-Detention’s customer and the third party have allcertified that the project is complete and that all sub-contractors ofISI-Detention have been paid or other appropriate documentation provided, theretainage amount is paid to ISI-Detention.

 

After a project is sold and ISI-Detentionreceives a contract, ISI-Detention prepares engineering drawings and schedulesor lists creating more detail and information than in the design phase, whichtakes place early on in the development of a project. During the constructionphase of the project, ISI-Detention orders materials from vendors and arrangesfor those materials to be shipped to the project site. Typically, ISI-Detentionsends its employees to the job site to install this equipment. ISI-Detention’sprojects usually take 9 to 14 months; some larger projects may run longer.

 

From time to time, ISI-Detention’scustomers require that ISI-Detention provide not only the detention equipmentbut the security electronics as well. When this occurs, ISI-Detention usesMCS-Detention (a wholly owned subsidiary of ISI) to provide the securityelectronics to ISI-Detention. The price for the detention equipment and theprice for the security electronics (closed circuit television, infra-redalarms, access control systems, etc.) are combined together and submitted byISI-Detention to its customer as a package price.

 

When competitive bids are solicited inconnection with the construction of a correctional facility, ISI-Detention bidsfor the detention equipment portion of the overall project as a directcontractor or as one of the subcontractors for a general contractor. Thefurnished and installed package proposed by ISI-Detention typically includessecurity locking systems and hardware, security hollow metal (doors andframes), detention furniture (tables, bunks, benches, mirrors, etc.), securityelectronic controls (closed circuit television, intercom, etc.) and securityglass and glazing. By providing this complete package furnished and installed,ISI-Detention is able to provide a warranty program and insure that all thepieces and components are fully integrated and inter-operate correctly.

 

ISI-Detention’stypical warranty is a limited warranty of one year and is provided in more than95% of the contracts entered into. This warranty provides for repair orreplacement of defective materials or workmanship, if a failure occurs withinone year of installation of the product. In very limited circumstances,ISI-Detention will provide an extended warranty of two years (with the samerepair and replacement obligations as the one year warranty) when it isdemanded by a significant customer or is otherwise required to secure acontract. In even more limited circumstances, an extended warranty of threeyears (with the same repair and replacement obligations as the one yearwarranty) will be provided.

 

The aggregate cost of fulfilling ISIDetention’s warranty obligations on completed contracts in 2006 and 2007 hasbeen less than $150,000 for those years combined, and there have been no claimsasserted by customers or users of ISI’s products that are outside the normalscope of warranty work required. Additionally, since all of the products soldby ISI are manufactured by others, the ultimate burden for warranty of thoseitems is passed on to the manufacturers by ISI

 

***MCS-Detention***

 

MCS-Detention provides electronicsecurity systems for correctional facilities. MCS-Detention develops electronicsecurity systems for its customers using door controls, intercoms, closedcircuit television (CCTV) and other low voltage electronic security systemsthat can all be controlled from one location at one console. MCS-Detention doesnot manufacture any of the hardware that is sold and installed as part of itssecurity solutions. Hardware is purchased from third parties and installed asrequired by the plans and specifications for each project. MCS-Detention’sexpertise lies in designing, engineering, supplying, installing and maintainingcomplex, customized security, access control, video and electronic securitycontrol system solutions at correctional and government facilities. Typically,the ultimate structure of most transactions in which MCS Detention becomesinvolved is a situation where MCS-Detention is a subcontractor to anotherentity, which entity could be a general contractor, ISI-Detention or acompetitor of ISI-Detention.

 

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Manysolutions are simultaneously provided for the customer, because MCS-Detentiondetermines the needs of its customer and puts systems together (from manydifferent manufacturers) to fit those needs. More importantly, MCS-Detentioncan integrate 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 control stations. Included intheir 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.

 

ContractingStructure: Most transactions in which MCS-Detention becomes involved result ina contract with a customer who is an owner or construction manager (where ISIis a prime or direct contractor), or an agreement with a general contractor orelectrical contractor (where ISI is a subcontractor). MCS-Detention’s customersalso include ISI-Detention and competitors of ISI-Detention that lack thein-house capability to undertake a security electronics project. MCS-Detentionmay seek these projects on its own as a stand-alone vendor or as part of a teamthat has been assembled to pursue the project. The team approach is morecommonly utilized by ISI-Detention, though it is an important part ofMCS-Detention’s business model to act as a stand alone vendor.

 

Team Contracting: A team is typicallyassembled by a general contractor, architect, engineer, developer or a privatecorrectional facility operator to submit a proposal to negotiate with acustomer or submit a competitive bid on a correctional project. In these teams,MCS-Detention is the ‘‘Electronic Security Solutions Principal’’. The membersof the team negotiate the amount and terms of the contract for their respectiveparts 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.

 

Contractswith owners, construction managers, general contractors and electrical arepursued in both competitively-bid situations and negotiated transactions. Theseconstitute approximately 90% of MCS-Detention’s annual project volume. Theprocesses related to competitively bid contracts and negotiated transactionsare as follows:

 

(i)             Competitively bid contract: MCS-Detention, acting alone or asthe Electronic Security Solutions Principal for a team, is asked to submit aproposal with a price to a customer (owner, general contractor, constructionmanager or electrical subcontractor) for a portion of the work on a correctionsproject. There are usually other organizations competing with MCS-Detentionthat are also submitting proposals with pricing. The customer collects all thebids from the many vendors or teams, chooses the best one, and then submits abid or proposal to its prospective customer in a bid competition. IfMCS-Detention’s customer is an owner or construction manager, and the ownerselects MCS-Detention as the winning bidder, then MCS-Detention enters into anagreement with the owner or construction manager. If MCS-Detention’s customeris a general contractor or an electrical engineer and that customer is selectedas the winning bidder, then the customer engages MCS-Detention for that portionof the project for which MCS-Detention submitted a proposal or bid. In many bidcompetitions, the successful bidder is determined by which party has submittedthe ‘‘best’’ bid, not necessarily the ‘‘lowest’’ bid. We believe that therelationships we have developed with architects, engineers, general contractorsand others, has occasionally facilitated MCS-Detention being selected as the ‘‘best’’bidder (and winning the contract) in situations where it was not the lowestbidder. However, there have been other situations where MCS-Detention has notbeen the successful bidder when it was, in fact, the lowest bidder.

 

(ii)          Negotiated transaction: MCS-Detention, acting alone or as theElectronic Security Solutions Principal for a team, prepares a proposal for aportion of the work on a correctional project that is to be submitted to aprospective customer for a negotiated transaction. The parties negotiate theterms of the agreements without competitive bidding. Many of these negotiatedtransactions are with repeat customers. This arrangement allows MCS-Detentionto enter into a contract with a customer without the price pressure andelimination of value-added services that are common in competitively bidtransactions.

 

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(iii) Intercompany Transaction: WhenMCS-Detention’s customer is ISI-Detention, an intercompany arrangement forbilling and receivables are created.

 

MCS-Detentionmaintains its sales force in San Antonio, Texas and in Indianapolis, Indiana.Sales are pursued nationwide from those locations.

 

MCS-Detention estimates the cost andpricing of a project in a process that is similar to that of ISI-Detention.MCS-Detention will review the design drawings and written specifications, tocreate the same ‘‘take-offs,’’ or lists, of products and materials that arerequired on a project. MCS-Detention will then distribute the lists to vendors,receive the vendors’ bids on their respective portions of the project, and thenMCS-Detention will calculate the costs to furnish and install the productsrequired. MCS-Detention then adds profit and overhead to its calculations anddetermines the final price for the customer. In determining the final price,MCS-Detention uses the same subjective criteria that ISI-Detention uses.

 

The contracts that MCS-Detention securesare subject to similar competitive bidding processes as are the contractsentered into by ISI-Detention. All products supplied by MCS-Detention arepurchased from third-party vendors, assembled and prepared by MCS-Detention,and then sold by MCS-Detention to its customer. Typically, all MCS-Detentionsystems are installed and tested by MCS personnel. The terms of the contractsMCS-Detention enters into with its customers are similar to the types ofcontracts entered into by ISI-Detention. The types of customers that are servedby 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.

 

***MCS-Commercial***

 

MCS-Commercialdesigns, engineers, supplies, installs, and maintains professional security,access control, video and fire alarm system solutions for large commercialcustomers.

 

ContractingStructure: Approximately 34% of the work of MCS-Commercial is negotiatedservice work, which is not subject to competitive bidding and is billed on anhourly basis for time and materials. The remaining 66% of MCS-Commercial’s workis generally equally divided between negotiated contracts and competitively bidtransactions on commercial (not correctional) projects. Most non-service worktransactions result in a contract with a customer who is an owner orconstruction manager of a project (where MCS-Commercial is a prime or directcontractor) or an agreement with a general contractor or electrical contractor ona project (where MCS-Commercial is a subcontractor).

 

MCS-Commercial has focused uponrelationship selling and negotiated contracts, because in the commercial(non-governmental) arena, competitive bidding is not mandated by law, and theparties have the option of negotiating a contract should they choose to do so.MCS-Commercial will continue to focus upon the negotiated transaction sector ofits business, by aggressively seeking out and courting relationships withowner/customers.

 

MCS-Commercial pursues the majority ofits work on its own as a stand-alone vendor, though a smaller portion ispursued as part of a team that has been assembled to pursue the project. Theteam approach is more commonly utilized by ISI Detention, though it is animportant part of MCS-Commercial’s business model.

 

Team Contracting: A team is typicallyassembled by a general contractor, architect, engineer, developer, or electriccommercial project. In these teams, MCS-Commercial is the ‘‘Electronic SecuritySolutions Principal’’. The members of the team negotiate the amount and termsof the contract for their respective parts of the project. This means thatMCS-Commercial enters into a contract with a general contractor or electricalcontractor without having to directly participate in a bid competition. Thiscan occur because the members of the team have previously worked together, andthe team members have experience in dealing with most, if not all, of the otherteam 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 team’s proposal is submitted in the name of thegeneral or lead contractor.

 

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Contracts with owners, constructionmanagers, general contractors and electrical contractors are pursued in bothcompetitively bid situations and negotiated transactions. These constituteapproximately 66% of MCS-Commercial’s annual project volume. The processesrelated to competitively bid contracts and negotiated transactions are asfollows:

 

(i)             Competitively bid contract: MCS-Commercial, acting alone oras the Electronic Security Solutions Principal for a team, is asked to submit aproposal with a price to customer (owner, general contractor, constructionmanager or electrical subcontractor) for a portion of the work on a commercial(non-correctional) project. There are usually other organizations competingwith MCS-Commercial, also submitting proposals with pricing. The customercollects all the bids from the many vendors or teams, chooses the best one, andthen submits a bid or proposal to their prospective customer in a bidcompetition. If MCS-Commercial’s customer is an owner or construction manager,and the owner selects MCS-Commercial as the winning bidder, then MCS-Commercialenters into an agreement with the owner or construction manager for theirportion of the project. If MCS-Commercial’s customer is a general contractor oran electrical engineer, and that customer is selected as the winning bidder,then the customer engages MCS-Commercial for that portion of the project forwhich MCS-Commercial submitted a proposal or bid. In many bid competitions thesuccessful bidder is determined by which party has submitted the ‘‘best’’ bid,not necessarily the ‘‘lowest’’ bid. We believe that the relationships we havedeveloped with architects, engineers, general contractors and others, havefacilitated ISI occasionally being selected as the ‘‘best’’ bidder’’ (andwinning the contract) in situations where it was not the lowest bidder.However, there have been other situations where MCS-Commercial has not been thesuccessful bidder when it was, in fact, the lowest bidder.

 

(ii)          Negotiated transaction: MCS-Commercial, acting alone or asthe Electric Security Solutions Principal for a team, prepares a proposal for aportion of the work on a commercial (non-correctional) project, which is to besubmitted to a prospective customer for a negotiated transaction. The partiesnegotiate the terms of the agreements without competitive bidding. Thisarrangement allows MCS-Commercial to enter into a contract with a customerwithout the price pressure and elimination of value-added services that iscommon in competitively bid transactions.

 

MCS-Commercialsupplies security electronic products to end-users and contractors. Theseproducts include: access control systems, fire alarms, video, CCTV, soundpaging systems and structured cabling. In contrast to ISI-Detention andMCS-Detention, which sell their products to the corrections industry for jailsand prisons, MCS-Commercial typically sells its products to contractors thatare building or renovating commercial projects, or to owners of commercialproperties. MCS-Commercial does not manufacture any of the hardware that issold and installed as part of its security solutions. Hardware is purchasedfrom third parties and installed as required by the plans and specificationsfor each project. Although the products of MCS-Commercial and MCS-Detention aresimilar in many respects (i.e. access control systems, CCTV, etc.),MCS-Commercial sells products only to commercial customers for commercialprojects.

 

MCS-Commercial maintains sales/serviceoffices in Dallas, San Antonio, Austin and Houston, Texas as well as in Denver,Colorado. Each office is responsible for selling and servicing MCS-Commercialproducts in its respective geographical area.

 

The process of estimating and pricingprojects for MCS-Commercial is substantially the same process used byISI-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’ isintended to mean hard goods generally related to all facets of modern securitysystems. Therefore this term includes not only operational computer terminals(with software loaded upon them), computer monitors and networking devices, butit also includes security grade doors, windows, locks, hinges, door closers,door handles, cameras, sensors, intercoms, fire alarms, smoke alarms, access controls,installation hardware (screws, nuts, bolts, cables, etc.) and similar goodsinvolved in modern correctional, governmental and commercial security systems.

 

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**General**

 

None of ISI’s three divisions manufacturesthe hardware that it sells. Hardware is purchased from third parties andresold. ISI-Detention and MCS-Detention do not have long-term agreements withtheir third-party hardware vendors. Most of the hardware that these twodivisions typically recommend be used in any particular customized securitysolution for a customer is available to them from more than one hardwarevendor. Accordingly we do not believe that such long-term agreements arenecessary. MCS-Commercial has distribution agreements in place with some of itsthird-party vendors to distribute certain product lines. Computers are includedin the hardware that the divisions sell to their customers. Those computersrequire software, and that software is purchased from third parties. None of ourproprietary software is sold separately to our customers. The divisions loadthe third-party software on the computers (or it is installed by themanufacturer of the computer) and insure that the computers are workingproperly before they are sold and shipped to the customer.

 

Hardware re-sales are not impacted bywhether we act as a contractor or subcontractor on a particular project. Ineither instance, whether as a subcontractor or a contractor, we purchasehardware, pre-assemble and test it, and once approved, ship the goods to thejobsite, where the hardware is installed. Whether we are a subcontractor to ageneral contractor, or a party to a direct contract with an owner of a project,these internal processes at ISI do not change. The key relevant difference inISI acting as a general/prime contractor or a subcontractor with regard tohardware re-sales is merely the identity of the party with whom ISI contractsand the party to whom ISI looks for initial payment.

 

Whetherwe are acting as a general/prime contractor or a subcontractor, the cost of thehardware is included in Cost of Revenue/Contract Costs in our financialstatements, and the revenue generated by the sale of that hardware is reflectedin Contract Revenues in our financial statements. The profit from the sale ofhardware is first reflected in Gross Profit in our financial statements, whichis then reduced by general, sales and administrative costs, etc. In eithersituation, 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.

 

Thesecurity solution created by us for each customer is a unique combination ofdifferent security devices, made by many different manufacturers. These devicesinclude access controls (keypads, card swipe readers, and key fob proximityreaders at doorways), electric locks, closed circuit television equipment, firealarm systems and smoke detectors, etc. These many different devices were notoriginally manufactured to work together in an integrated system. Eachmanufacturer developed its product to work in a ‘‘typical’’ environment, andeach manufacturer determines what ‘‘typical’’ would be.

 

Each project presents us with a uniquecombination of a one-of-a-kind array of security related devices in a uniquegeographical 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 ISI divisions provide.

 

Theunusual communication and operational problems between systems presented to usin each project requires project-specific programming to resolve. The cost ofsuch project-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 communication conflictsbetween disparate systems quickly and accurately.

 

Thislibrary of unique software solutions, created on a project-by-project basis isthe foundation of the proprietary TotalWerks suite of software programs that weuse to solve communication conflicts between security devices. This suite ofsoftware is a development tool used by us and it is not sold to any customer.The TotalWerks suite allows the fabrication and engineering personnel ofMCS-Detention and MCS-Commercial to quickly create the software solutions thatare needed for a specific project.

 

Beforeany system is shipped to a customer, it is first assembled in the MCS-Detentionor MCS-Commercial offices, in a simulated real-world environment. TheTotalWerks software is used during this intensive testing, and allows theengineering and fabrication staff to test every input/output device (doorswitch, card swipe reader, security keyboard, night watchman guard tour signaldevice, etc.) in the expected real-world environment for that project in orderto insure that each device works properly with all the other required systems,before the system is shipped to the customer.

 

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The TotalWerks suite of software isessentially a combination of the adaptations and tools that ISI has created forindividual projects, and the cost of developing almost all of the component piecesof the Suite was charged to individual projects for which each separateadaptation or tool was created. The cost of the additional work completed onthe TotalWerks suite to streamline its operation has been minimal. Therefore,ISI does not maintain a separate research and development program.

 

In2005, we purchased 90 computers for resale to its customers for a total cost ofapproximately $252,000. In 2006, we purchased 104 computers for resale to itscustomers for a total cost of approximately $291,200. In 2007, we purchased 110computers for resale to its customers for a total cost of approximately$79,220. Those computers, which were used for our touch screen solutionutilized in the corrections market, required software, and that software was purchasedfrom third parties.

 

Thereare two software packages that are loaded on these computers that requirelicensing, and the transfer of the license to ISI’s customer is handleddifferently for each of the packages:

 

(i)             Microsoft Windows XP — This operating system software packageis well known to the business community. ISI pays the manufacturer of thecomputer for the license for this software package for each computer that ISIpurchases for resale to its customers. The license for Windows XP is purchasedin the name of an entity. The license is not registered in our name or that ofour customer. The license is purchased from the computer manufacturer, andWindows XP is installed on the computer by the computer manufacturer. All ofthe licensing documentation that establishes that the software on each computeris properly licensed and is delivered by the computer manufacturer to us. Uponcompletion of the project for which the computer was purchased, we deliver toour customer all of the authenticating documentation for the software package.The validation certificates, registration numbers, discs containing thesoftware, and all similar authenticating data are provided to our customer.This provides the customer with the documentation required to substantiate itsunfettered ownership of the software package. The cost of each license forWindows XP is included in the cost of the computer. In 2005, we paidapproximately $8,100 for 90 licenses for Windows XP, at a per-copy price ofapproximately $90. In 2006 ISI paid approximately $9,360 for 104 licenses forWindows XP, at a per copy price of approximately $90.  In 2007 we paid approximately $9,900 for 110licenses for Windows XP, at a per copy price of approximately $90.

 

(ii)          Wonderware — This software is a graphics interface programthat, among other things, makes ‘‘touch screens’’ actually touchable. Thelicense for this software is actually registered in the name of our customer.The license for the software is issued to our customer and bears the name of thecustomer. The license is purchased from the software manufacturer and isinstalled on the computer by us. All of the licensing documentation whichestablishes that the software on each computer is properly licensed to ourcustomer and is delivered by the computer manufacturer to us. Upon completionof the project for which the computer was purchased, we deliver to our customerall of the authenticating documentation for the software package. Thevalidation certificates, registration numbers, discs containing the softwareand all similar authenticating data are provided to our customer. This providesthe customer with the documentation required to substantiate its unfetteredownership of the software package. The cost of each license for Wonderware is $750.00.The amount paid annually for such licenses will vary with the number ofcomputers sold. In 2005, ISI spent approximately $108,000 on 90 copies ofWonderware, at a per-copy price of approximately $1,200. In 2006, ISI spentapproximately $124,800 on 104 copies of Wonderware, at a per-copy price ofapproximately $1,200.  In 2007, ISI spentapproximately $57,000 on 75 copies of Wonderware, at a per-copy price ofapproximately $760.

 

We have made a concerted effort to becomea total solutions provider of security and detention for the correctionsdesign/build market. In the security industry, a ‘‘total solutions provider’’means that a vendor has the ability to design customized solutions for a widerange of security needs, and provide all of the hardware and software for thosesolutions, rather than designing a wide array of solutions, but only actuallyfulfilling the design in one or two areas. If a customer selects a series ofsecurity vendors, each providing a separate and independent system that addressesonly a limited security need, then the numerous systems required to provideoverall security can cause many unanticipated problems in operations,maintenance, and upgrades. ISI, as a ‘‘total solutions provider,’’ can provideits customers with one source for a wide range of security solutions that aretested and proven to work together.

 

Our operating units provide a range ofproducts as well as value-added services such as design assistance toarchitects, engineers and owners through writing specifications, providing CADdocuments, equipment selection and vendor recommendation. The breadth of itsofferings has enabled us to establish a leadership position in the design/buildcorrections market; in turn, this recognized expertise in providing customized,high-level solutions to the most demanding of customers has allowed us toacquire projects in other security-sensitive sectors, such as the healthcareindustry, water treatment plants, federal courthouses and upscale privatecommercial buildings.

 

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Through our design assistance andperformance, we develop relationships that make repeat business with customersmore likely. For example, more than 60% of the revenue for ISI-Detention andMCS-Detention during 2005, 2006, and 2007 has been the result of contracts withrepeat customers. These repeat customers typically allow ISI to negotiate thework, especially on design-build projects. Design-build projects are contractswhere ISI provides substantial design assistance to its customers.

 

**Bonding**

 

Performanceand payment bonds are an important component of our business, because manycustomers require that performance and payment bonds be delivered to thecustomer before the customer will enter into a contract. Approximately 39% ofcontract revenues and 35% of overall company revenues for 2007 were generatedby ‘‘bonded’’ contracts (contracts that require performance and payment bonds),and approximately 37% of ISI revenues in the past three years have been derivedfrom bonded contracts.

 

From 2004 through the ISI merger in July 2007,bonding capacity had been made available to us through ISI*MCS, an entitycreated and owned by the Chief Executive Officer and President of ISI, SamYoungblood and Don Carr, respectively. Since the consummation of the acquisitionof ISI, ISI*MCS has not provided any new bonded contracts for ISI or Argyle.Subject to the final determination by a bonding company, our insurance agentestimates that sufficient new bonding capacity to address the total expectedbusiness in 2008 will be available to us upon receipt of additional equityfinancing and/or subordinated debt financing. The Company currently anticipatessuch financing to take place by April 2008. However, if we are unable toengage in a financing and we are unable to secure a line of bonding capacity,then we will not be able to enter into contracts that require such bonds. Thiswould significantly reduce our expected sales and reduce the level of ourfuture financial performance. Some of the additional factors that might causeISI to be unable to obtain such bonds include, but are not limited to,unacceptably high premium rates for such bonds, the unavailability of bondingcapacity at an acceptable cost from a bonding company with an acceptablefinancial rating, or the collateral/financial requirements of the bondingcompany. Such requirements are generally intended to provide liquidity to abonding company should it become obligated to pay a claim. These requirementscan include minimum cash reserves, letters of credit for the benefit of thebonding company and other irrevocable commitments of working capital that areunacceptably high. In addition, because ISI*MCS no longer has a relationshipwith us, we no longer have the benefit of a long-standing relationship with abonding company.

 

Thebonding company that issued the performance and payment bonds is an interestedparty in all matters regarding the bonded contracts. A bonding company isobligated to complete a project for which it has issued bonds and willtypically seek recovery of its costs to complete the contract from allavailable parties. The result is that a dispute with an owner or generalcontractor arising from a bonded contract must also include consideration ofthe interests of the bonding company, typically a well-financed and highlysophisticated party. The addition of this sophisticated party to disputesregarding bonded contracts increases the risk that a default or breach of abonded contract by ISI will result in a loss to ISI. Even if ISI is able toresolve or avoid a dispute with an owner or general contractor, resolving adispute with a bonding company that has paid a claim to complete a project willincrease the potential risk of loss to ISI. 

 

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**Acquisitions**

 

Prior to its acquisition of ISI, Argyle,either itself or through its subsidiaries, sought to acquire companies thatmeet many of the following criteria and Argyle continues to seek to acquirecompanies that are synergistic with one or more of its existing businesses and/ or that fit into many of the following criteria:

 

·     Has demonstrated competitiveadvantage in at least one key area;

 

·     Enhances existing geographic footprint;

 

·     Increases market share in existing verticalmarkets or channels;

 

·     Facilitates entry into targeted newvertical markets or channels;

 

·     Brings products or technology that canserve existing markets or channels;

 

·     Offers a new technology that iscomplementary to Argyle’s strategy;

 

·     Has international presence or potential;

 

·     Is profitable, or can quickly becomeprofitable;

 

·     Has potential/opportunity for attractiverevenue and margin growth;

 

·     Has strong share in a relevant market;

 

·     Has capable management team that sharesArgyle’s vision and strategy;

 

·     Has a customer-focused, solutionsphilosophy;

 

·     Has track record of capitalizing onconvergence opportunities; and

 

·     Is fairly priced.

 

On July 31, 2007, Argyle consummated abusiness combination, acquiring 100% of the outstanding capital stock of ISIDetention Contracting Group, Inc. and its subsidiaries, the value of whichthe Board of Directors determined was greater than 80% of Argyle’s assets atthe time of the merger. Prior to the acquisition of ISI, Argyle had nooperations and was considered a developmental stage enterprise. ISI is deemedto be a ‘‘predecessor’’ to the combined company. The accompanying consolidatedbalance sheet includes the assets and liabilities related to the acquisition ofISI, adjusted to fair value pursuant to Statement of Financial AccountingStandards (SFAS) No. 141, *BusinessCombinations*.

 

Argyle used an estimated $20.5 million(excluding Argyle and ISI transaction costs) of the net proceeds of the initialpublic offering to acquire ISI.  At theclosing of the merger, the following consideration was paid by the Company tothe stockholders and debt holders of ISI:

 

·      $18.6 million in cash;

 

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

 

·                  $1.9 million of unsecured promissory notes convertibleinto shares of common stock of the Company at a conversion price of $10 pershare.

 

Additionally, Argyle incurred totaltransaction costs of approximately $1.7 million, including legal costs paid toLoeb & Loeb of $0.5 million, $0.6 million related to certain MacquarieSecurities (USA) Inc.’s (formerly Giuliani Capital Advisors) advisory fees andfairness opinion, $0.3 million paid in M&A fees to WFG Investments andadditional costs of $0.3 million related to accountants, consultants, printerfees and other miscellaneous expenses. Such costs do not include transactioncosts of approximately $1.0 million incurred by ISI (related primarily toattorney, brokerage and accounting fees).

 

The ISI acquisition met thepreviously set criteria in terms of; business sectors served (access controland perimeter / outdoor), markets served (US), channels served (IT / IPintegrators), and products offered (solutions strategy and strong brandequity).  ISI had financial metrics ofrevenues, gross margins, operating margins, and cash flows all exceeding thepreviously set acquisition criteria.  Theclose proximately of ISI to the Company’s headquarters in San Antonio, theexperience and expertise of the ISI management team, and the similar corporateculture and philosophy made the acquisition particularly attractive.

 

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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.  Inconsideration for the sale of its assets to MCFSA, Fire Quest received cash inthe amount of $0.75 million and a promissory note in the aggregate principalamount of $0.25 million (“Fire Quest Promissory Note”). The Promissory Noteswill bear interest at the rate of 7.25% per year and will become due andpayable 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 “Promissory Notes”) in the aggregate principal amount of$3.0 million. The aggregate principal amount of the Promissory Notes may bereduced depending on the occurrence of certain events described in the AssetPurchase Agreement. The payment of the Promissory Notes is guaranteed by andsecured by the assets of ISI and the Company; bears interest at 6% per year andwill become due and payable on December 31, 2012.****OnFebruary 28, 2008 the holders of the Promissory Notes may convert up to$1,500,000 of the outstanding balance of the Promissory Notes into shares ofArgyle’s common stock at the average closing price of Argyle’s common stock forthe 20 trading days preceding the conversion date, provided that the conversionprice may be no less than $8.00 per share.

 

On January 31, 2008,ISI Controls, Ltd. (“ISI-Controls”), a wholly owned subsidiary of ISI,  closed a transaction, pursuant to whichISI-Controls acquired 100% of the outstanding units of Com-Tec Security, LLC (“Com-Tec”),resulting in Com-Tec becoming a wholly owned subsidiary of ISI-Controls.Com-Tec is engaged in the business of custom design, manufacture andinstallation of electronic security and communication 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 “Promissory Note”). Theaggregate principal amount of the Promissory Note may be reduced depending onthe occurrence of certain events described in the Unit Purchase Agreement byand among ISI-Controls, the Seller and Jeffrey E. Corcoran as the SellerRepresentative (the “Unit Purchase Agreement”). The Promissory Note isguaranteed by and secured by the assets of ISI and the Company; bears interestat 7% per year and will become due and payable on April 1, 2011.

 

**Customers**

 

Our company is customer focused and takespride in its customer retention. We continuously focus on finding ways tobetter serve our clients.

 

Our diverse customer base consistsprimarily of contractors, construction companies and architects catering topublicly and privately run detention facilities and commercial construction.For fiscal year 2006, ISI generated 16% of its revenues from its top customer,26% from the top two and 34% from the top three. ISI’s largest customer represented$9.5 million of revenues. Other large customers represented 10%, 8%, and 5% ofrevenues in fiscal year 2006.  Thecompany is progressing in diversifying its customer base: for fiscal year 2007,ISI generated 8% of its revenues from its top customer, 15% from the top twoand 20% from the top three. ISI’s largest customer represented $6.7 million ofrevenues. Other large customers represented 7%, 6%, and 5% of revenues infiscal year 2007.

 

**Competition**

 

Thesecurity services industry is a large and competitive market. We compete forcontracts based on our strong client relationships, successful past performancerecord, significant technical expertise and specialized knowledge. We oftencompete against defense contractors, as well as specialized informationtechnology consulting and outsourcing firms. ISI-Detention’s competitorsinclude Norment Security Group (part of Compudyne), Cornerstone DetentionProducts, Sierra Steel, CCC Group, G-S Company, and Pauly Jail BuildingCompany. There are also several smaller regional companies that compete withISI-Detention.

 

MCS-Detention’s competitors for itshardware/software solutions include: Norment Security Group, Stanley Integrator(part of Stanley Works), Simplex Grinnell (part of Tyco), ESi Companies, SouthwestCommunications, and Accurate Controls. MCS-Commercial faces a much broaderarray of competitors such as: Koetter, Siemens, DSS, Fire Alarm Services, FireAlarm Control Services, Tyco, Chubb and Lone Star. Management does not expectcompetition in any of the sectors to decline in the foreseeable future.

 

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Someof the companies we compete with are much larger than us, and such companieshave significantly greater resources than us. However, the larger conglomeratesthat compete in the detention sector offer only the electronic portion of ourdetention security solution. There are very few companies that provide bothelectronic and physical security solutions, Norment (part of Compudyne) beingthe most prominent, allowing general contractors to deal with a single supplierfor all of their correctional security needs. The commercial security sectorhas always had a few very large competitors and many moderate size competitors.The latter companies continue to thrive on the basis of their sales capability,project execution performance and their after-project service. The commercialsecurity market has proven to be large enough in prior years to support growthfor both large and moderate size security companies. 

 

**Employees**

 

As of December 31, 2007, we had approximately 397full-time employees. Future success depends significantly on our ability toattract, retain and motivate qualified personnel. We are not a party to anycollective bargaining agreement, have not experienced any strikes or work stoppages andconsider our relationship with our employees to be satisfactory.

 

**Market**

 

The Company’s focus markets include thecorrections market and the commercial security market in attractive geographicareas throughout the world.  The graphicbelow depicts our current comprehensive focus areas as well as our anticipated futureservice offerings.

 

 

The Company seeks opportunities in the **Outdoor **& perimeter, **Access**control, and **Intrusion** detection markets ineach of which **Video**surveillance is a commonmarket element.  The Company is activelyseeking acquisition targets that can serve these markets and can becomplementary to one another in the access to these customers and markets.  The Company believes it has key competenciesin **Consulting** and**ProjectManagement,**and although we currently provide some services in **Risk & Threat Analysis**we may seek to expand ourservice offering in those areas**.**

 

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Our Company is a comprehensive securitysolutions provider to our diverse customer base because it addresses themajority of their physical electronic security requirements.  We meet these requirements with a broad rangeof specific but custom integrated security solutions delivered on a turnkeybasis.  Our goal is to become a trustedresource to our customers, and in doing so develop long standing relationships,through which we then become an ongoing provider of recurring maintenance andsupport services for both systems installed by us as well as legacysystems.  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 correctionsand commercial markets, our long term customer relationships represent agrowing source of predictable future installation revenue as well as recurringservices — at growth rates that well exceed that of our competitors.  Currently, our primary business is thedelivery 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.  As we consider potential acquisitioncandidates, our goal is to extend our national footprint in the commercial /government systems integration market sector and we may determine that it is inour best interests to acquire selective technologies in software and hardwarethat have been developed by successful organizations. We will only considersuch acquisitions if we determine that our ownership of such technologies willnot compromise the best possible products and services to our customer base andwill not disturb the sales channels of these products to their respectivemarkets. 

 

*DetentionMarket.*Thedetention market has been expanding in recent years. Atthe end of 2006, there were 2,385,213 prisoners (up from 2,320,359 at end of2005) being held in federal or state prisons or in local jails or juvenilefacilities. Statistically, 1 in every 133 U.S. residents (up from 1 in every136 in 2005) was in prison or jail in 2006. The latter was an increase of 2.8%from year end 2005. The average growth in both the prison and jail populationsduring the previous ten years has been approximately 3% per year. At the end of2006, state prisons were operating between 2% below and 14% above capacity, andfederal prisons were operating at 34% above capacity. As a result of this situation,some states have had to move their excess prisoners to other states wheredetention facilities have some excess capacity to absorb additional prisoners.Management believes that we are well positioned to take advantage of thecontinued growth in population in detention facilities. The statisticspresented above were obtained from publicly available U.S. Department ofJustice Bureau of Justice Statistics Bulletins.

 

The current prison construction programsof various federal agencies, states, counties and cities are driven by manydifferent factors pertaining to inmate populations. In addition to annualincreases in inmate population, these factors include the increase in the rateof juvenile and female incarceration, the segmenting of violent sexualpredators, the segmenting of aging inmates, the recent rapid increase in therate of illegal alien incarceration, plus the significant transient movement ofthe population, which also causes an increase in incarceration rates indifferent locations.

 

Privateprison operators are growing at a much faster rate than the 2.5% to 3.0%increase in inmate growth (Bureau of Justice Statistics Bulletin). One of thereasons for this accelerated growth is the increasing acceptance of thefinancing plans that have been developed by the private operators.  We are planning to pursue projects by privateprison operators in 2008.

 

*CommercialSecurity Market.*The North Americanelectronic security market reached $23.8 billion by the end of 2005, of which70% was in the commercial/industrial sector — MCS-Commercial’s market. Thefastest growing sectors within that market are video (10% per year) and access control(8 - 9% per year), both areas in which MCS-Commercial competes.MCS-Commercial also competes in the fire protection area. MCS-Commercial isalso able to design and provide fire alarm products and services. The firealarm market is a potential catalyst for garnering video and access controlbusiness because of the unique licensing requirements mandated by state andlocal authorities which oversee an industry that is focused more on life-safetythan on property protection. Many of the organizations vying forcommercial/industrial business lack the fire alarm certification licensingneeded to provide a total system solution.

 

Note: The statistics presented above were obtained fromdocuments originally published by JP. Freeman & Co., IMS Research, andThe Freedonia Group, market research organizations serving the physicalsecurity industry.

 

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**Business Strategy**

 

*Solutions Focus.*As the industry continues to grow, we are focusingour efforts in a manner that will allow us to respond to the needs of ourcustomers.  In order to accomplish thegoals of our clients, we have implemented a business strategy that isclient-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

 

· Employboth organic growth and strategic acquisitions to create a publicly held globalsecurity company that operates in the areas of our focus markets and channels.

 

·Capitalize on acquisition targets in a globally fragmented market.

 

· Moveexpeditiously 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.

 

**SpecificObjectives for 2008 — 2010**

 

**               **The Company has outlined thefollowing items as critical success milestones to be met in the next threeyears:

 

·                  Effectively assimilatingacquisitions by realizing targeted synergies.

·                  Annually increasecorrections and commercial recurring revenues.

·                  Retain significant number oflarge customers and focus on adding new customers to mitigate risk.

·                  Expand U.S. Commercialfootprint by year end 2008, with a presence in at least 15 cities.

·                  By year end 2009, acquireperimeter capabilities that open new markets for the Company and aresynergistic with existing commercial channels.

·                  Establish internationalfootprint, by year end 2010.

* *

*Design-build/ Negotiated Market Sector*

 

We plan to focus ourgrowth efforts on the design-build/negotiated market sector. In order toaccomplish that growth, management will need to hire additional personnel. Ourmanagement has slated specific positions in sales and project development thatmust be filled with quality people to meet this growth goal. Although no firmtargets have been set, benchmarks to determine the progress will be based onthe increase of the backlog of work and in new customers from new territoriesand markets. How successfully the plan is being executed will be determined bywhether we are able to stay within budget, maintain planned growth in sales andearnings and by periodically checking on new projects. New projects will bemonitored to determine increased sales activity and to determine probable salesclosing success rates.

 

Weanticipate that the continued focus on growth in the design build/negotiatedsector will consume the majority of our available resources. We are planningexpansion in this sector because we believe we can add value through designexpertise that allows us to satisfy customers and eliminate the ‘‘bid andchase,’’ or competitive bidding environment, where we are not always able toprovide higher added value services to the customer.

 

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*DetentionMarket Sector*

 

In the detention sector, concentrating onthe design-build/negotiated market offers us the following advantagesapplicable to the detention market customer base:

 

·                                          Develops a customerrelationship at the initiation of projects, thereby maximizing the probabilityof success in the sales opportunity;

 

·                                          Limits the exposure tocompetition, since the project requirements can be written around uniquecompany product capabilities;

 

·                                          Positions us on the ‘‘customer’sside of the table’’ for a consolidated team sales effort relative to thefacility operator/owner; and

 

·                                          Avoids the ‘‘low biddertake all’’ sector of the market in which reduced margins are typical in orderto position us for better margin returns.

 

**Key Alliances**

 

Inthe detention sector, creating, maintaining and enhancing key alliances withgeneral contractors involved in the development and construction of detentionfacilities is critical for the development of a steady and recurring revenuestream in a market that is steadily growing.

 

Inthe commercial sector, the focus is to develop alliances with very large andmulti-site regional or national organizations that will then utilize ourcapabilities for their security needs in growth/expansion projects and/or inmany locations, so as to provide a steady and profitable revenue stream forus.  The technology partners that arecritical to our success are in five primary areas; access control, video, firedetection, printers, and intercom.  Thecompany has established relationships with companies in each of those fields.

 
| ***Access Control***                   | *** *** | ***Video***       | *** *** | ***Fire Detection / Printers / Intercom*** | *** *** |
|----------------------------------------|--------------|-------------------|--------------|--------------------------------------------|--------------|
|                                   |         |              |         |                                       |         |
| GE Security                            |         | American Dynamics |         | EST                                        |         |
| Info Graphic Systems                   |         | DVTEL             |         | FARGO                                      |         |
| AMAG Technology                        |         | NICE              |         | AIPHONE                                    |         |
| DSX                                    |         | KALATEL           |         | Zenitel                                    |         |
| Access Specialists, Inc.          |         | SONY              |         |                                       |         |
| Lenel Systems International, Inc. |         | Panasonic         |         |                                       |         |
| Casi Rusco                             |         | Bosch             |         |                                       |         |
| Cernium                                |         |              |         |                                       |         |

 

**Geographic Expansion andStrategic Acquisitions**

 

Inboth sectors of the business, the acquisition of comprehensive videodevelopment/manufacturing capability that can be tightly integrated with Argyle’sother products will greatly enhance our competitive posture in capturingbusiness and will also result in more of the project revenue remaining in-housefor enhanced margin.  In addition,through our strategic acquisitions, we are obtaining office locationsthroughout the US, resulting in our detention sector having the ability tobetter service our customers.

 

In the commercial sector, eitheracquisition of existing solution providers in some of the larger metropolitanmarkets in the U.S., or internal expansion to address those markets, willgreatly enlarge our national footprint and better enable us to service themulti-site organizations that are being sought as customers. Externalacquisitions will give us access to new customers in the regions that are ofinterest and would give us a running start as opposed to the slower build-upthat would ensue from internal expansion.

 

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**Marketing Initiatives**

 

Weintend to develop a market for our integrated detention electronic securitysolution utilizing our proprietary software system. We plan to focus on threemarkets not we have not significantly penetrated at this time — the Midwest,Northeast and West coast — by establishing a local sales presence in thesegeographic markets to sell our detention solutions to contractors andintegrators there. We have enlisted the support of an experienced salesprofessional with a background in the detention systems market to spearheadthis effort.

 

**Sales**

 

OurSales organization and goals can be characterized as follows:

 

·                                          Focus on sales and marketing toniche target markets.

·                                          Maintain a dedicated nationalaccount sales team with the necessary credentials to capture larger scale andmulti-site commercial security opportunities.

·                                          Support a committed sales teamto sell our hardware/software solutions to organizations that compete with theparent, but lack their own in-house capabilities.

·                                          Target organizations operatingin regions of the market that are not currently addressed today.

·                                          Sustain a highly motivated andorganized sales organization that is instrumental to profitability, thatrewards excellence, and that quickly weeds out non-performers.

** **

**Marketing**

 

                Successfullybranding ourselves and each of our divisions to create greater visibility inthe industry and across the nation is the central goal of our marketingefforts.  The following provides a listof our marketing initiatives and objectives:

 

·                  Coordinate media relation and public relation campaigns forall Argyle products and services, and the ISI/MCS development team.

·                  Support and promote Argyle industry expertsby securing speaking engagements, interviews, quotes, and mentions.

·                  Continue to develop and improve acentralized database system where all sales and marketing staff can track salesleads and customer information.

·                  Increase association membership andcertification opportunities through staff affiliation (i.e. Design BuildInstitute of America).

·                  Develop and implement marketing strategiesfor all acquisitions.

·                  Continue to enhance project bid spreadsheetfor cost code & pricing structure.

·                  Roll-out revised project “turn-over”procedures.

·                  Continue to review sales bids and how theproject can impact the company as a whole (i.e. market vs. capacity).

·                  Develop a risk analysis format.

·                  Upgrade Argyle website to one that providesinteractive features.

·                  Establish new ideas regarding ways topromote ISI/MCS brand, service, company, and industry experts through researchingnews and daily events.

·                  Establish a newsletter that will be mailedout nationally to current and potential clients.

·                  Create or redevelop marketing collateralthat emphasizes our commitment to our customers by offering services as well assolutions.

·                  Develop new booth design for conventionsthat showcases the company’s organization.

·                  Facilitate and refine “smarts &parts” bidding requirements.

 

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**Competitive Strengths**

 

Ourmanagement team is competitively well positioned and believes that it has anumber of strengths versus the competition:

 

·               Ability to react to changing technologicalneeds.

 

·               A software platform that lends itself tovery rapid adaptation to the specific requirements of individual facilities andto the use of the two major operating systems in the market-Windows and Linux,with minimal effort.

 

·               A broad array of software drivers thatallow our solutions to utilize a wide variety of security system peripheralsfrom many different third-party suppliers.

 

·               A solid reputation in both the detentionand the commercial market sectors with its customers for on-time projectexecution, security solution performance and customer service that results in asignificant amount of repeat business being garnered. For example, more than60% of the revenue for ISI and MCS during 2005, 2006, and 2007 has been theresult of contracts with repeat customers.

 

Many of ourcompetitors do not have the in-house capability for electronic systemsolutions. We provide these solutions to our customers thereby furtherenhancing our value to clients. Furthermore, we believe that we have leading edge solutions, includingtouch screen and PDA wireless control for the detention industry, plus asoftware development process that provides timely and efficient securitysolutions for customers.

 

**Research and Development**

 

A software development team within MCS provides ouroperating arms with new features and capabilities in developing securitysolutions. Software development from the R&D team allows new technologiesto be reviewed and incorporated into our product lines.  The development team not only looks atsoftware advances but also hardware breakthroughs.  The development team has projects in variousstages of development which, when completed, will provide us with technologyand integration advantages over our competition.  For example, technology is being developed toallow our customers to have a more active role in modifications to their ownproducts.  Technologies using RFID,Bluetooth, Multi-Touch, RSS, Pod casting, Ultra-wideband and VoIP will bringenhancements and new feature sets to an already technologically well positionedproduct line.  Product lines acquiredduring recent acquisitions are being researched.  New hardware and software feature sets forthese products are being developed which will again set standards in themarketplace but also reduce the fabrication time allowing quicker jobsitedeployments.

 

**Government Regulations**

 

Variousstates within the United States require companies performing the type of workperformed by us in detention facilities to be licensed. We maintain activelicenses in every state in which we do business that requires licensing.Outside of detention facilities, many states and local municipalities requirecompanies that provide turnkey electronic security systems for commercialfacilities to obtain and maintain special security licenses.

 

Theprocess of obtaining specialty security licenses is bureaucratic. We havedesignated personnel to oversee the process for maintaining all of ourlicenses. Obtaining new licenses typically requires that a test be taken inthat state, if it requires a state license. If a state license expires or isrevoked for any reason, it could prevent us from being authorized to enter intoa contract in that state. If a local license expires or is revoked for anyreason, we may be assessed a fine, depending on the delinquency in regard tothat license.

 

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Thefollowing is a list of the specialty licenses that we have secured as of December 31,2007:

 

Alabama –– Detention & SecurityEquipment

Arkansas –– Sound & IntercomSystems, Fire Detection Systems, Signal & Burglar Alarm Systems,Computer CablingArizona –– Low Voltage Communication SystemsCalifornia –– Low Voltage SystemsFlorida –– Alarm System ContractorGeorgia –– Unrestricted Low VoltageIowa –– SubcontractorIdaho –– Electrical Limited Energy Specialty ContractorLouisiana –– Electrical ControlsMinnesota –– Technology Systems ContractorMississippi –– Security, Burglar & Fire Alarms

Montana –– Subcontractor

North Carolina –– Low Voltage Electricaland Alarm

North Dakota –– Subcontractor

Nebraska –– Subcontractor

New Mexico — Sound, Intercommunication,Alarm System

Nevada –– Low Voltage Systems Tennessee- Electrical Controls

Texas –– Private Security Alarm License andFire Alarm License

Virginia –– Electronic Communications

City of Arvada –– Building Subcontractor

City of Aurora –– Fire Alarm Contractor andFire Alarm Supervisor

City of Boulder –– Fire Alarm Systems

City of Broomfield –– Contractor

City of Centennial –– Business license andAccess Control and Security

City of Colorado Springs –– Fire Alarm

City of Denver –– Access Control System andElectrical Signal

City of Lakewood –– Contractor

City of Littleton –– Miscellaneous

City of Loveland –– Fire Alarm

City of Thornton — Contractor –– Fire Alarm

City of Westminster –– General BuildingContractor

City of Wheat Ridge — Electrical Signal

 

 

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**Item 1A. Risk Factors**

 

**Risksassociated with our business**

 

 Aninvestment in our securities involves a high degree of risk. You shouldconsider carefully all of the material risks described below, together with theother information contained in this prospectus before making a decision toinvest in our securities.

 

***Budgetconstraints of federal, state and local governments could reduce our revenues.***

 

Contracts for which federal, state orlocal governments are the ultimate customer have historically accounted for amajor portion of ISI’s business. The detention systems segment, the largestbusiness segment, outfits correctional facilities and courthouses. Many stateand local governments operate under very tight budget constraints. These budgetconstraints could cause them to delay, reduce the scope of, or cancel pendingprojects, which could reduce our revenues.

 

***Our failureto obtain and/or maintain required local/state licenses could reduce ourrevenue.***

 

A portion of our business depends uponobtaining and maintaining required licenses. All such licenses are subject toaudit by the relevant government agency. Any failure to obtain or maintainrequired licenses could result in the termination of certain of our contractsor cause us to be unable to bid or re-bid on certain contracts. In addition, weand/or our employees may be required to maintain certain facility securityclearances. If we or our employees were found not to be in compliance, we couldbe excluded from bidding on certain contracts, removed from projects and/orfined, all of which would adversely impact our financial condition and goodstanding.

 

ISIhas been subject to one audit of its licensing. In 2005, the Arkansas LicensingBoard conducted a hearing regarding the renewal of ISI’s Contractor License forthe State of Arkansas. The outcome of the hearing was successful, and ISI wasissued a Contractor’s License.

 

***We operate under fixed price contracts, andits failure to accurately estimate its costs may reduce its profitability.***

 

Approximately 90% of our revenues resultfrom fixed price contracts. If we do not accurately estimate our costs onprojects, we could suffer losses on fixed price contracts. Unanticipatedincreases in the cost of raw materials could also result in our losing money oncontracts. If we suffer losses on our contracts, our profitability will bereduced. In addition, the revenues that we record under these contracts arerecognized under the ‘‘percentage of completion method of accounting.’’ Thismethod requires considerable judgment and, as a result, the estimates derivedat any point in time could differ significantly and result in materialdiscrepancies between the revenues and the financial reality of the applicablecontract.

 

***Our abilityto obtain payment and/or performance bonds is critical to our ability toconduct business.***

 

Performanceand payment bonds are an important component of our business, because manycustomers require that performance and payment bonds be delivered to thecustomer before the customer will enter into a contract. Approximately 39% ofcontract revenues and 35% of overall company revenues for 2007 were generatedby ‘‘bonded’’ contracts (contracts that require performance and payment bonds),and approximately 36% of ISI revenues in the past three years have been derivedfrom bonded contracts.

 

 

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From 2004 through the acquisition of ISIin July 2007, bonding capacity had been made available to ISI throughISI*MCS, an entity created and owned by the Chief Executive Officer andPresident of ISI, Sam Youngblood and Don Carr, respectively. Since theconsummation of the acquisition of ISI, ISI*MCS has not provided any new bondedcontracts for ISI or Argyle.  Since ouracquisition of ISI, ISI has been receiving bonding for individual jobs asneeded. Subject to the final determination by a bonding company, our insuranceagent estimates that sufficient new bonding capacity to address the totalexpected business in 2008 will be available to us upon receipt of additionalequity financing and/or subordinated debt financing. The Company currentlyanticipates such financing to take place by April 2008. However, if we areunable to engage in a financing and we are unable to secure a line of bondingcapacity, then we will not be able to enter into contracts that require suchbonds. This would significantly reduce our expected sales and reduce the levelof our future financial performance. Some of the additional factors that mightcause ISI to be unable to obtain such bonds include, but are not limited to,unacceptably high premium rates for such bonds, the unavailability of bondingcapacity at an acceptable cost from a bonding company with an acceptablefinancial rating, or the collateral/financial requirements of the bondingcompany. Such requirements are generally intended to provide liquidity to abonding company should it become obligated to pay a claim. These requirementscan include minimum cash reserves, letters of credit for the benefit of thebonding company and other irrevocable commitments of working capital that areunacceptably high. In addition, because ISI*MCS no longer has a relationshipwith us, we no longer have the benefit of a long-standing relationship with abonding company.

 

The bonding company that issued theperformance and payment bonds is an interested party in all matters regardingthe bonded contracts. A bonding company is obligated to complete a project forwhich it has issued bonds and will typically seek recovery of its costs tocomplete the contract from all available parties. The result is that a disputewith an owner or general contractor arising from a bonded contract must alsoinclude 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 ISI will result in a loss toISI. Even if ISI is able to resolve or avoid a dispute with an owner or generalcontractor, resolving a dispute with a bonding company that has paid a claim tocomplete a project will increase the potential risk of loss to ISI. 

 

***If we arerequired to make any significant payments as a result of our indemnificationobligations arising from specified ISI*MCS bonding contracts or guarantees,such payments may negatively impact our results of operation.***

 

Argyleagreed that after the acquisition of ISI was consummated, it would indemnifyand hold harmless Sam Youngblood and Don Carr, their spouses, attorneys, agentsand permitted 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. ISI management estimatesthat the potential risk for Argyle on such indemnification could beapproximately $31,583,019 which consists of all potential liability that couldarise from all bonded contract obligations due and owing by ISI as of December 31,2007 and assumes that all work performed or to be performed on bonded contractsis unsatisfactorily completed.

 

***If we are unable to design and market ourproduct offerings in a timely and efficient manner, we may not remaincompetitive.***

 

Some of our markets are characterized bycontinuing technological advancement, changes in customer requirements, andevolving product standards. In particular, the detention segment specializes inthe development, implementation, and support of complex, integrated softwaresystems, and accordingly, we devote a substantial amount of resources toproduct development. To compete successfully, we must develop and market newproducts that provide increasingly higher levels of performance andreliability. Product development is highly uncertain and we cannot guaranteethat we will successfully develop new products. Our inability to develop andmarket these products or to achieve customer acceptance of these products couldlimit our ability to compete in the market.

 

In addition, we offer a wide variety ofproducts. If the design or marketing of a product, or products, is notsuccessful and we must allocate more resources to ensure the products’ success,it could lower the profitability of the product, or products, or affectcustomer perceptions as to the quality of the products and services beingoffered. 

 

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***We depend onthird-party hardware for our customized security solutions.***

 

We purchase the hardware for ourcustomized security solutions from third-party vendors. Currently ourISI-Detention and MCS-Detention divisions do not have long-term agreements withthe third-party vendors with whom they do business. Any reduction orinterruption in the supply or manufacturing of hardware from these third-partyvendors could limit our ability to offer and deliver complete securitysolutions to its customers and could result in reduced revenues.

 

Our MCS-Commercial division 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 governmentregulation that could cause delays in the delivery of our products and servicesand may subject Argyle to audits or other similar review processes.***

 

As a contractor and subcontractor toagencies of various federal, state and local governments, we are obligated tocomply with a variety of regulations governing our operations and theworkplace. Unforeseen problems in the performance of contracts could cause theloss of licensing to do business within a particular city, county, state, orother governmental entity resulting in us losing contracts with that entity. Inaddition, changes in federal, state and local laws and regulations may impactour ability to secure new contracts or require us to make costly changes to ouroperations which could reduce our profitability in order to obtain contracts. 

 

***Our inabilityto effectively integrate acquisitions could reduce our profitability.***

 

Part of our business strategy is togrow through strategic acquisitions. For the acquisition of a new business tobe successful, we must integrate the operations, systems and personnel fromthose acquired businesses into Argyle. This integration process requires, amongother things, that we continually evaluate our operations, financial systemsand controls and, when necessary, enhance and adjust those systems andcontrols. If the newly acquired businesses are not successfully integrated intoArgyle, the key employees and their relationships with new customers, as wellas their expertise and reputation in the industry, could be lost and/ordestroyed, resulting in lower than expected sales and reduced repeat business,if any, from those acquired customers. Additionally, the new customers acquiredcould be lost which would reduce expected revenues from the acquisition andreduce expected profitability.

 

***We may need additional financing forbonding requirements, working capital, and capital expenditures and additionalfinancing may not be available on favorable terms.***

 

In order to operate the business, we mayneed to obtain additional surety bonds, maintain working capital, or makesignificant capital expenditures. In order to do any of those things, we may needto obtain additional capital. Therefore, our ability to operate and grow isdependent upon, and may be limited by, among other things, the availability offinancing arrangements. If we are not able to obtain the additional capitalnecessary to pursue new projects or maintain our operations, we may not be ableto grow as quickly as we plan. In addition, even if we are able to obtainadditional financing, the additional financing may not be on terms which arefavorable to us and could hamper our profitability.

 

***We couldpotentially incur liability to clients and others.***

 

Our involvement in the public securityand justice business exposes us to potential liability claims from our clients.Our products are used in applications where their failure could result inserious personal injuries or death. In the area of corrections, prisoners aregenerally viewed as litigious. We have sought ways to minimize losses fromthese sources by obtaining product liability and professional liabilityinsurance policies; however, a successful claim could result in liability inexcess of coverage limits or the cancellation of insurance coverage and resultin our having to pay a large amount of our working capital to cover thoseclaims. 

 

 

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***We aredependent upon key personnel.***

 

Wedepend on the expertise, experience and continued services of our seniormanagement and key employees such as:

 

|   |     | · | * * | *Bob Marbut — Chief Executive Officer of  Argyle Security, Inc.*Mr. Marbut is the chief executive of Argyle, and his  knowledge of our business and reputation in the industry make him important  to our success.                                                                                                                                         |
|--------|----------|--------|----------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Roni Chaimovski — Chief Executive Officer  of Argyle Security, Inc.*Mr. Chaimovski is the co-chief executive of Argyle,  and his knowledge of our business and reputation in the industry make him  important to our success.                                                                                                                             |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   | * * | · |     | *Donald Neville — Executive Vice President  and Chief Financial Officer of Argyle Security, Inc.*Mr. Neville is the chief  financial officer of Argyle, and his knowledge and experience in capital  markets make him important to our success.                                                                                                            |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Sam Youngblood — Chief Executive Officer  of ISI.*Mr. Youngblood  is the chief executive of ISI, and his knowledge of our business and  reputation in the industry make him important to our success.                                                                                                                                                          |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Don Carr — President of ISI.*Mr. Carr is the key  manager of sales for ISI. His experience and management capabilities have  made him a major part of the historical success of ISI.                                                                                                                                                                           |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Mark McDonald — President of  MCS-Detention.*Mr. McDonald is the principal creator of the  proprietary software utilized by ISI in estimating the cost and pricing of a  project. Mr. McDonald’s expertise in the use and refinement of this  software and his knowledge of the technological perspective of the security  industry are significant. |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Robert ‘‘Butch’’ Roller — President of  MCS-Commercial.*Mr. Roller is responsible for operations and  cost-efficient employee performance, and he provides substantial operational  back-up for Mr. Youngblood.                                                                                                                       |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Mike Peterson — President of PDI.*Mr. Peterson is the  founder and the key manager of sales administration for PDI. His experience  and management capabilities have made him a major part of the historical  success of PDI.                                                                                                                                  |
|   |     |   |     |                                                                                                                                                                                                                                                                                                                                                                      |
|   |     | · | * * | *Jeff Paulik — President of Com-Tec.*Mr. Paulik has  progressed from Sales Representative to Vice President of Sales to his  current role. Mr. Paulik has been with the company since 1985 and has  over 30 years of experience in the security electronics field.                                                                                         |

 

Our operations and most decisionsconcerning the business of ISI will be made or significantly influenced by suchindividuals. The loss of members of senior management or key employees couldresult in the deterioration or loss of relationships with certain customers orsuppliers, which could result in a material loss of business for ISI.

 

***We are in acompetitive industry with well financed competitors.***

 

As a result of increasing consolidationin the corrections and security industries and increasing attention fromventure funds and private equity groups, many of our competitors, some of whichwere already larger and better financed than us, have grown and obtainedsignificant financing. Accordingly, we expect competition to increase in thenear future. We also expect that some of our competitors will feel increasingpressure to underbid government and commercial projects, in order to deploytheir workforces and maintain or step up their activity levels. This may makeit more difficult for us to prevail on competitive bids for projects to thedegree ISI has historically experienced. 

 

 

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***Many of ournew contracts are subject to competitive bidding.***

 

Most governmental agencies and manycommercial customers require that their significant contracts be competitivelybid. Typically they utilize the ‘‘Request for Proposal’’ (RFP) method whereseveral competitors submit their sealed proposals for a particular project, orthe ‘‘Request for Qualifications’’ (RFQ) process where competitors submit theirqualifications for consideration by the customer. Some contracts are open forbidding, using the standard ‘‘Straight Bid’’ process where the detailedspecifications for a project are published and contractors submit a ‘‘Bid’’ orfixed price, for the contract to build the project. Other competitive biddingprocesses are also utilized. Our success in responding to an RFP, RFQ, StraightBid, or other competitive bidding process is dependent upon the quality of ourestimating process, knowledge of the industry, knowledge of our customers andother factors requiring significant judgment and expertise. Because of thenature of the bidding process, we cannot know if we will be successful on anygiven bid, which makes it difficult to accurately forecast the timing ofprojects and budget the allocation of resources. To the extent we have madesignificant capital expenditures in the development and estimating of acontract or project, we may not recover our entire capital investment in thatproject.

 

When seeking competitive bids, one of thefactors that most governmental entities and commercial customers evaluate isthe financial strength of the bidders. To the extent they believe we do nothave sufficient financial resources, we will be unable to effectively competefor contracts. 

 

***Our abilityto win new contracts depends on many factors outside of our control.***

 

Our growth in the corrections industry isgenerally dependent upon our ability to win new contracts. This depends on anumber of factors we cannot control, including crime rates and sentencingpatterns in various jurisdictions. Accordingly, the demand for security relatedgoods and services for new correctional facilities could be adversely affectedby the relaxation of enforcement efforts, leniency in conviction and sentencingpractices or through the legal decriminalization of certain activities that arecurrently proscribed by criminal laws. For instance, changes in laws relatingto drugs and controlled substances or illegal immigration could reduce thenumber of persons arrested, convicted and sentenced, thereby potentiallyreducing demand for new correctional facilities to house them. Similarly,reductions in crime rates could lead to reductions in arrests, convictions, andsentences 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 bids for new contractsdirectly to government agencies and commercial customers as a direct contractorto provide the security solutions for a project. In other instances, we provideour bid for security solutions to a general contractor, who adds our pricing toall the other pricing for an entire project. In those instances we act as asubcontractor to the general contractor. The owner of the project (thegovernmental entity or commercial owner) will choose whether they wish toreceive bids only from general contractors, or whether they wish to receivebids separately from the entities providing security solutions, such as us andour competitors. When we are acting as a subcontractor to a general contractor,we have far less control and input over the final price for the projectsubmitted to the owner by the general contractor than when ISI submits a biddirectly and such circumstances therefore reduce our ability to win contracts.

 

***Governmental agencies may investigate andaudit our contracts and, if any improprieties are found, we may be required torefund revenues, pay unexpected taxes, forego anticipated revenues and/or maybe subject to penalties and sanctions, including prohibitions on our bidding inresponse to competitive bidding processes.***

 

Governmental agencies and most commercialcustomers will have the authority to audit and investigate our contracts withthem. As part of that process, some governmental agencies review ourperformance on the contract, our pricing practices, change orders, othercompliance with the terms of the contracts, and applicable laws, regulationsand standards. For example, if an agency determines that we have improperlyclassified a specific contract as non-taxable, we could be required to paysales, use or other taxes for which no reserve was created at the time the bidwas submitted by us. If the agency determines that we have improperly billedthe governmental entity in violation of the terms of the contract, we could berequired to refund revenues, or forgo anticipated revenues. If a governmentaudit uncovers improper or illegal activities by us or it otherwise determinesthat these activities have occurred, we may be subject to civil and criminalpenalties and administrative sanctions, including termination of contracts,forfeitures of profits, suspension of payments, fines and suspension ordisqualification from doing business with the government. 

 

25

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***If we fail tosatisfy our contractual obligations, our ability to compete for futurecontracts will be limited.***

 

Our failure to comply with contractrequirements or to meet our clients’ performance expectations when performing acontract could injure our reputation, which, in turn, would impact our abilityto compete for new contracts. Our failure to meet contractual obligations couldalso result in substantial actual and consequential damages. In addition, ourcontracts often require us to indemnify clients for our conduct that causeslosses to the client. Some contracts may contain liquidated damages provisionsand financial penalties related to performance failures. Although we haveliability insurance, the policy limits may not be adequate to provideprotection against all potential liabilities. 

 

***Negative media coverage, includinginaccurate or misleading information, could injure our reputation and ourability to bid for government contracts.***

 

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 and other publiccorrectional projects may prompt higher than normal media scrutiny. In thatatmosphere, inaccurate, misleading, or negative media coverage about us couldharm our reputation and, accordingly, our ability to bid for and win newcontracts. 

 

***If outstanding warrants are exercised, theunderlying common shares will be eligible for future resale in the publicmarket. ‘‘Market overhang’’ from the warrants results in dilution and couldkeep the market price of our stock lower than it would otherwise be.***

 

Outstanding warrants and unit purchaseoptions to purchase an aggregate of 3,987,546 shares of common stock issued inconnection with Argyle’s initial public offering are currently exercisable. Ifthey are exercised, a substantial number of additional shares of our commonstock will be eligible for resale in the public market, which could keep themarket price of our stock lower than it would otherwise be. 

 

***Registrationrights held by our initial stockholders who purchased shares prior to ourinitial public offering may keep the market price of our stock lower than itwould otherwise be.***

 

Our initial stockholders who purchasedcommon stock prior to its initial public offering are entitled to demand thatwe register the resale of their shares at any time after they are released fromescrow. If such stockholders exercise their registration rights with respect toall of their shares, there will be an additional 1,081,261 shares of commonstock 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. 

 

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

 

We have never declared or paid any cashdividends on our shares of common stock. We intend to retain all futureearnings, if any, for use in the operations and expansion of the business. As aresult, we do not anticipate paying cash dividends in the foreseeable future.Any future determination as to the declaration and payment of cash dividendswill be at the discretion of our Board of Directors and will depend on factorsthe Board of Directors deems relevant, including among others, our results ofoperations, financial condition and cash requirements, business prospects, andthe terms of our credit facilities and other financing arrangements. It islikely that the debt financing arrangements we put into place in connectionwill prohibit 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 no guaranteethat our common stock will appreciate in value. 

 

***Our securities are quoted on theOver-the-Counter Bulletin Board, which may limit the liquidity and price of oursecurities more than if the securities were quoted or listed on an exchange.***

 

Our securities are quoted on theOver-the-Counter Bulletin Board, a FINRA-sponsored and operated inter-dealerautomated quotation system. Quotation of our securities on the Over-the-CounterBulletin Board will limit the liquidity and price of our securities more thanif the securities were quoted or listed on an exchange. 

 

 

26

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***We may choose to redeem our outstandingwarrants at a time that is disadvantageous to the warrant holders.***

 

Subjectto there being a current prospectus under the Securities Act of 1933, Argylemay redeem all of its outstanding warrants at any time after they becomeexercisable at a price of $.01 per warrant, upon a minimum of 30 days priorwritten notice of redemption, if and only if, the last sale price of our commonstock equals or exceeds $11.50 per share for any 20 trading days within a 30trading day period ending three business days before Argyle sends the notice ofredemption. Calling all of our outstanding warrants for redemption could forcethe warrant holders:

 

|   |   | · |   | To exercise the warrants and pay the exercise price for  such warrants at a time when it may be disadvantageous for the holders to do  so;                                    |
|--------|--------|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   | · |   | To sell the warrants at the then current market price when  they might otherwise wish to hold the warrants; or                                                                |
|   |   | · |   | To accept the nominal redemption price which, at the time  the warrants are called for redemption, is likely to be substantially less  than the market value of the warrants. |

*** ***

***Our warrantholders may not be able to exercise their warrants, which may create liabilityfor us.***

 

Holdersof the warrants we issued in our initial public offering and private placementwill be able to receive shares upon exercise of the warrants only if (i) acurrent registration statement under the Securities Act of 1933 relating to theshares of 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.

 

**Item 1B. Unresolved Staff Comments**

 

None.

 

 

27

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**Item 2. Description of Property**

 

Theprincipal properties of the Company at December 31, 2007 are as follows:

 
| ** **                                                                  | ** ** | **Approximate** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------|------------|------------|------------|
| ** **                                                                  | ** ** | **Square**      | ** ** | ** ** | ** ** |
| **Location**                                                                | ** ** | **Footage**     | ** ** | **Type**   | ** ** |
| San Antonio, Texas                                                          |       |            |       |       |       |
| Offices - Corporate headquarters                                            |       | 2,547           |       | Lease      |       |
| Offices - ISI administrative, ISI-Detention and  MCS-Detention headquarters |       | 16,000          |       | Lease      | (1)        |
| Offices - MCS-Commercial headquarters and regional office                   |       | 8,000           |       | Lease      | (1)        |
| Offices - MCS-Detention                                                     |       | 7,000           |       | Lease      | (1)        |
| Austin, Texas                                                               |       |            |       |       |       |
| Warehouse - MCS-Commercial                                                  |       | 400             |       | Lease      |       |
| Offices - MCS-Commercial                                                    |       | 800             |       | Lease      |       |
| Dallas, Texas                                                               |       |            |       |       |       |
| Warehouse - MCS-Commercial                                                  |       | 659             |       | Lease      |       |
| Offices - MCS-Commercial                                                    |       | 14,350          |       | Lease      |       |
| Denver, Colorado                                                            |       |            |       |       |       |
| Warehouse - MCS-Commercial                                                  |       | 1,100           |       | Lease      |       |
| Offices - MCS-Commercial                                                    |       | 6,680           |       | Lease      |       |
| Houston, Texas                                                              |       |            |       |       |       |
| Warehouse - MCS-Commercial                                                  |       | 900             |       | Lease      |       |
| Offices - MCS-Commercial                                                    |       | 4,328           |       | Lease      |       |
| Noblesville, Indiana                                                        |       |            |       |       |       |
| Warehouse and offices - MCS-Commercial                                      |       | 900             |       | Lease      |       |

 

(1) Properties leased by Green Wing Management, Ltd., an entity owned andcontrolled by Sam Youngblood and Don Carr. The leases on these properties were amended as part of the acquisition ofISI to reflect a term of 12 years ending in 2019 and to require that anappraisal be completed by a qualified appraiser to determine the market rate ofthe leases. The rental rate to be paid on these properties, after theacquisition 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.

 

**Item 3. Legal Proceedings**

 

Weare a party to routine and non-material litigation and administrationproceedings that arise from time to time in the ordinary course of business,none of which, individually or in the aggregate, is expected to have a materialeffect on our financial situation or ability to operate.

 

**Item 4. Submission of Matters to aVote of Security Holders**

 

During the fourth quarter of our fiscal year ended December 31,2007, there were no matters submitted to a vote of security holders.

 

 

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**PART II**

 

**Item 5. Market for Registrant’sCommon Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities**

 

Argyle’s common stock, warrants and unitsare quoted on the OTC Bulletin Board under the symbols ARGL, ARGLW and ARGLUrespectively.

 

Argyle’s units commenced public tradingon January 30, 2006, and common stock and warrants commenced publictrading on March 2, 2006. The table below sets forth, for the calendarquarters indicated, the high and low bid prices for the securities as reportedon the OTC Bulletin Board in U.S. dollars. These quotations reflect inter-dealerprices, without markup, markdown or commissions, and may not represent actualtransactions.

 
| ** **                                       | ** ** | **Common Stock** | ** ** | **Warrants** | ** ** | **Units** | ** ** |
|--------------------------------------------------|------------|------------------|------------|--------------|------------|-----------|------------|
| ** **                                       | ** ** | **High**         | ** ** | **Low**      | ** ** | **High**  | ** ** | **Low** | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter 2006                               |       | 7.55             |       | 7.25         |       | 1.35      |       | 0.93 |   | 8.85 |   | 7.90 |   |
| Second Quarter 2006                              |       | 7.45             |       | 7.22         |       | 1.56      |       | 1.02 |   | 8.86 |   | 8.00 |   |
| Third Quarter 2006                               |       | 7.30             |       | 7.14         |       | 1.08      |       | 0.88 |   | 8.30 |   | 8.00 |   |
| Fourth Quarter 2006                              |       | 7.45             |       | 7.15         |       | 1.55      |       | 0.75 |   | 8.80 |   | 7.94 |   |
|                                             |       |             |       |         |       |      |       |   |   |   |   |   |   |
| 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 (through March 26, 2008) |       | 7.80             |       | 6.75         |       | 2.39      |       | 1.65 |   | 10.00 |   | 8.25 |   |

 

**Numberof Holders of Common Stock**

 

Asof December 31, 2007, there were of record 14 holders of common stock,three of warrants, and one of units. Argyle believes the number of beneficialholders of each of these securities is significantly greater than the number ofrecord holders.

 

**Dividends**

 

We have never declared or paid cashdividends on our capital stock and do not anticipate declaring or paying cashdividends in the foreseeable future. Payments of future dividends, if any, willbe at the discretion of our board of directors after taking into account variousfactors, including our financial condition, operating results, current andanticipated cash needs, plans for expansion and other factors that our board ofdirectors may deem relevant.

 

 

29

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**RecentSales of Unregistered Securities**

 

During the fourth quarter of our fiscal year ended December 31,2007, there were no issuances of securities that were not previously reported.

 

On January 25, 2008 we issued 55,000 unregisteredshares of our common stock to officers and key employees listed below. Theseshares vest December 31 in three equal tranches on each of 2008, 2009, and2010.

 
| **Stockholders** | ** ** | **Number of  Shares** | ** ** |
|------------------|------------|-----------------------|------------|
| Bob Marbut       |       | 15,000                |       |
| Roni Chaimovski  |       | 15,000                |       |
| Sam Youngblood   |       | 10,000                |       |
| Don Carr         |       | 5,000                 |       |
| Don Neville      |       | 10,000                |       |

 

On January 25, 2008 we issued 30,000 unregisteredshares of our common stock to the directors listed below. These shares are notsubject to vesting restrictions.

 
| **Stockholders** | ** ** | **Number of  Shares** | ** ** |
|------------------|------------|-----------------------|------------|
| Lloyd Campbell   |       | 10,000                |       |
| Wesley Clark     |       | 5,000                 |       |
| Walter Klein     |       | 10,000                |       |
| John Smith       |       | 5,000                 |       |

 

Such shares were issued pursuant to the exemption fromregistration contained in Section 4(2) of the Securities Act as theywere issued to officers and directors of Argyle.

 

**Repurchasesof Equity Securities**

 

During the fourth quarter of our fiscal year ended December 31,2007, there were no repurchases of common stock.

 

 

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**Item 6. Selected Financial Data**

 

Thefollowing table summarizes our selected historical consolidated financialinformation and selected consolidated financial information of ISI, whichshould be read in conjunction with ‘‘Management’s Discussion and Analysis ofFinancial Condition and Results of Operations’’ and the financial statementsand related notes included elsewhere in this document. The information as ofand for the periods ended December 31st, and for the seven month periodended July 31, 2007 for ISI, are derived from the respective auditedfinancial statements of Argyle and ISI and the information as of and for theother periods presented are derived from their respective unaudited interimfinancial 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 | ) |

 

(1)                                  ‘‘Revenues- related party’’ are those revenues generated by work sub-contractedfrom ISI*MCS (an entity owned 67% by Sam Youngbood, CEO of ISI, and 33% by DonCarr, President of ISI). Messrs. Youngblood and Carr created ISI*MCS in2004 to provide bonding on contracts that require bonding. The performance ofthose contracts 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 a subcontractorto ISI*MCS. After the merger, the amount of ‘‘Revenues - related party’’will decrease annually as the contracts with ISI*MCS, outstanding at the timeof the merger, are completed. 

 

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**Argyle Security Inc.**

** **

**CondensedConsolidated Statement of Operations Data:**

 

| ** **                                       | ** ** | **June 22,  2005  (inception)  through  December 31,** | ** ** | **Year Ended  December 31,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------------------|------------|-----------------------------------|------------|
| **($ in thousands, except per share data)** | ** ** | **2005**                                                         | ** ** | **2006**                          | ** ** | **2007** | ** ** |
| Revenues                                         |       | $                                                                | —     |                              | $          | — |   | $ | 44,053 |   |
| Cost of revenues                                 |       | —                                                           |       | —                            |       | 34,020 |   |
| Gross profit                                     |       | —                                                           |       | —                            |       | 10,033 |   |
| Total operating expenses                         |       | 8                                                                |       | 1,024                             |       | 9,812 |   |
| Income / (loss) from operations                  |       | (8                                                               | )          | (1,024                            | )          | 221 |   |
| Interest income                                  |       | —                                                           |       | 1,352                             |       | 1,005 |   |
| Interest expense                                 |       | —                                                           |       | (64                               | )          | (838 | ) |
| Income / (loss) before income taxes              |       | (8                                                               | )          | 264                               |       | 388 |   |
| Income tax expense / (benefit)                   |       | —                                                           |       | 91                                |       | 169 |   |
| Net income / (loss)                              |       | $                                                                | (8         | )                                 | $          | 173 |   | $ | 219 |   |
| Net income / (loss) per share:                   |       |                                                             |       |                              |       |   |   |
| Basic                                            |       | $                                                                | (0.01      | )                                 | $          | 0.04 |   | $ | 0.04 |   |
| Diluted                                          |       | $                                                                | (0.01      | )                                 | $          | 0.04 |   | $ | 0.04 |   |

 

**CondensedConsolidated Balance Sheet Data of Argyle and ISI:**

 

| ** **                                                                   | ** ** | **Predecessor  (ISI)** | ** ** | **Argyle**            | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | **December 31,**  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| **($ in thousands, except per share data)**                             | ** ** | **2006**               | ** ** | **2006**              | ** ** | **2007** | ** ** |
| Total current assets                                                         |       | $                      | 25,113     |                  | $          | 30,182 |   | $ | 40,507 |   |
| Total assets                                                                 |       | $                      | 31,617     |                  | $          | 30,681 |   | $ | 81,148 |   |
| Total current liabilities                                                    |       | $                      | 19,056     |                  | $          | 1,905 |   | $ | 20,520 |   |
| Common stock, warrants and deferred interest subject to  possible redemption |       | $                      | 5,019      |                  | $          | 5,914 |   | $ | — |   |
| Total stockholders’ equity (deficit)                                    |       | $                      | (13,247    | )                     | $          | 22,862 |   | $ | 36,664 |   |

 

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**Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**ForwardLooking Statements**

 

This Annual Report on Form 10-K includesforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended. We have based these forward-looking statements on our currentexpectations and projections about future events. These forward-lookingstatements are subject to known and unknown risks, uncertainties andassumptions about us that may cause our actual results, levels of activity,performance or achievements to be materially different from any future results,levels of activity, performance or achievements expressed or implied by suchforward-looking statements. In some cases, you can identify forward-lookingstatements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,”“anticipate,” “believe,” “estimate,” “continue,” or the negative of such termsor other similar expressions. Factors that might cause or contribute to such adiscrepancy include, but are not limited to, those described in our otherSecurities and Exchange Commission filings. The following discussion should beread in conjunction with our Financial Statements and related Notes theretoincluded elsewhere in this report.

 

**Overview**

 

 Argyle Security, Inc.is a Delaware corporation incorporated on June 22, 2005 in order to serveas a vehicle for the acquisition of an operating business through a merger,capital stock exchange, asset acquisition or other similar businesscombination.  Argyle completed its initial public offering in January 2006.  As provided in its certificate ofincorporation, Argyle was required, by July 30, 2007, to consummate abusiness combination or enter a letter of intent, agreement in principle ordefinitive agreement relating to a business combination, in which case Argylewould be allowed an additional six months to complete the transactions contemplatedby such agreement.

 

On July 31, 2007,pursuant to the terms of a merger agreement, dated December 8, 2006, asamended on June 29, 2007 and July 11, 2007 (the “Merger Agreement”),Argyle acquired all of the assets and liabilities of ISI-Detention ContractingGroup, Inc. (“ISI”) through the merger of Argyle’s wholly-ownedsubsidiary, ISI Security Group, Inc., into ISI. As a result of the merger,ISI became a wholly owned subsidiary of Argyle. ISI is a provider of physicalsecurity solutions 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, the allowance for doubtfulaccounts, inventories and related reserves, long-lived assets, investments andincome taxes. We base our estimates and assumptions on historical experience,knowledge of current conditions and our understanding of what we believe to bereasonable that might occur in the future considering available information.Actual results may differ from these estimates, and material effects on ouroperating results and financial position may result.

 

*Percentage-of-CompletionEstimates* - ISIuses percentage-of-completion accounting to determine revenue and gross marginearned on projects. Estimating the percentage completion on a project is amajor critical estimate that ISI depends on. This estimate is determined asfollows:

 

33

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Construction Contracts:

 

1. 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.

 

2. As the projectis performed and purchases and costs are incurred, these are recorded in thesame detail as the original estimate.

 

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

 

4. On a monthlybasis, 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 differs, 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.

 

5. Revenues fromconstruction contracts are recognized on the percentage-of-completion method inaccordance with SOP 81-1. ISI recognizes revenues on signed contracts andchange orders. ISI generally recognizes revenues on unsigned change orderswhere it has written notices to proceed from the customer and where collectionis 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. ISI generally considers contracts to besubstantially complete upon departure from the work site and acceptance by thecustomer. If any jobs are identified during the review process which areestimated to be a loss job (where estimated costs exceed contract price), theentire estimated loss is recorded in full, without regard to the computedpercentage of completion.

 

These estimates ofpercentage completion of a project determine the amounts of revenues and grossmargin that are earned to date on a project. For example, if a contract is$100,000 with a 20% gross margin of $20,000, then a project that is estimatedto be 50% complete accrues $50,000 in revenues and $10,000 in gross margin. Ifthe percentage completed is adjusted to 25%, then the revenues on the contactwould be $25,000, and the earned gross margin would be $5,000. These estimateswould be changed in the current month, and the actual accrual of the revenueand gross margin earned on this project would be reduced in the current month.

 

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 attempts to recognize losses (overruns of cost estimates) as soon asthey can be quantified. Management attempts to recognize gains (under-runs ofcost estimates) when they can be quantified and are certain.

 

Costs incurred prior toaward 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 onthe Company’s experience with similar contracts in recent years, the retentionbalance at each balance sheet date will be collected within the subsequentfiscal 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.

 

*ServiceSales -** ***Service revenues are recognized whenthe services have been delivered to and accepted by the customer. These aregenerally short-term projects which are evidenced by signed service agreementsor customer work orders or purchase orders. These salesagreements/customer orders generally provide for billing to customers based ontime at quoted hourly or project rates, plus costs of materials and suppliesfurnished by the Company.

 

34

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*IBNREstimates for Health Insurance* - On an annual basis, Argyle estimates its healthinsurance cost, for its self-insured employee base at the acquired company ISI,based upon expected health insurance claims for the current year. The insurancecompany which provides both the stop loss and total aggregate insurancecoverages also provides the average or expected and maximum claims for eachclass. The average and maximum claims are based on our demographics and priorclaim history. Argyle uses the average claims history for the trailing thetwelve months as its basis for accruing health care cost. This accrual isautomated and is part of the payroll function for each pay period.

 

*Deferredincome taxes* -Deferred income taxes are provided for temporary differences between thecarrying amount of assets and liabilities for financial reporting purposes andthe amounts for tax purposes. Valuation allowances are provided against thedeferred tax asset amounts when the realization is uncertain.

 

*Allowancefor Doubtful Accounts* - Argyle provides an allowance for bad debt through an analysis inwhich the bad debts that had been written off over a trailing five year periodare compared on a percentage basis to the aggregate sales for the same period.The resulting percentage is applied to the sales for year to date and a monthlyreserve is accrued accordingly. Additionally, management analyzes specificcustomer accounts receivable for any potentially uncollectible accounts andwill add such accounts to the reserve or write them off if warranted, afterconsidering lien and bond rights, and then considers the adequacy of theremaining unallocated reserve compared to the remaining accounts receivablebalance (net of specific doubtful accounts).

 

*Non CashCompensation Expense*- On January 1, 2006, Argyle adopted SFAS No. 123 (revised 2004), *ShareBased Payment*.SFAS No. 123(R) requires all share-based payments to employees,including grants of employee stock options, to be recognized in the financialstatements based on their fair values.

 

Purchase options (ISO / non-qualified) grants:

 

On a quarterly basis, Argylecomputes the value of newly issued purchase options (ISO and non-qualified) byutilizing the Black-Scholes valuation model based upon their expected lifevesting period, industry comparables for volatility and the risk-free rate onUS Government securities with matching maturities. The value of the purchaseoptions are then straight-line expensed over the life of the purchase options.

 

Restricted and performance stock grants:

 

On a quarterly basis, Argylecomputes the value of newly issued stock grants 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.

 

Currently the performanceunits carry no value as the associated performance objectives have not beenapproved by the Board of Directors.

 

**Pro Formaand Adjusted Pro Forma Financial Information**

 

Since we acquired ISI in July 2007,we do not believe a comparison of the results of operations and cash flowsfor the year ended December 31, 2007 versus December 31, 2006 isbeneficial to our stockholders. In order to assist investors in betterunderstanding the changes in our business between the years ended December 31,2006 and December 31, 2007, we are presenting in management’s discussionand analysis section below in the pro forma and adjusted pro forma results ofoperations for the Company and ISI for the years ended December 31, 2007and December 31, 2006 as if the acquisition of ISI occurred on January 1,2007 and January 1, 2006, respectively. We derived the pro forma resultsand adjusted pro forma results of operations from (i) the auditedconsolidated financial statements of ISI for the period from January 1,2007 to July 31, 2007 (the date of the ISI acquisition) and (ii) ouraudited consolidated financial statements for the years ended December 31,2007 and December 31, 2006. We are presenting the pro forma and theadjusted pro forma information in order to provide a more meaningful comparisonof our operating results with prior periods. The adjusted pro forma financialstatements differ from the pro forma financial statements in that they excludethe amortization of intangible assets associated with the merger in determiningadjusted pro forma net income.

 

35

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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 income as net income before theimpact of purchase accounting for acquisitions, acquisition-related costs,discontinued operations and certain significant items including one timeexpenses associated with stock appreciation rights. The adjusted pro forma netincome measure is not, and should not be viewed as, a substitute for U.S. GAAPnet 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 is being utilized:

 

·                          Senior management receives a monthlyanalysis of our operating results that is prepared on an adjusted pro forma netincome basis;

 

·                          Our annual budgets are prepared on anadjusted pro forma net income basis; and

 

·                          Annual and long-term compensation,including annual cash bonuses, merit-based salary adjustment, and share-basedpayments for various levels of management will consider financial measures thatinclude adjusted pro forma net income and the associated earnings per share.The adjusted pro forma net income measure will represent a significant portionof target objectives that are utilized to determine the annual compensation forvarious levels of management, although the actual weighting of the objectivemay vary by level of management and job responsibility and may be considered inthe determination of certain long-term compensation plans.

 

Despite the importance ofthis measure to management in goal setting and performance measurement, westress that adjusted pro forma net income is a non-GAAP financial measure thathas no standardized meaning under US-GAAP and therefore, has limits in itsusefulness to investors. Because of its non-standardized definition, adjustedpro forma net income (unlike U.S. GAAP net income) may not be comparable withthe calculation of similar measures for other companies. Adjusted pro forma netincome is presented solely to permit investors to more fully understand howmanagement assesses our performance.

 

**We also recognize that, as aninternal measure of performance, the adjusted pro forma net income and theassociated earnings per share measure has limitations and we do not restrictour performance-management process solely to this metric. A limitation of theadjusted 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 industry.**

 

**In addition, annual and long-termcompensation, including annual cash bonuses, merit-based salary adjustments andshare-based payments for various levels of management that will be made infuture years will likely include a non-discretionary formula that measuresour performance using revenue growth and relative total shareholder return.**

 

The adjusted pro formaresults of operations are not necessarily indicative of the results ofoperations that may have actually occurred had the merger taken place on thedates noted, or the future financial position or operating results of us orISI. 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.

 

36

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EBITDA is used bymanagement as a performance measure for benchmarking against the Company’speers and competitors. The Company believes EBITDA is useful to investorsbecause it is frequently used by securities analysts, investors and otherinterested parties to evaluate companies in the security industry. Additionally,we use EBITDA for internal performance measurements. EBITDA is not a recognizedterm under GAAP. Argyle and ISI compute EBITDA using the same consistentmethod from quarter to quarter. EBITDA includes net income, interest, taxes,depreciation, and amortization. The presentation of EBITDA is not intended tobe considered in isolation or as a substitute for the financial informationprepared and presented in accordance with GAAP.

 

Belowis a table showing Argyle’sAdjusted Pro Forma Consolidated Statements ofOperations. The Pro Forma Consolidated Statements of Operations are included inthe notes to our financial statements on page F-13.

 

**Argyle Security, Inc**

**Adjusted Pro Forma Consolidated Statements of Operations**

**(in thousands, except per share data)**

**(unaudited)**

** **

| ** **                                                      | ** ** | **Year Ended  December 31,** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                      | ** ** | **2007**                          | ** ** | **2006** | ** ** |
| Revenues:                                                       |       |                              |       |   |   |
| Contract revenues                                               |       | $                                 | 44,288     |   | $ | 30,968 |   |
| Contract revenues - related party                               |       | 31,788                            |       | 19,855 |   |
| Service and other revenues                                      |       | 11,110                            |       | 6,929 |   |
| Total revenues                                                  |       | 87,186                            |       | 57,752 |   |
| Cost of revenues:                                               |       |                              |       |   |   |
| Contract costs                                                  |       | 58,061                            |       | 41,130 |   |
| Service and other costs, excluding amortization of  intangibles |       | 8,074                             |       | 4,839 |   |
| Total cost of revenues                                          |       | 66,135                            |       | 45,969 |   |
| Gross profit                                                    |       | 21,051                            |       | 11,783 |   |
| Operating expenses:                                             |       |                              |       |   |   |
| Salaries & related (inc stock-based compensation)      |       | 8,882                             |       | 5,573 |   |
| Consulting fees and outside services                            |       | 1,880                             |       | 899 |   |
| Depreciation                                                    |       | 1,294                             |       | 782 |   |
| Other general and administrative expenses                       |       | 4,192                             |       | 3,875 |   |
| Amortization of intangible assets                               |       | —                            |       | — |   |
| Total operating expenses                                        |       | 16,248                            |       | 11,129 |   |
| Operating income (loss)                                         |       | 4,803                             |       | 654 |   |
| Other income (expense):                                         |       |                              |       |   |   |
| Interest income                                                 |       | 246                               |       | 459 |   |
| Interest expense                                                |       | (1,703                            | )          | (1,501 | ) |
| Total other income (expense)                                    |       | (1,457                            | )          | (1,042 | ) |
| Income (loss) before provision for income taxes                 |       | 3,346                             |       | (388 | ) |
| Provision for income taxes                                      |       | 690                               |       | 286 |   |
| Net income (loss)                                               |       | $                                 | 2,656      |   | $ | (674 | ) |
|                                                            |       |                              |       |   |   |
| Weighted-average number of shares outstanding:                  |       |                              |       |   |   |
| Basic                                                           |       | 5,749,342                         |       | 5,495,005 |   |
| Diluted                                                         |       | 6,775,445                         |       | 5,495,005 |   |
| Net income / (loss) per share:                                  |       |                              |       |   |   |
| Basic                                                           |       | $                                 | 0.46       |   | $ | (0.12 | ) |
| Diluted                                                         |       | $                                 | 0.39       |   | $ | (0.12 | ) |

 

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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.

 

**Reconciliation of GAAP Net Income to Pro Forma Net Income**

**Adjusted Pro Forma Net Income and Pro Forma EBITDA**

**(in thousands)**

**(unaudited)**

 

| ** **                                                                             | ** ** | **Year Ended  December 31,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
|                                                                                   | ** ** | **2007**                          | ** ** | **2006** | ** ** |
| **GAAP net income (loss)**                                                             | ** ** | **$**                             | **219**    | ** ** | **$** | **173** | ** ** |
| Pro forma adjustments - addbacks (reductions)                                          |       |                              |       |   |   |
| Argyle salary expense (increase) for management team in  2007 and 2006                 |       | (350                              | )          | (888 | ) |
| Non-cash compensation expense (increase) for 2007 and 2006                             |       | (330                              | )          | (566 | ) |
| SARS adjustment expense reduction for 2007                                             |       | 1,364                             |       | — |   |
| Depreciation expense (increase) on revalued assets in 2007  and 2006                   |       | (81                               | )          | (139 | ) |
| Amortization of intangible expense (increase) in cost of  goods sold for 2007 and 2006 |       | (1,960                            | )          | (3,361 | ) |
| Amortization of intangible expense (increase) in operating  expenses for 2007 and 2006 |       | (574                              | )          | (983 | ) |
| Interest income (reduction) for 2007 and 2006                                          |       | (763                              | )          | (1,104 | ) |
| Interest expense reduction for 2007 and 2006                                           |       | 2,143                             |       | 2,393 |   |
| GAAP net income (loss) for ISI (predecessor)                                           |       | (131                              | )          | (688 | ) |
| Benefit for income taxes on pro forma adjustments for 2007  and 2006                   |       | 209                               |       | 1,580 |   |
| **Pro forma net income (loss)**                                                        | ** ** | **$**                             | **(254**   | **)** | **$** | **(3,584** | **)** |
| Amortization of intangible expense in cost of goods sold  for 2007 and 2006            |       | 3,361                             |       | 3,361 |   |
| Amortization of intangible expense in operating expenses  for 2007 and 2006            |       | 1,332                             |       | 1,332 |   |
| Increase / (benefit) for income taxes on pro forma  adjustments for 2007 and 2006      |       | (1,783                            | )          | (1,783 | ) |
| **Adjusted pro forma net income  (loss)**                                              | ** ** | **$**                             | **2,656**  | ** ** | **$** | **(674** | **)** |
| Interest, net                                                                          |       | 1,457                             |       | 1,042 |   |
| Depreciation expense                                                                   |       | 1,291                             |       | 1,132 |   |
| Amortization expense                                                                   |       | —                            |       | — |   |
| Taxes, net                                                                             |       | 690                               |       | 286 |   |
| **Pro forma EBITDA**                                                                   | ** ** | **$**                             | **6,094**  | ** ** | **$** | **1,786** | ** ** |

 

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Below is a table of proforma revenues, cost of sales, and gross margins for years ended December 31,2007 and 2006.

 
| ** **                                             | ** ** | **December 31, 2007** | ** ** | **December 31, 2006** | ** ** | **Percent Increase (Decrease)** | ** ** |
|--------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **ISI**                    | ** ** | **MCS**                    | ** ** | **Commercial**                  | ** ** | **Total** | ** ** | **ISI** | ** ** | **MCS** | ** ** | **Commercial** | ** ** | **Total** | ** ** | **ISI** | ** ** | **MCS** | ** ** | **Commercial** | ** ** | **Total** | ** ** |
| Net  revenues                                          |       |                       |       |                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract  revenues / contract revenues - related party |       | $                          | 33,720     |                       | $          | 22,114                          |       | $ | 20,242 |   | $ | 76,076 |   | $ | 21,697 |   | $ | 13,276 |   | $ | 15,850 |   | $ | 50,823 |   | 55.4 | % | 66.6 | % | 27.7 | % | 49.7 | % |
| Service  and other revenues                            |       | 257                        |       | 333                        |       | 10,520                          |       | 11,110 |   | $ | 83 |   | $ | 159 |   | $ | 6,687 |   | 6,929 |   | 209.6 | % | 109.4 | % | 57.3 | % | 60.3 | % |
| Total  net revenues                                    |       | $                          | 33,977     |                       | $          | 22,447                          |       | $ | 30,762 |   | $ | 87,186 |   | $ | 21,780 |   | $ | 13,435 |   | $ | 22,537 |   | $ | 57,752 |   | 56.0 | % | 67.1 | % | 36.5 | % | 51.0 | % |
| *% of total*                                           |       |                       |       |                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Cost of  revenues                                      |       |                       |       |                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract  revenues / contract revenues - related party |       | $                          | 25,256     |                       | $          | 16,261                          |       | $ | 16,544 |   | $ | 58,061 |   | $ | 17,700 |   | $ | 10,033 |   | $ | 13,397 |   | $ | 41,130 |   | 42.7 | % | 62.1 | % | 23.5 | % | 41.2 | % |
| Service  and other revenues                            |       | 175                        |       | 255                        |       | 7,644                           |       | 8,074 |   | 120 |   | 139 |   | 4,580 |   | 4,839 |   | 45.8 | % | 83.5 | % | 66.9 | % | 66.9 | % |
| Total  cost of revenues                                |       | $                          | 25,431     |                       | $          | 16,516                          |       | $ | 24,188 |   | $ | 66,135 |   | $ | 17,820 |   | $ | 10,172 |   | $ | 17,977 |   | $ | 45,969 |   | 42.7 | % | 62.4 | % | 34.5 | % | 43.9 | % |
| Gross  margin                                          |       |                       |       |                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract  revenues / contract revenues - related party |       | $                          | 8,464      |                       | $          | 5,853                           |       | $ | 3,698 |   | $ | 18,015 |   | $ | 3,997 |   | $ | 3,243 |   | $ | 2,453 |   | $ | 9,693 |   | 111.8 | % | 80.5 | % | 50.8 | % | 85.9 | % |
| Service  and other revenues                            |       | $                          | 82         |                       | $          | 78                              |       | $ | 2,876 |   | $ | 3,036 |   | (37 | ) | 20 |   | 2,107 |   | 2,090 |   | 321.6 | % | 290.0 | % | 36.5 | % | 45.3 | % |
| Total  gross margin                                    |       | $                          | 8,546      |                       | $          | 5,931                           |       | $ | 6,574 |   | $ | 21,051 |   | $ | 3,960 |   | $ | 3,263 |   | $ | 4,560 |   | $ | 11,783 |   | 115.8 | % | 81.8 | % | 44.2 | % | 78.7 | % |
| Gross  margin percentage                               |       |                       |       |                       |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Contract  revenues / contract revenues - related party |       | 25.1                       | %          | 26.5                       | %          | 18.3                            | %          | 23.7 | % | 18.4 | % | 24.4 | % | 15.5 | % | 19.1 | % | 36.4 | % | 8.6 | % | 18.1 | % | 24.1 | % |
| Service  and other revenues                            |       | 31.9                       | %          | 23.4                       | %          | 27.3                            | %          | 27.3 | % | -44.6 | % | 12.6 | % | 31.5 | % | 30.2 | % | 171.5 | % | 85.7 | % | -13.3 | % | -9.6 | % |
| Total  gross margin percentage                         |       | 25.2                       | %          | 26.4                       | %          | 21.4                            | %          | 24.1 | % | 18.2 | % | 24.3 | % | 20.2 | % | 20.4 | % | 38.5 | % | 8.6 | % | 5.9 | % | 18.1 | % |

 

ISI Detention segmentrevenues increased by 56.0% of total Company revenues from the same period in2006. This increase for ISI Detention was lower than that of 67.1% increase ofrevenues for MCS Detention. The total Company margin increase from 20.4% to24.1% was directly attributable to the increased margins in the ISI Detention(increased 38.5%) and MCS Detention (increased 8.6%) which had the largestportion of revenues.  Detention relatedrevenues comprised 64.7% of total Company revenues.

 

**Discussionof Financial Results**

 

*Revenues*

 

More than 85% of ISI’srevenues are generated by fixed-price contracts. The success of a fixed-pricecontract is based in large part upon the quality of the process utilized whenestimating the costs that will be incurred in performing the contract. Thelarger the project and the longer the term of completion of the contract, thegreater the number of variable factors there are to be considered and evaluatedin estimating costs. A successful estimating process requires substantialexperience and judgment. Management is aware of the significant need forexperience and qualified estimating personnel and regularly monitors theestimating process and its results.

 

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 ISI’s competitors on the same project. Other bidders may bidexceptionally low (even at a loss) in order to secure a contract that thecompetitor may desperately need in order to maintain at least a modestlevel of cash flow, or for other reasons. Management must evaluate the bidsthat were submitted in competition with ISI’s bid, based on their knowledge ofeach competitor’s history and character (for example, some typically bid high,some typically bid low), the condition of the market, the complexity of theproject, the type of construction and other factors. This review, conductedregularly, 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.

 

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ISI also generatesservice revenues. These are generally short-term projects which are evidencedby signed service agreements, 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 ISI. Service revenues are recognized whenthe services have been delivered to and accepted by the customer.

 

This is our first year ofreportable revenues. Prior to our acquisition of ISI, we had no revenues.

 

*Cost ofRevenues*

 

Cost of revenues consistsof the direct costs to complete a material fixed-price contract and includesvariable costs related to the project, such as material, direct labor, projectmanagement costs, travel related expenses to the projects, hotel costs spentwhile the project is on-going, truck expenses utilized on those projects andcell phones of the personnel while they are on those projects. We also reviewour inventories for indications of obsolescence or impairment and providereserves as deemed necessary.

 

*Selling,General and Administrative Expenses*

 

Selling, general andadministrative expenses consist primarily of salaries and benefits for sellingand administrative personnel, including the human resources, executive, financeand legal. These expenses also include fees for professional services and otheradministrative expenses.

 

40

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**Revenues**

 

This is our first year ofreportable revenues. Prior to our acquisition of ISI, we had no revenues.

 

*Pro FormaNet Revenues*

 

The following tablepresents pro forma net revenues for the years ended December 31, 2007 and2006 (in thousands):

 
| ** **                             | ** ** | **Pro Forma Net  Revenues** | ** ** | ** **                  | ** ** | ** **                 | ** ** |
|----------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **Year Ended**              | ** ** | **Year Ended**              | ** ** | **Year to Year**           | ** ** |
| ** **                             | ** ** | **December 31,  2007** | ** ** | **December 31,  2006** | ** ** | **Increase /  (Decrease)** | ** ** |
| ** **                             | ** ** | ** **                  | ** ** | **% of  Net**               | ** ** | ** **                 | ** ** | **% of   Net** | ** ** | ** ** | ** ** | **% Inc /** | ** ** |
| ** **                             | ** ** | **Amount**                  | ** ** | **Revenue**                 | ** ** | **Amount**                 | ** ** | **Revenue** | ** ** | **Amount** | ** ** | **(Decr)** | ** ** |
| **Contract revenues**                  |       | $                           | 43,516     |                        | 50.0       |                       | $          | 30,968 |   | 53.6 |   | $ | 12,548 |   | 40.5 | % |
| **Contract revenues - related  party** |       | 32,560                      |       | 37.3                        |       | 19,855                     |       | 34.4 |   | 12,705 |   | 64.0 | % |
| **Service and other revenues**         |       | 11,110                      |       | 12.7                        |       | 6,929                      |       | 12.0 |   | 4,181 |   | 60.3 | % |
| **Net revenues**                       |       | $                           | 87,186     |                        | 100.0      |                       | $          | 57,752 |   | 100.0 |   | $ | 29,434 |   | 51.0 | % |

 

  On a proforma basis, ISI had revenues of $87.2 million (including related party revenueof $32.6 million) and $57.8 million (including related party revenue of$19.9 million) for the years ended December 31, 2007 and 2006,respectively, representing an increase of $29.4 million or 51.0%. Thesignificant increase in contract revenues is primarily due to several majorfactors including, but not limited to, the addition of new products through thedevelopment of internal software applications that has allowed the company tocapture a larger part of its market. Also, the Company has focused on buildingits service revenue base by adding salespeople and improving performance toretain more customers, which has contributed to the increase in servicerevenues by approximately 60.3% over the same period last year.

 

As used in this analysis,“related party” revenue is that revenue that is generated by work sub-contractedfrom ISI*MCS (an entity owned by Sam Youngblood, CEO of ISI, and by Don Carr,President of ISI).  Messrs. Youngblood and Carr created ISI*MCS in2004 to provide bonding on contracts that require bonding. The performance ofthose contracts is subcontracted to ISI as a subcontractor to ISI*MCS. The sub-contracted work is for third party customers of ISI*MCS thatrequire bonded contracts.  After the acquisition of ISI by Argyle, ISI*MCSwill no longer provide bonding and subcontract work to ISI and ISI will secureits own bonding capacity and use that bonding capacity to directly enter intobonded contracts with third party customers, thereby eliminating the need tocontract for the work as a subcontractor to ISI*MCS. After the merger, theamount of “Revenues - related party” will decrease annually as the contractswith ISI*MCS, outstanding at the time of the merger, are completed.

 

The pro forma revenue mix was 87.3% contract revenuesand 12.7% service revenues for the year ended December 31, 2007 comparedto 88.0% and 12.0%, respectively, for the corresponding period in 2006.

 

In the last three years theentire corrections and commercial security markets have been growing, which hasbeen a factor in a portion of the Company’s success.  Should these markets continue to grow, theCompany with its strong market position should continue to see increasingrevenue opportunities.   Since January 2008,  the Company has been implementing plans to increaserevenues.  Some of the expected increaseswill be derived from the marketing of packaged products from the portfolios ofthe companies Argyle acquired in January 2008.  A brief discussion of those acquisitions isincluded in *Note 23 to the Consolidated Financial Statements —Subsequent Events.*

 

41

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**Cost ofRevenues**

 

This has been our first year of reportable cost ofrevenues. Prior to our acquisition of ISI, we had no cost of revenues.

 

*AdjustedPro Forma Cost of Revenues*

 

The following table reconciles adjusted pro forma costof revenues to pro forma cost of revenues for the years and December 31,2007 and 2006 (in thousands):

 
| ** **                                                          | ** ** | **Adjusted Pro  Forma Cost of Revenues** | ** ** | ** **                             | ** ** | ** **                              | ** ** |
|---------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                          | ** ** | **Year Ended  December 31, 2007**   | ** ** | **Year Ended  December 31, 2006** | ** ** | **Year to Year  Increase / (Decrease)** | ** ** |
| ** **                                                          | ** ** | **Amount**                               | ** ** | **% of  Net  Revenue**                 | ** ** | **Amount**                              | ** ** | **% of  Net  Revenue** | ** ** | **Amount** | ** ** | **% Inc / (Decr)** | ** ** |
| **Contract costs / contract costs  — related party**           |       | $                                        | 58,061     |                                   | 66.6       |                                    | $          | 41,130 |   | 71.2 |   | $ | 16,931 |   | 41.2 | % |
| **Service and other costs,  excluding amortization of intangibles** |       | 8,074                                    |       | 9.3                                    |       | 4,839                                   |       | 8.4 |   | 3,235 |   | 66.9 | % |
| **Adjusted pro forma total cost  of revenues**                      |       | $                                        | 66,135     |                                   | 75.9       |                                    | $          | 45,969 |   | 79.6 |   | $ | 20,166 |   | 43.9 | % |
| **Amortization of intangibles**                                     |       | 3,361                                    |       | 3.8                                    |       | 3,361                                   |       | 5.8 |   | — |   | — |   |
| **Pro forma cost of revenues**                                      |       | $                                        | 69,496     |                                   | 79.7       |                                    | $          | 49,330 |   | 86.4 |   | $ | 20,166 |   | 40.9 | % |

 

On a pro forma basis, cost of revenues increased by$20.2 million, or 40.9%, to $69.5 million for the year ended December 31,2007, compared to $49.3 million for the corresponding period in 2006. On anadjusted pro forma basis, cost of revenues increased by $20.2 million, or43.9%, to $66.2 million for the year ended December 31, 2007, compared to$46.0 million for the corresponding period in 2006. The increase in cost ofsales resulted from ISI working on a greater number of projects in 2007 than in2006. However, while the number of projects rose from 2006, the relativepercentage of material cost and labor cost remained relatively constant betweenthe two periods.

 

The amortization of acquired backlog has beenallocated to cost of revenues and primarily relates to the developed technologyacquired from the acquisition of ISI on July 31, 2007. The impact of thisamortization (which was excluded from adjusted pro forma cost of revenues) forthe year ended December 31, 2007 was $3.4 million.

 

                TheCompany has been implementing its plan to reduce costs and improveefficiencies.  Some of these effortsinclude implementing the best technology in all organizations.  For example, some of the technology used bythe acquired companies was superior to our own, especially with respect toproduction costs.  Additionally, wediscovered that some of the technology we developed is faster and more efficientto that of the acquired companies. The current effort to “swap technology” isproceeding and production cost savings are expected results of these efforts.

 

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**GrossMargin**

 

This has been our first year of reportable grossmargin. Prior to our acquisition of ISI, we had no gross margin.

 

*AdjustedPro Forma Gross Margin*

 

The following table reconciles adjusted pro formagross margin to pro forma gross margin for the year ended December 31,2007 and 2006 (in thousands):

 
| ** **                          | ** ** | **Adjusted Pro  Forma Gross Margin**               | ** ** | ** **                                         | ** ** | ** **                               | ** ** |
|-------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|------------------------------------------|------------|
| ** **                          | ** ** | **Year Ended**** ****December 31, 2007** | ** ** | **Year Ended**** ****December 31, 2006** | ** ** | **Year to Year  Increase /  (Decrease)** | ** ** |
| ** **                          | ** ** | **Amount**                                         | ** ** | **% of  Net  Revenue**                             | ** ** | **Amount**                               | ** ** | **%  of Net  Revenue** | ** ** | **Amount** | ** ** | **% Inc / (Decr)** | ** ** |
| **Adjusted pro forma gross margin** |       | $                                                  | 21,051     |                                               | 24.1       |                                     | $          | 11,784 |   | 20.4 |   | $ | 9,267 |   | 78.6 | % |
| **Amortization of intangibles**     |       | (3,361                                             | )          | (3.8                                               | )          | (3,361                                   | )          | (5.8 | ) | — |   | — |   |
| **Pro forma gross margin**          |       | $                                                  | 17,690     |                                               | 20.3       |                                     | $          | 8,423 |   | 14.6 |   | $ | 9,267 |   | 110.0 | % |

 

On a pro forma basis for the year ended December 31,2007, there was gross margin of $17.7 million compared to a gross margin of$8.4 million for the corresponding period in 2006. On an adjusted pro formabasis for the year ended December, 2007, there was gross margin of $21.1million compared to a gross margin of $11.8 million for the correspondingperiod in 2006. The increase in adjusted gross margin was directly attributableto the Company’s stronger pricing position which provides higher marginsand development of software to automate production, which allows forefficiencies in production and thus lowers costs, thus increasing grossmargins. A major contributor to the increase in gross margin is the increase inservice revenues as a percentage of the overall revenues. Service revenuesenjoy a higher gross margin than the contract revenues. The company alsoincreased gross margin by controlling costs through the upgrading of projectmanagement processes to support installations and services.

 

The amortization of acquired backlog in the cost ofsales section has been allocated to cost of revenues and represents the onlydifference between pro forma gross margins and adjusted pro forma gross marginsfor the year ended December 31, 2007 and 2006.

 

**               **As previously discussed in revenues andcost of revenues sections Argyle has been implementing its plans to increaserevenues, improve efficiencies, and reduce costs, all with the expectation toimprove gross margins in coming periods. Argyle has also seen margins improve over the last year due to thefollowing:

 

·                  Lower margin work was completed in prior years and quarters;

·                  Service revenues with higher margins continue to increase, thereforeincreasing overall margin percentages; and

·                  Production and delivery variable costs have been reduced throughsoftware tools development, code compression, and training which has improvedmargin percentages.

 

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**OperatingExpenses**

 

Operating expenses consist primarily of salaries andbenefits for selling and administrative personnel, including human resources,executive, finance, and legal. These expenses also include fees forprofessional services and other administrative expenses as well as amortizationof intangible assets.  Operating expensesincreased to $9.8 million for the year ended December 31, 2007, comparedto $1.0 million for the corresponding period in 2006. Substantially all of the expenseincrease is attributed to the acquisition of ISI on July 31, 2007.

 

*AdjustedPro Forma Operating Expenses*

 

The following table reconciles adjusted pro formaoperating expenses to pro forma operating expenses for the year ended December 31,2007 and 2006 (in thousands):

 
| ** **                                       | ** ** | **Adjusted Pro  Forma Operating Expenses** | ** ** | ** **                             | ** ** | ** **                              | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                       | ** ** | **Year Ended  December 31, 2007**     | ** ** | **Year Ended  December 31, 2006** | ** ** | **Year to Year  Increase / (Decrease)** | ** ** |
| ** **                                       | ** ** | **Amount**                                 | ** ** | **% of  Net  Revenue**                 | ** ** | **Amount**                              | ** ** | **% of  Net  Revenue** | ** ** | **Amount** | ** ** | **% Inc / (Decr)** | ** ** |
| **Adjusted pro forma total  operating expenses** |       | $                                          | 16,248     |                                   | 18.6       |                                    | $          | 11,129 |   | 19.3 |   | $ | 5,119 |   | 46.0 | % |
| **Amortization of intangible  assets**           |       | 1,332                                      |       | 1.5                                    |       | 1,332                                   |       | 2.3 |   | — |   | 0.0 | % |
| **Pro forma total operating  expenses**          |       | $                                          | 17,580     |                                   | 20.1       |                                    | $          | 12,461 |   | 21.6 |   | $ | 5,119 |   | 41.1 | % |

 

On a pro forma basis, operating expenses increased$5.1 million (or 41%) to $17.6 million for the year ended December 31,2007 from $12.5 million for the corresponding period in 2006. On an adjustedpro forma basis, operating expenses increased $5.1 million (or 46%) to $16.2million for the year ended December 31, 2007 from $11.1 million for thecorresponding period in 2006. The increase is primarily due to additionalexpenses needed to support the increased number of projects on which ISIis working, increased sales and marketing efforts to promote future growth, andcorporate services expenses associated with the parent company entity.  The 2007 expense growth at over 45% and whileless than the 51% increase in pro forma revenues will be lower in followingyears as 2007 had large increases to build infrastructure to support growth infuture years.

 

Additionally, $1.4 million in compensation expenserelated to stock appreciation rights granted in connection with the acquisitionthat were recorded by ISI in July 2007 has been excluded from pro formaand adjusted pro forma operating expenses. The amortization of customer baseand software has been allocated to operating expenses and primarily relates tothe acquisition of ISI on July 31, 2007. The impact of this amortization, whichwas excluded from pro forma operating expenses, was $1.3 million.

 

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**OtherIncome/Expense**

 

Total other income/expense represents interest earnedon the net proceeds of our initial public offering and the private placementheld in trust through the date of the acquisition and interest expense forinterest on our line of credit, unsecured subordinated debt, and our bridgenotes issued in April 2007. Total other income/expense for the year ended December 31,2007 was $.02 million compared to $1.3 million for the corresponding period in2006.

 

*Pro FormaInterest Income and Interest Expense*

 

The following table presents pro forma interest andother income for the year ended December 31, 2007 and 2006 (in thousands):

 
| ** **                                               | ** ** | **Pro Forma Other  Income/Expense**    | ** ** | ** **                             | ** ** | ** **                              | ** ** |
|----------------------------------------------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                               | ** ** | **Year Ended  December 31, 2007** | ** ** | **Year Ended  December 31, 2006** | ** ** | **Year to Year Increase /  (Decrease)** | ** ** |
| ** **                                               | ** ** | **Amount**                             | ** ** | **% of  Net  Revenue**                 | ** ** | **Amount**                              | ** ** | **% of  Net  Revenue** | ** ** | **Amount** | ** ** | **% Inc / (Decr)** | ** ** |
| **Interest on cash and cash  equivalents held in trust** |       | $                                      | 246        |                                   | 0.3        |                                    | $          | 460 |   | 0.8 |   | $ | (214 | ) | (46.5 | )% |
| **Interest expense**                                     |       | (1,703                                 | )          | (1.9                                   | )          | (1,502                                  | )          | (2.6 | ) | (201 | ) | 13.4 | % |
| **Interest, net**                                        |       | $                                      | (1,457     | )                                      | (1.6       | )                                       | $          | (1,042 | ) | (1.8 | ) | $ | (415 | ) | 39.8 | % |

 

Pro forma net interest for the year ended December 31,2007 mainly represents interest earned on the net proceeds of our initialpublic offering and the private placement held in trust through the date of theacquisition. Interest expense increased to $(1.7) million from for the yearended December 31, 2007 from $(1.5) million for the corresponding periodin 2006. Interest expense for the year ended December 31, 2007 and 2006mainly represents interest on our line of credit, unsecured subordinated debt,and our bridge notes issued in April 2007.

 

**NetIncome/(Loss)**

 

For the year ended December 31, 2007, we had netincome of $219,000 compared to a net income of $173,000 for the correspondingperiod in 2006. The results of operations for the year ended December 31,2007 include the results of operations for ISI from August 1, 2007 throughDecember 31, 2007. Our primary source of income prior to the consummationof our initial business combination with ISI was interest earned on the fundsheld in the trust account.

 

*AdjustedPro Forma Net Income / (Loss)*

 

The following table reconciles adjusted pro forma netincome / (loss) to pro forma income / (loss) for the year ended December 31,2007 and 2006 (in thousands):

 
| ** **                                  | ** ** | **Adjusted Pro Forma Net  Income / (Loss)** | ** ** | ** **                             | ** ** | ** **                              | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|
| ** **                                  | ** ** | **Year Ended  December 31, 2007**      | ** ** | **Year Ended  December 31, 2006** | ** ** | **Year to Year Increase /  (Decrease)** | ** ** |
| ** **                                  | ** ** | **Amount**                                  | ** ** | **% of  Net  Revenue**                 | ** ** | **Amount**                              | ** ** | **% of  Net  Revenue** | ** ** | **Amount** | ** ** | **% Inc / (Decr)** | ** ** |
| **Adjusted pro forma net income /  (loss)** |       | $                                           | 2,656      |                                   | 3.0        |                                    | $          | (674 | ) | (1.1 | ) | $ | 3,330 |   | 494.1. | % |
| **Amortization of intangibles**             |       | 4,693                                       |       | 5.4                                    |       | 4,693                                   |       | 8.1 |   | 0 |   | 0.0 | % |
| **Taxes, net**                              |       | (1,783                                      | )          | (2.1                                   | )          | (1,783                                  | )          | (3.0 | ) | 0 |   | 0.0 | % |
| **Pro forma net income / (loss)**           |       | $                                           | (254       | )                                      | 0.3        |                                    | $          | (3,584 | ) | (6.2 | ) | $ | 3,330 |   | 93.0 | % |

 

For the year ended December 31, 2007, we had proforma net loss of ($254,000) compared to a pro forma net loss of ($3.6) millionfor the corresponding period in 2006. For the year ended December 31,2007, we had an adjusted pro forma net income of $2.7 million compared to anadjusted pro forma net loss of ($674,000) for the corresponding period in 2006.The adjusted pro forma results for the year ended December 31, 2007include the pro forma results of operations for ISI from January 1, 2007through December 31, 2007. Our primary source of income prior to theconsummation of our initial business combination with ISI was interest earnedon the funds held in a trust account.

 

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

 
| ** **           | ** ** | **Pro Forma EBITDA**                   | ** ** | ** **                             | ** ** | ** **                              | ** ** |
|----------------------|------------|----------------------------------------|------------|----------------------------------------|------------|-----------------------------------------|------------|
| ** **           | ** ** | **Year Ended  December 31, 2007** | ** ** | **Year Ended  December 31, 2006** | ** ** | **Year to Year Increase /  (Decrease)** | ** ** |
| ** **           | ** ** | **Amount**                             | ** ** | **%**** ****of  Net  Revenue**    | ** ** | **Amount**                              | ** ** | **% of  Net  Revenue** | ** ** | **Amount** | ** ** | **% Inc / (Decr)** | ** ** |
| **Pro Forma EBITDA** |       | $                                      | 6,094      |                                   | 7.0        | %                                       | $          | 1,786 |   | 3.1 | % | $ | 4,308 |   | 241.2 | % |
|                      |            |                                        |            |                                        |            |                                         |            |  |  |  |  |  |  |  |  |  |

 

Pro forma and adjusted pro forma EBITDA rose by $4.3to $6.1 million in the year ended December 31, 2007, compared to $1.8million in the prior year period. The EBITDA margin increased to 7.0% from3.1%.  The increase in EBITDA was duelargely to the increase in gross margins from 14.6% to 20.3% which has beenpreviously discussed.

 

**Resultsof Operations for the Year Ended December 31, 2006**

 

Argyle reported net income of $172,512for the year ended December 31, 2006, before the deduction of $175,747 ofinterest income, 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$1,332,087 for the year ended December 31, 2006, and its funds outside thetrust account earned interest of $20,242. Argyle had no funds in trust as of December 31,2005.

 

For the year ended December 31,2006, Argyle incurred expenses of $469,943 for consulting and professionalfees, $130,632 for stock compensation, $148,516 for franchise taxes, $82,411for insurance 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$469,943 for the year ended December 31, 2006 relate primarily to monthlyconsulting fees that, cumulatively, totaled approximately $288,000, legal feesof approximately $52,000, auditing, tax and accounting fees of approximately$103,000 and bankers’ fees and expenses of approximately $25,000. As of December 31,2006, four consultants (Alan Wachtel, Graham Wallis, Cindy Kittrell and MarkMellin, whose services are described above) 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 twelve months ended December 31,2006 in addition to his compensation as a part-time employee at SecTecGLOBAL, Inc.

 

On February 1, 2006, Argyle’sofficers and directors exercised options and purchased 18,761 shares of commonstock for an aggregate cost of $507. The compensation cost associated withthese options of $130,632 was recorded in the first quarter of 2006 and wascomputed utilizing the Black-Scholes pricing model.

 

The franchise tax expense of $148,516 forthe year ended 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 theyear ended December 31, 2006 relates to the amortization of the prepaiddirectors and officers insurance 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 $48,000, computer server hosting expense of approximately$21,000, communications expenses of approximately $12,000, stock transfer feesof $13,000, office supplies and expenses of approximately $6,000 and othermiscellaneous costs of approximately $31,000.

 

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**Resultsof Operations for the Period from June 22, 2005 (inception) to December 31,2005**

 

Argyle had a net loss of $7,743 for the period ended December 31,2005 as a result of formation and operating costs. Additionally, deferredoffering costs of approximately $295,000 were incurred in 2005. These costsconsisted of professional fees of approximately $203,000, road show and travelexpenses of approximately $25,000, and regulatory and filing fees ofapproximately $67,000. Argyle had no income in 2005.

 

**Liquidityand Capital Resources**

 

Asof December 31, 2007, we had $3.6 million in cash and cash equivalents.

 

InJanuary 2006, Argyle completed a private placement of 125,000 units to itsexecutive officers and their affiliates and received net proceeds ofapproximately $0.9 million. On January 30, 2006, Argyle consummated itsinitial public offering of 3,700,046 units (which included 75,046 units sold aspart of the underwriter’s over-allotment option). Each unit in both the privateplacement and the public offering consisted of one share of common stock andone redeemable common stock purchase warrant. Each warrant entitles the holderto purchase from Argyle one share of Argyle’s common stock at an exercise priceof $5.50 per share.

 

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 at July 31, 2007 tofund the ISI acquisition.

 

In connection with the Public Offeringand the Private Placement, Argyle’s officers and directors placed all theshares owned by them before the Private Placement and the Public Offering intoan escrow account. Except in certain circumstances, the shares held in escrowmay not be released prior to January 24, 2009.

 

On April 16, 2007, Argyle’s officersand directors, an affiliate of Bob Marbut, Argyle’s Chairman and Co-ChiefExecutive Officer, and certain of Argyle’s consultants, pursuant to a note andwarrant acquisition agreement, loaned Argyle an aggregate of $0.3 million andin exchange received promissory notes in the aggregate principal amount of $.3million and warrants to purchase an aggregate of 37,500 shares of Argyle’scommon stock. The promissory notes were repaid in full plus accrued interest inAugust 2007.

 

On July 31, 2007, Argyle consummateda business combination, acquiring 100% of the outstanding capital stock of ISIDetention Contracting Group, Inc. and its subsidiaries, the value of whichthe Board of Directors determined was greater than 80% of Argyle’s assets atthe time of the merger. Prior to the acquisition of ISI, Argyle had nooperations and was considered a developmental stage enterprise. ISI is deemedto be a ‘‘predecessor’’ to the combined company. The accompanying consolidatedbalance sheet includes the assets and liabilities related to the acquisition ofISI, adjusted to fair value pursuant to Statement of Financial AccountingStandards (SFAS) No. 141, *BusinessCombinations*.

 

Argyle has used an estimated $20.5million (excluding Argyle and ISI transaction costs) of the net proceeds of theinitial public offering to acquire ISI. Additionally, Argyle incurred totaltransaction costs of approximately $1.7 million, including legal costs paid toLoeb & Loeb of $0.5 million, $0.6 million related to certain MacquarieSecurities (USA) Inc.’s (formerly Giuliani Capital Advisors) advisory fees andfairness opinion, $0.3 million paid in M&A fees to WFG Investments andadditional costs of $0.3 million related to accountants, consultants, printerfees and other miscellaneous expenses. Such costs do not include transactioncosts of approximately $1.0 million incurred by ISI (related primarily toattorney, brokerage and accounting fees).

 

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As part of the ISI merger, publicstockholders holding 211,965 of the aggregate number of shares sold in thePublic Offering elected to redeem such shares. The per share redemption pricewas equal to $7.80 per share including interest earned thereon in the trustaccount, net of taxes paid and payable, $0.6 million of interest income whichwas released from the trust account in September 2006 to fund our workingcapital, and amounts owed to the underwriter for the Private Placement(approximately $0.5 million plus interest). Approximately $1.6 million was paidto redemptive shareholders in August of 2007.

 

In the 2006 annual reporton Form 10-K, Argyle disclosed that declining cash available outside thetrust account and the lack of assurance that the Company would be able tosuccessfully complete a business combination within the required time frameraised substantial doubt about Argyle’s ability to continue as a going concern.With the completion of the ISI acquisition and release of funds held in trust,there is no longer substantial doubt about Argyle’s ability to continue as agoing concern.

 

***WorkingCapital***

 

Our primary liquidity needs are forfinancing ISI’s working capital (including premiums and fees incurred inconnection with bid and performance bonds) and their purchase of computers andrelated equipment. The nature of its business and operations as a detentioncontractor causes cash flow from operations to be highly volatile. Its largeconstruction contracts can produce or consume cash. The production orconsumption of cash is dependent on factors inherent to the constructionindustry, including billing and payment terms of the contracts. ISI has inplace a credit facility to allow it to manage its working capital requirements.

 

At December 31, 2007, we had currentassets of $40.5 million and current liabilities of $20.5 million resulting in aworking capital surplus of approximately $20.0 million compared to a surplus of$6.0 million based upon ISI’s current assets and liabilities at December 31,2006.

 

***Long-TermDebt***

 

Notespayable and long-term debt consists of the following (in thousands):

 

| **Collateral**                                                     | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------|------------|
| Notes payable:                                                     |       |                       |       |
| Vehicles and equipment                                             |       | $                          | 190        |   |
| Unsecured debt — related party                      |       | 5,952                      |       |
| Unsecured convertible  debt — stockholders          |       | 1,925                      |       |
|                                                               |       | 8,067                      |       |
| Less current maturities                                            |       | 81                         |       |
| Long-term debt for notes — less current  maturities |       | $                          | 7,986      |   |
| Line of credit                                                     |       | $                          | 7,979      |   |

 

***Vehicles and Equipment***

 

Amount includes notesrelated to Company vehicles and various equipment. Vehicle and equipment notesare staggered in regards to their maturity, each amortizing over 36 — 48month periods.  Interest rates on theindividual notes range from fixed rate of 7% up to Prime plus 1.0%. Includedwith the equipment is a note related to the phone system with a fixed rate ofinterest at 9.0% which matures in 2008.

 

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***Unsecured Debt — Related Party***

 

These refer to notespayable to a significant stockholder of Argyle. The notes are unsecured andsubordinated to the line of credit facility. The unsecured note agreementcontains prepayment options without prepayment penalties. Interest accrues at11.58% per annum and is payable quarterly. The total debt of $6.0 million isdue and payable in one single payment on January 31, 2010. There are bothfinancial and restrictive covenants associated with the note agreement. As of December 31,2007, the Company was in compliance with all covenants.

 

***Unsecured Convertible Debt — Stockholders***

 

As part of the mergerconsideration, the Company issued unsecured convertible debt to thestockholders in the amount of $1.9 million which bears interest at 5% per annum,paid semiannually. The notes mature five years from the date of issuance on July 31,2012. The notes may be converted in whole or in part into shares of the Company’scommon stock at the election of the note holder at a share price of $10.00 anytime after January 1, 2008. The debt may be redeemed by the Company at$10.00 per share any time after January 1, 2009.

 

***Unsecured Debt — Stockholders***

 

In April 2007, Argyle’s officers and directors,an affiliate of Argyle’s Chairman and Co-Chief Executive Officer, and certainof Argyle’s consultants, pursuant to a note and warrant acquisition agreement,loaned Argyle an aggregate of $0.3 million and in exchange received promissorynotes in the aggregate principal amount of $0.3 million and warrants topurchase an aggregate of 37,500 shares of Argyle’s common stock. The warrantsare exercisable at $5.50 per share of common stock and expire on January 24,2011.

 

The warrants also may be exercised on a net-sharebasis by the holders of the warrants. The Company has 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 $0.9million) using an expected life of 2 years, volatility of 2.39%, and arisk-free rate of 5%. However, because the Company’s warrants have a limitedtrading history, the volatility assumption was based on information currentlyavailable to management. The promissory notes had an interest at a rate of 4%per year and were repayable 30 days after the consummation of a businesscombination. The notes and the associated accrued interest were paid in full inAugust 2007.

 

***Line of Credit Facility***

 

At December 31,2007, the Company has a line of credit facility totaling $9.0 million. The lineof credit is secured by all tangible and intangible assets of the Companyexcluding vehicles. The line calls for all accounts receivable collections tobe deposited directly to a lockbox. Interest is payable quarterly and iscalculated at the lender’s base rate (greater of prime or federal funds rate)plus 0.5% or 350 basis points in excess of LIBOR for the applicable period. Theoutstanding balance on the line at December 31, 2007 was $8.0 million, dueDecember 31, 2009, with an interest rate of prime plus 0.5%. The agreementcontains both financial and restrictive covenants, including a restriction onthe payment of dividends. At December 31, 2007, the Company was incompliance with such covenants. The Company has agreed to pay an annualcommitment fee of 0.5% per year on the unused borrowing capacity, which was$1.0 million at December 31, 2007. In January 2008, the Companyincreased its line of credit facility to $12.0 million and added a newacquisition loan facility in the amount of $4.3 million.  The line of credit facility matures in January 2010and the acquisition loan facility matures in June 2011.

 

***Capital Leases***

 

ISI sold its owner-occupied real estateto a partnership owned by ISI’s stockholders during 2004 and entered into aleaseback of the properties with the partnership. ISI entered into a secondlease on another property owned by the same partnership in 2006. Both leaseswere triple net leases.  A triple netlease is a lease agreement on a property where the tenant or lessee agrees topay all real estate taxes, building insurance, and maintenance (the three ‘Nets’)on the property in addition to any normal fees that are expected under theagreement (rent, etc.). In such a lease, the tenant or lessee is responsiblefor all costs associated with repairs or replacement of the structural buildingelements of the property.

 

The terms of the aforementioned leases weremodified on July 31, 2007 to extend the expiration date from 2018 to 2019and increase the monthly rental from $23,667 to $24,000. The modification didnot materially affect the carrying value of the assets or related liabilitiesrecorded in the accompanying consolidated balance sheet. The Company reassessedthese leases for proper classification under SFAS No. 13, *Accounting for Leases*, and determined they remain properlyclassified as capital leases.

 

49

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***Commitments***

 

Our corporate office lease space expiredas of July 31, 2007 and we currently operate under a month-to-month leasearrangement. No lease agreements contain bargain purchase options or similarclauses in which management intends to execute or that are considered materialrequiring disclosure.

 

In August 2007 we entered into a letter of creditfacility with a financial institution. The letter of credit may not exceed$500,000. The facility requires a 1% annual commitment fee on the unusedportion of the letter of credit facility. The commitment fee is to be paidquarterly.

 

**OffBalance Sheet Arrangements**

 

Argyle does not have any off-balance sheetarrangements.

 

**ContractualObligations**

 

**Contractual Obligations as of December 31, 2007(Unaudited)**

 

| **Contractual obligations ($ in thousands)** | ** ** | **Total**  | ** ** | **< 1 Year** | ** ** | **1- 3 Years** | ** ** | **3 - 5 Years** | ** ** | **> 5 Years** | ** ** |
|---------------------------------------------------|------------|------------|------------|-----------------|------------|----------------|------------|-----------------|------------|------------------|------------|
| Principal on Long Term Debt Obligations           |       | $          | 14,121     |            | $          | 81             |       | $               | 14,024     |             | $          | 16 |   | $ | — |   |
| Capital Lease Obligations                         |       | 3,357      |       | 288             |       | 576            |       | 576             |       | 1,917            |       |
| Operating Lease Obligations                       |       | 482        |       | 211             |       | 219            |       | 52              |       | —           |       |
| Promissory Notes - Shareholders                   |       | 1,925      |       | —          |       | 1,925          |       | —          |       | —           |       |
| Interest on Long Term Debt Obligations            |       | 3,879      |       | 1,297           |       | 2,579          |       | 3               |       | —           |       |
| **Total**                                         | ** ** | **23,765** | ** ** | **1,877**       | ** ** | **19,323**     | ** ** | **647**         | ** ** | **1,917**        | ** ** |
|                                                   |            |            |            |                 |            |                |            |                 |            |                  |            |  |  |  |  |  |

 

**Item 7A. Quantitative and QualitativeDisclosures About Market Risk**

 

       Marketrisk is the sensitivity of income to changes in interest rates, foreignexchanges, commodity prices, equity prices, and other market-driven rates orprices.

 

At December 31, 2007, the Companyhad a line of credit facility totaling $9.0 million. The line of credit issecured by all of our tangible and intangible assets excluding vehicles.Interest is payable quarterly and is calculated at the lender’s base rate(greater of prime or federal funds rate) plus 0.5% or 350 basis points inexcess of LIBOR for the applicable period. The outstanding balance on the lineat December 31, 2007 was $8.0 million with an interest rate of prime plus0.5%. The facility has a maturity date of December 31, 2009.

 

In January 2008, the Companyincreased its line of credit facility to $12.0 million and added a newacquisition loan facility in the amount of $4.3 million.  The line of credit facility matures in January 2010and the acquisition loan facility matures in June 2011.

 

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 $163,000 based on the total creditavailable to Argyle.

 

**Item 8. Financial Statements andSupplementary Data**

 

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

 

50

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

 

On April 18, 2006, our Board ofDirectors terminated Goldstein Golub Kessler LLP as Argyle’s principalaccountants.

 

DuringArgyle’s fiscal year ended December 31, 2005 and the subsequent interimperiod ended April 18, 2006, there were no disagreements with GoldsteinGolub Kessler LLP on any matter of accounting principles or practices,financial statement disclosure, or auditing scope or procedures, whichdisagreements, if not resolved to their satisfaction, would have caused them tomake reference in connection with their opinion to the subject matter of thedisagreement.

 

The audit reports of Goldstein GolubKessler LLP on the financial statements of Argyle as of and for the year ended December 31,2005 and as of and for the interim period ended January 30, 2006 did notcontain any adverse opinion or disclaimer of opinion, nor were they qualifiedor modified as to uncertainty, audit scope, or accounting principles.

 

On May 1, 2006, Argyle engaged Ernst &Young LLP as its independent registered public accounting firm for the fiscalyear ending December 31, 2006, and such engagement was approved by Argyle’sBoard of Directors. On August 30, 2007, Argyle’s Board of Directorsreappointed Ernst & Young LLP as it independent registered publicaccounting firm for the fiscal year ended December 31 2007.

 

During the fiscal year ended December 31, 2005and the subsequent interim period ended April 18, 2006, Argyle did notconsult with Ernst & Young LLP regarding (i) the application ofaccounting principles to a specific completed or contemplated transaction, orthe type of audit opinion that might be rendered on Argyle’s consolidatedfinancial statements and no written or oral advice was provided by Ernst &Young LLP that was an important factor considered by Argyle in reaching adecision as to any accounting, auditing or financial reporting issue or (ii) anymatter that was either the subject of a disagreement or event, as set forth inItem 304(a)(1)(iv) or Item 304(a)(1)(v) of Regulation S-K.

 

There were no ‘‘reportable events’’, asthat term is described in Item 304(a)(1)(v) of Regulation S-K, for theyear ended December 31, 2005 and the subsequent interim period ended April 18,2006.

** **

**Item 9A. 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 (“Exchange Act”) isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms. Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed under the Exchange Act is accumulated and communicatedto management, including the principal executive and financial officers, asappropriate to allow timely decisions regarding required disclosure. There areinherent limitations to the effectiveness of any system of disclosure controlsand procedures, including the possibility of human error and the circumventionor overriding of the controls and procedures. Accordingly, even effectivedisclosure controls and procedures can only provide reasonable assurance ofachieving their control objectives.

 

Our management, under the supervision of our Co-ChiefExecutive Officers, performed an evaluation of the effectiveness of the designand operation of our disclosure controls and procedures as of December 31,2007. Based on that evaluation, our management, including the Co-ChiefExecutive Officers, concluded that our disclosure controls and procedures wereeffective as of December 31, 2007.

 

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

 

Our management, including the Co-Chief ExecutiveOfficers, 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.

 

51

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Our management assessed the effectiveness of ourinternal control over financial reporting as of December 31, 2007.  In making this assessment, it used theframework entitled “Internal Control—Integrated Framework” set forth by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO). Basedon its evaluation of Argyle Security Inc.’s internal control over financialreporting in accordance with the COSO framework, management concluded that wemaintained an effective internal control over financial reporting as of December 31,2007.  Management has excluded ISI fromits assessment of internal control over financial reporting as of December 31,2007 as ISI was acquired on July 31, 2007. At December 31, 2007 and for the period from July 31 through December31, 2007, total assets, total assets less goodwill and net tangible assets, andtotal revenues subject to ISI’s internal control over financial reportingrepresented 94.9%, 49.4%, and 100.0% of Argyle’s consolidated total assets,total assets less goodwill and net intangible assets, and total revenues as ofand for the year ended December 31, 2007.

 

**Changes in Internal Control overFinancial Reporting**

 

During the quarter ended December 31, 2007management had completed testing and determined that the controls surroundingthe previously disclosed material weakness regarding the financial statementclose process and monitoring compliance with debt covenants were operatingeffectively. Management has concluded that remediation has been completed andthis represents a significant change in internal control over financialreporting.

 

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, 2007 that have materiallyaffected, or are reasonably likely to materially affect, Argyle Security, Inc.’sinternal control over financial reporting. We do provide assurance that noadditional material weaknesses will be identified.

 

**Item 9B. Other Information**

 

None

 

52

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**PART III**

 

**Item 10. Directors, ExecutiveOfficers 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 2008.

 

**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 2008.

 

**Item 12. Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder 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 2008.

 

**Item 13. Certain Relationships andRelated 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 2008.

 

**Item 14. Principal Accounting Feesand Services**

 

Ernst & Young LLP audited our financialstatements for the year ended December 31, 2007 and 2006. Goldstein GolubKessler LLP acted as our principal accountant from our inception through April 18,2006.   Through September 30, 2005, Goldstein Golub Kessler LLPhad a continuing relationship with American Express Tax and Business ServicesInc. (TBS), from which it leased auditing staff who were full time, permanentemployees of TBS and through which its partners provide non-audit services.Subsequent to September 30, 2005, this relationship ceased and GoldsteinGolub Kessler LLP established a similar relationship with RSM McGladrey, Inc.Goldstein Golub Kessler LLP has no full time employees and therefore, none ofthe audit services performed was provided by permanent full-time employees ofGoldstein Golub Kessler LLP. Goldstein Golub Kessler LLP manages and supervisesthe audit and audit staff, and is exclusively responsible for the opinion renderedin connection with its examination.

 

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 audited the predecessor (ISI) employee benefitplans for the years ended December 31, 2006 and 2005.

 

**AuditFees**

 

Fees for audit services provided by Ernst &Young LLP totaled $409,502 and $132,878 in 2007 and 2006, respectively,including fees associated with the audit of the annual financial statements forthe fiscal year ended December 31, 2007 and 2006, the reviews of theCompany’s quarterly reports on Form 10-Q, and for services performed inconnection with the Company’s registration statements.

 

Fees for audit services provided by Goldstein GolubKessler LLP totaled $6,000 in 2006 related to the audit for the fiscal yearended December 31, 2005.

 

Fees for audit services provided by Padgett,Stratemann & Co., LLP totaled $236,425 and $144,200 in 2007 and 2006,respectively, including fees associated with the audit of ISI DetentionContracting Group, Inc.  (ISI)financial statements for the seven months ending July 31, 2007 and fiscalyears ended December 31, 2006 and 2005, and audit services related to therestatement of ISI financial statements for the fiscal years ended December 31,2005, 2004 and 2003, quarterly reviews of ISI for purposes of filing in Argyle8-K filings during the acquisition period of ISI by the Company, and servicesperformed in connection with the Company’s registration statements.

 

53

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**Audit-RelatedFees**

 

Fees for audit-related services provided by Ernst &Young LLP totaled $269,600 and $28,500 in 2007 and 2006, respectively.Audit-related services principally include due diligence in connection withacquisitions in 2006, and a balance sheet audit in 2007 as a result of the ISIacquisition.

 

Other than the fees described under the caption “AuditFees” above, Goldstein Golub Kessler LLP did not bill any fees for servicesrendered to us during fiscal year 2006 for assurance and related services inconnection with the audit or review of our financial statements.

 

Fees for audit related services provided by Padgett,Stratemann & Co. LLP totaled $22,975 and $7,500 in 2007 and 2006, respectively.  Audit related services included due diligencein connection with acquisitions in 2007 and audits of ISI’s employee benefitplans for the years ended December 31, 2006 and 2005.

 

**TaxFees**

 

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

 

There were no fees billed by Goldstein Golub KesslerLLP for tax services in 2006, however, RSM McGladrey, Inc. didcharge us $3,264 for tax compliance services in 2006.

 

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

 

**AllOther Fees**

 

There were no fees billed by Ernst & YoungLLP for other professional services rendered during the fiscal years ended December 31,2007 or 2006.  There were $2,950 feesbilled by Goldstein Golub Kessler LLP for other professional services renderedduring the fiscal year December 31, 2007.

 

Fees for other professional services rendered byPadgett Stratemann &Co., Inc totaled $34,425 and $2,000 during the2007 and 2006, respectively.

 

**Pre-Approvalof 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 do not rely on pre-approval policies and procedures.

 

54

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**PART IV**

 

**Item 15. Exhibits and FinancialStatement Schedules**

 

(a)   (1) ConsolidatedFinancial Statements

 

Consolidated BalanceSheets

Consolidated Statement ofOperations

Consolidated Statement ofStockholders’ Equity

Consolidated Statement ofCash Flows

 

  (2) Schedules

 

None.

 

(b) Exhibits

 

The followingExhibits are filed as part of this report

 
| ** **           | ** ** | ** **                                                                                                                                           |
|----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Exhibit No.** | ** ** | **Description**                                                                                                                                      |
| 3.1                  |       | Second Amended  and Restated Certificate of Incorporation (1)                                                                                        |
|                 |       |                                                                                                                                                 |
| 3.2                  |       | By-laws(1)                                                                                                                                           |
|                 |       |                                                                                                                                                 |
| 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)                               |
|                 |       |                                                                                                                                                 |
| 10.3                 |       | Warrant  Clarification Agreement between the Company and American Stock  Transfer & Trust Company, dated August 10, 2006 (2)           |
|                 |       |                                                                                                                                                 |

 

55

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| 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)                                                                          |
|   |   |                                                                                                                                                                                                           |
| 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)                                                                       |
|   |   |                                                                                                                                                                                                           |

 

56

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| 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)                                                                                                               |
|   |   |                                                                                                                                                                                      |
| 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                                                                                                                                             |
|   |   |                                                                                                                                                                                      |

 

57

----

 
| 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 196th 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.                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 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.                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |
| 21.1   |   | List of  Subsidiaries                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                      |

 

58

----

 
| 23.1      |   | Consent of Ernst  & Young LLP                                                                                                                                   |
|-----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                                |
| 23.2      |   | Consent of Padgett, Stratemann & Co., LLP                                                                                                                       |
|      |   |                                                                                                                                                                |
| 23.3      |   | Consent of Goldstein Golub Kessler LLP                                                                                                                              |
|      |   |                                                                                                                                                                |
| 31.1      |   | Certification of  the Co-Chief Executive Officer (Principal Financial Officer) pursuant to  Rule 13a-14(a) of the Securities Exchange Act, as amended     |
|      |   |                                                                                                                                                                |
| 31.2      |   | Certification of  the Co-Chief Executive Officer and (Principal Executive Officer) pursuant to  Rule 13a-14(a) of the Securities Exchange Act, as amended |
|      |   |                                                                                                                                                                |
|  32. |   | Certification of  the Co-Chief Executive Officers pursuant to 18 U.S.C. 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.           |

 

----

| (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 Company’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 Company’s Current Report on Form 8-K dated January 2,  2008.                          |
| (10) | Incorporated by  reference to the Company’s Current Report on Form 8-K dated February 6,  2008.                         |

 

 

59

----

 

**SIGNATURES**

 

 Pursuant to the requirements of Section 13or 15 (d) of the Securities Exchange Act of 1934, the Registrant had dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                 |                                    |                                      |
|----------------------|-----------------------------------------|-------------------------------------------|
|                 | ARGYLE SECURITY,  INC.                  |
|            |                               |                                 |
| March 31,  2008 | By:                           | /s/ Bob  Marbut       |
|                 | Bob Marbut,  Co-Chief Executive Officer |

 

 Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities and on the datesindicated.

 
|                 |                                                                                             |                   |
|----------------------|--------------------------------------------------------------------------------------------------|------------------------|
| March 31,  2008 | By:                                                                                    | /s/   Bob  Marbut |
|                 | Bob Marbut,  Chairman of the Board and Co-Chief Executive Officer (Principal Executive  Officer) |

 
|                |                                                                       |                       |
|---------------------|----------------------------------------------------------------------------|----------------------------|
| March 31, 2008 | By:                                                              | /s/   Ron  Chaimovski |
|                | Ron Chaimovski,  Vice-Chairman of the Board and Co-Chief Executive Officer |

 
|                 |                    |                     |
|----------------------|-------------------------|--------------------------|
| March 31,  2008 | By:           | /s/    Wesley Clark |
|                 | Wesley Clark,  Director |

 
|                 |                                   |                      |
|----------------------|----------------------------------------|---------------------------|
| March 31,  2008 | By:                          | /s/   John  Smith    |
|                 | John Smith,  Director                  |
|                 |                                   |
|                 |                                   |
| March 31,  2008 |   /s/    Lloyd Campbell |
|                 | By:                                    | Lloyd Campbell,  Director |
|                      |                                        |                           |  |

 

 
| March 31,  2008 |                                 |   /s/    Walter Klein     |
|----------------------|--------------------------------------|------------------------------------------|
|                 | By:                                  | Walter Klein,  Director                  |
|                 |                                 |
|                 |                                 |
| March 31,  2008 | /s/    Donald Neville |
|                 | By:                                  | Donald Neville,  Chief Financial Officer |
|                      |                                      |                                          |  |

 

 

60

----

 

 

 

**ARGYLESECURITY, INC.**

**INDEX OFFINANCIAL 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 Independent Registered Public Accounting  Firm                     | F-4      |
|                                                                         |     |
| Report  of Management on Internal Controls Over Financial Reporting          | F-5      |
|                                                                         |     |
| Consolidated  Balance Sheets                                                 | F-6      |
|                                                                         |     |
| Consolidated Statements of Operations                                        | F-7      |
|                                                                         |     |
| Consolidated Statement of Changes in Stockholders’  Equity              | F-9      |
|                                                                         |     |
| Consolidated Statements of Cash Flows                                        | F-10     |
|                                                                         |     |
| Notes to Consolidated Financial Statements                                   | F-12     |

 

F-1

----

 

**Reportof Independent Registered Public Accounting Firm**

 

The Board of Directors and Stockholders

 

Argyle Security, Inc.

 

We have audited the accompanying consolidated balancesheets of Argyle Security, Inc. (formerly Argyle Security AcquisitionCorporation) (the Company)  as of December 31,2007 and 2006, and the related consolidated statements of operations,stockholders’ equity, and cash flows for the years then ended.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. We were not engaged to perform an audit of the Company’s internalcontrol over financial reporting. Our audits included consideration of internalcontrol over financial reporting as a basis for designing audit procedures thatare appropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting.  Accordingly, we express nosuch opinion. An audit also includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements, assessingthe accounting principles used and significant estimates made by management,and evaluating the overall financial statement presentation. We believe thatour audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financialposition of Argyle Security, Inc. at December 31, 2007 and 2006, andthe consolidated results of its operations and its cash flows for the yearsthen ended, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 2 to the financial statements, in2007 the Company changed its method of accounting for income taxes.

** **
| /s/ Ernst & Young LLP |
|-------------------------------------|
|                                |
| San Antonio, Texas                  |
| March 25, 2008                 |

 

F-2

----

 

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

To the Board of Directors and Stockholders

Argyle Security, Inc.

 

We have audited the statements of operations and cashflows of Argyle Security, Inc. (a corporation in the development stage)for the period from June 22, 2005 (inception) to December 31, 2005.These financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these financial statements basedon our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financial statements referred toabove present fairly, in all material respects, the results of its operationsand its cash flows for the period from June 22, 2005 (inception) to December 31,2005 in conformity with United States generally accepted accounting principles.

 

/s/ Goldstein Golub Kessler LLP

 

GOLDSTEIN GOLUB KESSLER LLP

New York, New York

 

February 3, 2006

 

F-3

----

 

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand StockholdersISI Detention Contracting Group, Inc. and Subsidiaries

 

We have audited theaccompanying consolidated balance sheet of ISI Detention Contracting Group, Inc.and Subsidiaries as of December 31, 2006 and the related consolidatedstatements of operations and cash flows for the seven months ended July 31,2007 and for the years ended December 31, 2006 and 2005. Theseconsolidated financial statements are the responsibility of the Company’s management.Our responsibility is to express an opinion on these consolidated financialstatements 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 theaudits to obtain reasonable assurance about whether the consolidated financialstatements are free of material misstatement. An audit includes examining, on atest basis, evidence supporting the amounts and disclosures in the consolidatedfinancial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well asevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of ISI Detention Contracting Group, Inc.and Subsidiaries as of December 31, 2006 and the results of theiroperations and their cash flows for the seven months ended July 31, 2007and for the years ended December 31, 2006 and 2005, in conformity withaccounting principles generally accepted in the United States of America.

 

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

 

October 30, 2007

 

F-4

----

 

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

To the Board of Directorsand Stockholders

The management of Argyle Security, Inc.(the “Company”) is responsible for establishing and maintaining adequateinternal 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 over financial reporting, nomatter how well designed, has inherent limitations. Therefore, internalcontrols over financial reporting determined to be effective can provide onlyreasonable assurance with respect to financial statement preparation andpresentation. Also, projections of any evaluation of effectiveness to futureperiods are subject to the risk that controls may become inadequate because ofchanges in conditions, or that the degree of compliance with the policies orprocedures may deteriorate.

 

Management assessed the effectiveness of theCompany’s internal control over financial reporting as of December 31,2007. 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).We have excluded from the scope of our assessment of internal control overfinancial reporting the operations and related assets of ISI, which we acquiredon July 31, 2007.  At December 31,2007 and for the period from July 31 through December 31, 2007, totalassets, total assets less goodwill and net intangible assets, and totalrevenues subject to ISI’s internal control over financial reporting represented94.9%, 49.4%, and 100.0% of Argyle’s consolidated total assets, total assetsless goodwill and net intangible assets, and total revenues as of and for theyear ended December 31, 2007.

 

Management’s assessment included an evaluationof the design of the Company’s internal controls over financial reporting andtesting of the operational effectiveness of its internal controls overfinancial reporting.

 

Based on our assessment, management hasdetermined that, as of December 31, 2007, the Company maintained effectiveinternal control over financial reporting. The annual report on internal control over financial reporting does notinclude an attestation report of the registrant’s registered public accountingfirm pursuant to temporary rules of the Securities and Exchange Commissionthat permit the registrant to provide only management’s report in its annualreport.

 
| By: /s/ Bob Marbut                            |   |   |   |
|-----------------------------------------------|--------|--------|--------|
| Bob Marbut                                    |   |   |   |
| (Principal Executive  Officer)                |   |   |   |
|                                          |   |   |   |
| By: /s/ Don Neville                           |   |   |   |
| Donald Neville                                |   |   |   |
| (Principal Accounting and  Financial Officer) |   |   |
|                                          |   |   |   |
| Dated: March 31, 2008                    |   |   |   |

 

F-5

----

 

 

 

**ARGYLESECURITY, INC.CONSOLIDATED BALANCE SHEETS**

(inthousands, except share data)

 
| ** **                                                                                                                                                                                                    | ** ** | ** **            | ** ** | ** **            | ** ** | **Predecessor (ISI)** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **December 31,** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                                                                                                                    | ** ** | **2007**              | ** ** | **2006**              | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                                                                    |       |                  |       |                  |       |                  |       |
| Current assets:                                                                                                                                                                                               |       |                  |       |                  |       |                  |       |
| Cash and cash equivalents                                                                                                                                                                                     |       | $                     | 3,556      |                  | $          | 694                   |       | $ | 359 |   |
| Cash and cash equivalents, held in trust                                                                                                                                                                      |       | —                |       | 29,453                |       | —                |       |
| Receivables:                                                                                                                                                                                                  |       |                  |       |                  |       |                  |       |
| Contract — net of allowance for doubtful accounts of $975 and $412 at  December 31, 2007 and 2006, respectively                                                                                     |       | 14,459                |       | —                |       | 13,431                |       |
| Contract receivables — related party                                                                                                                                                                     |       | 10,887                |       | —                |       | 6,262                 |       |
| Other receivables — related party                                                                                                                                                                        |       | 42                    |       | —                |       | —                |       |
| Costs and estimated earnings in excess of billings on incomplete  contracts                                                                                                                                   |       | 7,665                 |       | —                |       | 3,871                 |       |
| Intangible assets                                                                                                                                                                                             |       | 2,959                 |       | —                |       | —                |       |
| Refundable income taxes                                                                                                                                                                                       |       | 561                   |       | —                |       | 517                   |       |
| Other current assets                                                                                                                                                                                          |       | 378                   |       | 7                     |       | 673                   |       |
| Deferred income taxes, net                                                                                                                                                                                    |       | —                |       | 28                    |       | —                |       |
| Total current assets                                                                                                                                                                                          |       | 40,507                |       | 30,182                |       | 25,113                |       |
| Property and equipment, net                                                                                                                                                                                   |       | 5,187                 |       | 5                     |       | 3,970                 |       |
| Goodwill                                                                                                                                                                                                      |       | 19,937                |       | —                |       | 1,365                 |       |
| Intangible assets                                                                                                                                                                                             |       | 15,146                |       | —                |       | —                |       |
| Deposits, deferred transaction costs, and other assets                                                                                                                                                        |       | 371                   |       | 494                   |       | 1,169                 |       |
| Total other assets                                                                                                                                                                                            |       | 40,641                |       | 499                   |       | 6,504                 |       |
| Total assets                                                                                                                                                                                                  |       | $                     | 81,148     |                  | $          | 30,681                |       | $ | 31,617 |   |
|                                                                                                                                                                                                          |       |                  |       |                  |       |                  |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                                |       |                  |       |                  |       |                  |       |
| Current liabilities:                                                                                                                                                                                          |       |                  |       |                  |       |                  |       |
| Accounts payable and accrued liabilities                                                                                                                                                                      |       | $                     | 14,318     |                  | $          | 743                   |       | $ | 10,736 |   |
| Accounts payable — related party                                                                                                                                                                         |       | 40                    |       | —                |       | 1,806                 |       |
| Billings in excess of costs and estimated earnings on incomplete  contracts                                                                                                                                   |       | 5,733                 |       | —                |       | 6,005                 |       |
| Payable to redemptive shareholders                                                                                                                                                                            |       | —                |       | —                |       | —                |       |
| Notes and interest payable to stockholders                                                                                                                                                                    |       | 40                    |       | —                |       | —                |       |
| Deferred underwriting costs                                                                                                                                                                                   |       | —                |       | 1,162                 |       | —                |       |
| Current portion of capitalized lease obligations                                                                                                                                                              |       | 97                    |       | —                |       | 103                   |       |
| Current portion of long-term debt                                                                                                                                                                             |       | 81                    |       | —                |       | 406                   |       |
| Deferred income taxes, net                                                                                                                                                                                    |       | 211                   |       | —                |       | —                |       |
| Total current liabilities                                                                                                                                                                                     |       | 20,520                |       | 1,905                 |       | 19,056                |       |
| Long-Term Liabilities:                                                                                                                                                                                        |       |                  |       |                  |       |                  |       |
| Deferred income taxes                                                                                                                                                                                         |       | 6,095                 |       | —                |       | 248                   |       |
| Long-term debt — less current portion                                                                                                                                                                    |       | 15,965                |       | —                |       | 18,569                |       |
| Unsecured convertible debt — payable to parent                                                                                                                                                           |       | —                |       | —                |       | —                |       |
| Long-term capitalized lease obligations — less current portion                                                                                                                                           |       | 1,904                 |       | —                |       | 1,972                 |       |
| Warrants, subject to  redemption                                                                                                                                                                              |       | —                |       | —                |       | 5,019                 |       |
| Total long-term  liabilities                                                                                                                                                                                  |       | 23,964                |       | —                |       | 25,808                |       |
| Total liabilities                                                                                                                                                                                             |       | 44,484                |       | 1,905                 |       | 44,864                |       |
| Common stock of Argyle Security, Inc. , subject to possible redemption  — 764,627 shares at $7.50 per share                                                                                         |       | —                |       | 5,738                 |       | —                |       |
| Deferred interest  attributable to redemptive shares (net of taxes of $91)                                                                                                                                    |       | —                |       | 176                   |       | —                |       |
| Stockholders’ Equity                                                                                                                                                                                     |       |                  |       |                  |       |                  |       |
| Preferred stock of Argyle Security, Inc. — $.0001 par value; 1,000,000  shares authorized; 0 shares issued and outstanding                                                                          |       | —                |       | —                |       | —                |       |
| Common stock of ISI Detention— $1 par value; 3,000 shares authorized;  105 shares issued and outstanding at December 31, 2006                                                                       |       | —                |       | —                |       | —                |       |
| Common stock of Argyle Security, Inc. — $.0001 par value;  89,000,000 shares authorized; shares issued and outstanding 5,879,342 at  December 31, 2007 and 4,781,307 at December 31, 2006 |       | 1                     |       | —                |       | —                |       |
| Additional paid in capital                                                                                                                                                                                    |       | 36,279                |       | 22,697                |       | —                |       |
| Accumulated earnings (deficit)                                                                                                                                                                                |       | 384                   |       | 165                   |       | (13,247               | )          |
| Total stockholders’ equity                                                                                                                                                                               |       | 36,664                |       | 22,862                |       | (13,247               | )          |
| Total liabilities and stockholders’ equity                                                                                                                                                               |       | $                     | 81,148     |                  | $          | 30,681                |       | $ | 31,617 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

 

F-6

----

 

**ARGYLESECURITY, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

(inthousands, except per share data)

 
| ** **                                                                                                           | ** ** | ** **                       | ** ** | ** **            | ** ** | **June 22, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                           | ** ** | ** **                       | ** ** | ** **            | ** ** | **(inception)**        | ** ** |
| ** **                                                                                                           | ** ** | ** **                       | ** ** | ** **            | ** ** | **through**            | ** ** |
| ** **                                                                                                           | ** ** | **Year Ended December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                                                           | ** ** | **2007**                         | ** ** | **2006**              | ** ** | **2005**               | ** ** |
| Revenues:                                                                                                            |       |                             |       |                  |       |                   |       |
| Contract revenues                                                                                                    |       | $                                | 24,341     |                  | $          | —                 |       | $ | — |   |
| Contract revenues — related party                                                                               |       | 15,048                           |       | —                |       | —                 |       |
| Service and other revenues                                                                                           |       | 4,664                            |       | —                |       | —                 |       |
| Total revenues                                                                                                       |       | 44,053                           |       | —                |       | —                 |       |
| Cost of revenues:                                                                                                    |       |                             |       |                  |       |                   |       |
| Contract costs                                                                                                       |       | 29,435                           |       | —                |       | —                 |       |
| Service and other costs, including $1,400 of amortization of  intangibles                                            |       | 4,585                            |       | —                |       | —                 |       |
| Total cost of revenues                                                                                               |       | 34,020                           |       | —                |       | —                 |       |
| Gross profit                                                                                                         |       | 10,033                           |       | —                |       | —                 |       |
| Operating expenses:                                                                                                  |       |                             |       |                  |       |                   |       |
| Salaries and related expenses, including stock-based compensation                                                    |       | 3,891                            |       | 131                   |       | —                 |       |
| Consulting fees and outside services                                                                                 |       | 1,686                            |       | 494                   |       | —                 |       |
| Depreciation                                                                                                         |       | 737                              |       | 2                     |       | —                 |       |
| Other general and administrative expenses                                                                            |       | 2,943                            |       | 397                   |       | 8                      |       |
| Amortization of intangible assets                                                                                    |       | 555                              |       | —                |       | —                 |       |
| Total operating expenses                                                                                             |       | 9,812                            |       | 1,024                 |       | 8                      |       |
| Operating income (loss)                                                                                              |       | 221                              |       | (1,024                | )          | (8                     | )          |
| Other income (expense):                                                                                              |       |                             |       |                  |       |                   |       |
| Interest income                                                                                                      |       | 1,005                            |       | 1,352                 |       | —                 |       |
| Interest expense                                                                                                     |       | (838                             | )          | (64                   | )          | —                 |       |
| Total other income (expense)                                                                                         |       | 167                              |       | 1,288                 |       | —                 |       |
| Income (loss) before  provision for income taxes                                                                     |       | 388                              |       | 264                   |       | (8                     | )          |
| Provision for income taxes                                                                                           |       | 169                              |       | 91                    |       | —                 |       |
| Net income (loss)                                                                                                    |       | 219                              |       | 173                   |       | (8                     | )          |
| Deferred interest, net of taxes, attributable to common stock subject  to possible redemption                        |       | —                           |       | (176                  | )          | —                 |       |
| Net income (loss) allocable to holders of non-redeemable common stock                                                |       | $                                | 219        |                  | $          | (3                     | )          | $ | (8 | ) |
|                                                                                                                 |       |                             |       |                  |       |                   |       |
| Weighted-average number of  shares of common stock outstanding:                                                      |       |                             |       |                  |       |                   |       |
| Basic                                                                                                                |       | 5,187,086                        |       | 4,477,861             |       | 937,500                |       |
| Diluted                                                                                                              |       | 6,213,189                        |       | 4,477,861             |       | 937,500                |       |
| Net income (loss) per  share:                                                                                        |       |                             |       |                  |       |                   |       |
| Basic                                                                                                                |       | $                                | 0.04       |                  | $          | 0.04                   |       | $ | (0.01 | ) |
| Diluted                                                                                                              |       | $                                | 0.04       |                  | $          | 0.04                   |       | $ | (0.01 | ) |
| Weighted-average number of shares of common stock outstanding  exclusive of shares subject to possible redemption:   |       |                             |       |                  |       |                   |       |
| Basic                                                                                                                |       | 5,187,086                        |       | 3,773,985             |       | 937,500                |       |
| Diluted                                                                                                              |       | 6,213,189                        |       | 3,773,985             |       | 937,500                |       |
| Net income (loss) per share exclusive of common stock and related  deferred interest subject to possible redemption: |       |                             |       |                  |       |                   |       |
| Basic                                                                                                                |       | $                                | 0.04       |                  | $          | (0.00                  | )          | $ | (0.01 | ) |
| Diluted                                                                                                              |       | $                                | 0.04       |                  | $          | (0.00                  | )          | $ | (0.01 | ) |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

 

F-7

----

 

**ARGYLESECURITY, INC.CONSOLIDATED STATEMENTS OF OPERATIONS**

(inthousands, except per share data)

** **

** **
| ** **                                                        | ** ** | **Predecessor (ISI)**    | ** ** |
|-------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                        | ** ** | **January 1, 2007** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                        | ** ** | **through**              | ** ** | **Year Ended December 31,** | ** ** |
| ** **                                                        | ** ** | **July 31, 2007**   | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                         |       |                     |       |   |   |   |   |
| Contract revenues                                                 |       | $                        | 19,948     |   | $ | 30,968 |   | $ | 20,905 |   |
| Contract revenues — related party                            |       | 16,740                   |       | 19,855 |   | 14,476 |   |
| Service and other revenues                                        |       | 6,446                    |       | 6,929 |   | 3,853 |   |
| Total revenues                                                    |       | 43,134                   |       | 57,752 |   | 39,234 |   |
| Cost of revenues:                                                 |       |                     |       |   |   |   |   |
| Contract costs                                                    |       | 28,626                   |       | 41,130 |   | 28,213 |   |
| Service and other costs, including $0 amortization of intangibles |       | 4,890                    |       | 4,839 |   | 2,652 |   |
| Total cost of revenues                                            |       | 33,516                   |       | 45,969 |   | 30,865 |   |
| Gross profit                                                      |       | 9,618                    |       | 11,783 |   | 8,369 |   |
| Operating expenses:                                               |       |                     |       |   |   |   |   |
| Salaries and related expenses, including stock-based compensation |       | 4,641                    |       | 4,554 |   | 3,304 |   |
| Consulting fees and outside services                              |       | 194                      |       | 405 |   | 418 |   |
| Depreciation                                                      |       | 475                      |       | 641 |   | 652 |   |
| Other general and administrative expenses                         |       | 2,283                    |       | 2,910 |   | 2,185 |   |
| Amortization of intangible assets                                 |       | 203                      |       | 349 |   | 349 |   |
| Total operating expenses                                          |       | 7,796                    |       | 8,860 |   | 6,908 |   |
| Operating income (loss)                                           |       | 1,822                    |       | 2,923 |   | 1,461 |   |
| Other income (expense):                                           |       |                     |       |   |   |   |   |
| Interest income                                                   |       | 4                        |       | 211 |   | 8 |   |
| Interest expense                                                  |       | (3,010                   | )          | (3,830 | ) | (3,178 | ) |
| Total other income (expense)                                      |       | (3,006                   | )          | (3,619 | ) | (3,170 | ) |
| Income (loss) before  provision for income taxes                  |       | (1,184                   | )          | (696 | ) | (1,709 | ) |
| Benefit for income taxes                                          |       | (1,053                   | )          | (8 | ) | (525 | ) |
| Net income (loss)                                                 |       | $                        | (131       | ) | $ | (688 | ) | $ | (1,184 | ) |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

 

F-8

----

 

**ARGYLESECURITY, INC.STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

(inthousands, except share data)

 
| ** **                                      | ** ** | ** **       | ** ** | ** **  | ** ** | **Additional**  | ** ** | ** **             | ** ** | **Total**  | ** ** |
|-------------------------------------------------|------------|------------------|------------|-------------|------------|-----------------|------------|------------------------|------------|------------|------------|
| ** **                                      | ** ** | **Common Stock** | ** ** | **Paid in** | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** ** |
| ** **                                      | ** ** | **Shares**       | ** ** | **Amount**  | ** ** | **Capital**     | ** ** | **Earnings**           | ** ** | **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** | ** ** |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-9

----

 

**ARGYLESECURITY, INC.CONSOLIDATED STATEMENT OF CASH FLOWS**

(inthousands)

 
| ** **                                                                                         | ** ** | ** **                       | ** **  | ** **            | ** ** | **June 22, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|----------------------------------|-------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                         | ** ** | ** **                       | ** **  | ** **            | ** ** | **(inception)**        | ** ** |
| ** **                                                                                         | ** ** | ** **                       | ** **  | ** **            | ** ** | **through**            | ** ** |
| ** **                                                                                         | ** ** | **Year Ended December 31,** | ** **  | **December 31,** | ** ** |
| ** **                                                                                         | ** ** | **2007**                         | ** **  | **2006**              | ** ** | **2005**               | ** ** |
| **Cash flows from operating  activities:**                                                         |       |                             |        |                  |       |                   |       |
| Net income (loss)                                                                                  |       | $                                | 219         |                  | $          | 173                    |       | $ | (8 | ) |
| Adjustments to reconcile net income (loss) to net cash provided by  (used in) operating activities |       |                             |        |                  |       |                   |       |
| Stock-based compensation                                                                           |       | 236                              |        | 131                   |       | —                 |       |
| Amortization                                                                                       |       | 2,048                            |        | —                |       | —                 |       |
| Depreciation                                                                                       |       | 734                              |        | 2                     |       | —                 |       |
| 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                   |       | —                 |       |
| Tax payments relapsed from  the trust                                                              |       | 149                              |        | —                |       | —                 |       |
| Decrease (increase) in  contract receivables                                                       |       | (3,535                           | )           | —                |       | —                 |       |
| Decrease (increase) in  related party contract receivables                                         |       | (1,451                           | )           | —                |       | —                 |       |
| Decrease (increase) in  related party receivables                                                  |       | (3                               | )           | —                |       | —                 |       |
| Decrease (increase) in  costs and estimated earnings in excess of billings                         |       | (2,739                           | )           | —                |       | —                 |       |
| Decrease (increase) in  other assets                                                               |       | 500                              |        | (10                   | )          | —                 |       |
| Increase (decrease) in  accounts payable and accrued expenses                                      |       | 5,190                            |        | 178                   |       | 5                      |       |
| Increase (decrease) in  deferred income taxes                                                      |       | (322                             | )           | 91                    |       | —                 |       |
| Increase (decrease) in  billings in excess of costs and estimated earnings                         |       | (2,681                           | )           | —                |       | —                 |       |
| **Net cash used in operating activities**                                                          | ** ** | **$**                            | **(4,440**  | **)**                 | **$**      | **(103**               | **)**      | **$** | **(3** | **)** |
|                                                                                               |       |                             |        |                  |       |                   |       |
| **Cash flows from investing  activities:**                                                         |       |                             |        |                  |       |                   |       |
| Purchase of investments  held in trust                                                             |       | (171,372                         | )           | (318,720              | )          | —                 |       |
| Maturity of investments  held in trust                                                             |       | 171,372                          |        | 289,999               |       | —                 |       |
| Acquisition of ISI, net of  cash acquired                                                          |       | (17,260                          | )           | —                |       | —                 |       |
| Purchase of property and  equipment                                                                |       | (841                             | )           | (7                    | )          | —                 |       |
| Transaction costs                                                                                  |       | (1,967                           | )           | (58                   | )          | —                 |       |
| Increase / (decrease) in  other assets                                                             |       | (16                              | )           | —                |       | —                 |       |
| **Net cash used in investing activities**                                                          | ** ** | **$**                            | **(20,084** | **)**                 | **$**      | **(28,786**            | **)**      | **$** | **—** | ** ** |
|                                                                                               |       |                             |        |                  |       |                   |       |
| **Cash flows from financing  activities:**                                                         |       |                             |        |                  |       |                   |       |
| Gross proceeds from public  offering and private placement                                         |       | —                           |        | 30,600                |       | —                 |       |
| Offering costs                                                                                     |       | (7                               | )           | (873                  | )          | (167                   | )          |
| Proceeds from issuance and  exercise of options                                                    |       | —                           |        | 1                     |       | —                 |       |
| Receipt of funds held in  trust                                                                    |       | 30,200                           |        | —                |       | —                 |       |
| Investment banker fees  paid                                                                       |       | (1,370                           | )           | —                |       | —                 |       |
| Repayment on borrowings                                                                            |       | (12,942                          | )           | —                |       | —                 |       |
| Proceeds from borrowings                                                                           |       | 13,220                           |        | —                |       | —                 |       |
| Proceeds from notes  payable and warrants to stockholders                                          |       | 300                              |        | —                |       | 155                    |       |
| Repayment of notes payable  and warrants to stockholders                                           |       | (300                             | )           | (155                  | )          | —                 |       |
| Redemption of common stock                                                                         |       | (1,661                           | )           | —                |       | —                 |       |
| Issuance of common stock                                                                           |       | —                           |        | —                |       | 25                     |       |
| Payments on capital lease  obligations                                                             |       | (54                              | )           | —                |       | —                 |       |
| **Net cash provided by financing activities**                                                      | ** ** | **$**                            | **27,386**  | ** **            | **$**      | **29,573**             | ** ** | **$** | **13** | ** ** |
|                                                                                               |       |                             |        |                  |       |                   |       |
| **Net increase (decrease) in cash  and cash equivalents**                                          | ** ** | **$**                            | **2,862**   | ** **            | **$**      | **684**                | ** ** | **$** | **10** | ** ** |
| Cash and cash equivalents  at beginning of year                                                    | ** ** | **694**                          | ** **  | **10**                | ** ** | **—**             | ** ** |
| **Cash and cash equivalents at  end of year**                                                      | ** ** | **$**                            | **3,556**   | ** **            | **$**      | **694**                | ** ** | **$** | **10** | ** ** |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-10

----

 

**ARGYLESECURITY, INC.CONSOLIDATED STATEMENT OF CASH FLOWS**

(inthousands)

** **
| ** **                                                                                | ** ** | **Predecessor (ISI)**    | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                | ** ** | **January 1, 2007** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                                | ** ** | **through**              | ** ** | **Year Ended December 31,** | ** ** |
| ** **                                                                                | ** ** | **July 31, 2007**   | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Cash flows from operating  activities:**                                                |       |                     |       |   |   |   |   |
| Net income (loss)                                                                         |       | $                        | (131       | ) | $ | (688 | ) | $ | (1,184 | ) |
| Adjustments to reconcile net loss to net cash provided by (used in)  operating activities |       |                     |       |   |   |   |   |
| Interest accretion and  fair value adjustment on stock warrants                           |       | 1,400                    |       | 1,297 |   | 920 |   |
| Depreciation                                                                              |       | 475                      |       | 991 |   | 1,004 |   |
| Stock appreciation rights                                                                 |       | 1,364                    |       | — |   | — |   |
| Loss on disposal of assets                                                                |       | —                   |       | (5 | ) | — |   |
| Deferred income tax  expense (benefit)                                                    |       | (1,190                   | )          | (7 | ) | (78 | ) |
| Decrease (increase) in  contract receivables                                              |       | (636                     | )          | (4,181 | ) | (3,651 | ) |
| Decrease (increase) in  related party contract receivables                                |       | (3,174                   | )          | (3,935 | ) | 1,166 |   |
| Decrease (increase) in  other receivables                                                 |       | (131                     | )          | 215 |   | (192 | ) |
| Decrease (increase) in  costs and estimated earnings in excess of billings                |       | (1,055                   | )          | (1,078 | ) | (681 | ) |
| Decrease (increase) in  other assets                                                      |       | (368                     | )          | (156 | ) | 67 |   |
| Increase (decrease) in  accounts payable and accrued expenses                             |       | 1,363                    |       | 5,523 |   | 1,939 |   |
| Increase (decrease) in  related party accounts payable                                    |       | —                   |       | 6 |   | 302 |   |
| Increase (decrease) in  billings in excess of costs and estimated earnings                |       | 2,410                    |       | 2,471 |   | (296 | ) |
| **Net cash provided by (used in) operating  activities**                                  | ** ** | **$**                    | **327**    | ** ** | **$** | **453** | ** ** | **$** | **(684** | **)** |
|                                                                                      |       |                     |       |   |   |   |   |
| **Cash flows from investing  activities:**                                                |       |                     |       |   |   |   |   |
| Purchase of property and  equipment                                                       |       | (1,004                   | )          | (764 | ) | (298 | ) |
| Proceeds from sale of  property and equipment                                             |       | —                   |       | 7 |   | — |   |
| **Net cash used in investing activities**                                                 | ** ** | **$**                    | **(1,004** | **)** | **$** | **(757** | **)** | **$** | **(298** | **)** |
|                                                                                      |       |                     |       |   |   |   |   |
| **Cash flows from financing  activities:**                                                |       |                     |       |   |   |   |   |
| Loan origination fees and  other assets                                                   |       | 240                      |       | (98 | ) | (469 | ) |
| Line of credit, net                                                                       |       | 2,686                    |       | 507 |   | 22 |   |
| Proceeds from Long-term  borrowings                                                       |       | —                   |       | — |   | 715 |   |
| Net transaction costs                                                                     |       | (624                     | )          | — |   | — |   |
| Payments on long-term  borrowings and capital lease obligations                           |       | (542                     | )          | (162 | ) | (178 | ) |
| **Net cash provided by financing activities**                                             | ** ** | **$**                    | **1,760**  | ** ** | **$** | **247** | ** ** | **$** | **90** | ** ** |
|                                                                                      |       |                     |       |   |   |   |   |
| **Net increase (decrease) in cash  and cash equivalents**                                 | ** ** | **$**                    | **1,083**  | ** ** | **$** | **(57** | **)** | **$** | **(892** | **)** |
| Cash and cash equivalents  at beginning of year                                           | ** ** | **359**                  | ** ** | **416** | ** ** | **1,308** | ** ** |
| **Cash and cash equivalents at  end of year**                                             | ** ** | **$**                    | **1,442**  | ** ** | **$** | **359** | ** ** | **$** | **416** | ** ** |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

F-11

----

 

 

 

 

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2007**

 

**Note1 — Basis of Presentation**

 

Argyle Security, Inc.(formerly Argyle Security Acquisition Corporation) (the Company, we, us, our,or Argyle) was incorporated in Delaware in June 2005 as a blank checkcompany formed to acquire, through merger, capital stock exchange, assetacquisition, or other similar business combination, a business in the securityindustry. On July 31, 2007, Argyle consummated its initial acquisition throughthe acquisition of 100% of the outstanding capital stock of ISI DetentionContracting Group, Inc. and its subsidiaries (ISI). Prior to theacquisition of ISI, Argyle had no operations and was considered a developmentalstage enterprise. ISI is deemed to be a “predecessor” to the Company. As aresult, the statements of operations and statements of cash flows of ISI forthe period January 1, 2007 through July 31, 2007 and for the yearsended December 31, 2006 and 2005 are presented for comparative purposes.The results of operations and cash flows on a consolidated basis subsequent tothe acquisition of ISI are not comparative to the predecessor ISI results ofoperations and cash flows because the basis for the acquired assets andliabilities of ISI have been adjusted to fair value pursuant to Statement ofFinancial Accounting Standards (SFAS) No. 141, *Business Combinations*.

 

ISI is a detentionequipment contractor that specializes in turnkey installations, includingdesign, engineering, supply, and installation of various detention equipmentfor correctional facilities and institutions. The work is performed underfixed-price contracts. The projects are located in various cities in the UnitedStates. The length of the contracts varies but is typically less than twoyears. ISI also provides turnkey installations covering the full spectrum ofelectronic security and low voltage systems, including fire alarm, accesscontrol, closed circuit television, intercom, sound/paging, and other customdesigned systems.

 

The accompanyingfinancial statements of Argyle Security, Inc. include the accounts of theCompany and all wholly-owned subsidiaries. All significant intercompanytransactions and balances have been eliminated in consolidation.

 

The Company’s operations areclassified into three reportable segments, described in further detail in Note20.

 

In the 2006 annual reporton Form 10-K, Argyle disclosed that declining cash available outside thetrust account and the lack of assurance that the Company would be able tosuccessfully complete a business combination within the required time frameraised substantial doubt about Argyle’s ability to continue as a going concern.With the completion of the ISI acquisition and release of funds held in trust,there is no longer substantial doubt about Argyle’s ability to continue as agoing concern.

 

***Pro Forma Results of Operations***

 

The accompanyingconsolidated statements of operations only reflect the operating results of ISIfollowing the date of acquisition and do not reflect the operating results ofISI prior to the acquisition. Following are pro forma unaudited results ofoperations for the Company for the years ended December 31, 2007 and 2006assuming the acquisition of ISI occurred on January 1, 2007 and 2006,respectively:

 

F-12

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATE FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

**Pro FormaConsolidated Statements of Operations (Unaudited)**

 
| ** **                                                                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Revenues:                                                                                  |       |                             |       |   |   |
| Contract revenues                                                                          |       | $                                | 44,288     |   | $ | 30,968 |   |
| Contract revenues - related party                                                          |       | 31,788                           |       | 19,855 |   |
| Service and other revenues                                                                 |       | 11,110                           |       | 6,929 |   |
| Total revenues                                                                             |       | 87,186                           |       | 57,752 |   |
| Cost of revenues:                                                                          |       |                             |       |   |   |
| Contract costs                                                                             |       | 58,061                           |       | 41,130 |   |
| Service and other costs, including amortization of intangibles  ($3,361 for 2007 and 2006) |       | 11,435                           |       | 8,200 |   |
| Total cost of revenues                                                                     |       | 69,496                           |       | 49,330 |   |
| Gross profit                                                                               |       | 17,690                           |       | 8,422 |   |
| Operating expenses:                                                                        |       |                             |       |   |   |
| Salaries & related, including stock-based compensation                            |       | 8,882                            |       | 5,573 |   |
| Consulting fees and outside services                                                       |       | 1,880                            |       | 899 |   |
| Depreciation                                                                               |       | 1,294                            |       | 782 |   |
| Other general and administrative expenses                                                  |       | 4,192                            |       | 3,875 |   |
| Amortization of intangible assets                                                          |       | 1,332                            |       | 1,332 |   |
| Total operating expenses                                                                   |       | 17,580                           |       | 12,461 |   |
| Operating income (loss)                                                                    |       | 110                              |       | (4,039 | ) |
| Other income (expense):                                                                    |       |                             |       |   |   |
| Interest income                                                                            |       | 246                              |       | 459 |   |
| Interest expense                                                                           |       | (1,703                           | )          | (1,501 | ) |
| Total other income (expense)                                                               |       | (1,457                           | )          | (1,042 | ) |
| Income (loss) before  provision for income taxes                                           |       | (1,347                           | )          | (5,081 | ) |
| Benefit for income taxes                                                                   |       | (1,093                           | )          | (1,497 | ) |
| Net income (loss)                                                                          |       | $                                | (254       | ) | $ | (3,584 | ) |
|                                                                                       |       |                             |       |   |   |
| Weighted-average number of  shares outstanding:                                            |       |                             |       |   |   |
| Basic                                                                                      |       | 5,749,342                        |       | 5,495,005 |   |
| Diluted                                                                                    |       | 5,749,342                        |       | 5,495,005 |   |
| Net income / (loss) per  share:                                                            |       |                             |       |   |   |
| Basic                                                                                      |       | $                                | (0.04      | ) | $ | (0.65 | ) |
| Diluted                                                                                    |       | $                                | (0.04      | ) | $ | (0.65 | ) |

 

F-13

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

The Company derived thepro forma results of operations from (i) the audited consolidatedfinancial statements of ISI from January 1, 2007 to July 31, 2007(the date of the ISI acquisition) and (ii) the audited consolidatedfinancial statements of the Company for the year ended December 31, 2007and 2006. The pro forma results of operations are not necessarily indicative ofresults of operations that may have actually occurred had the merger takenplace on the dates noted, or the future financial position or operating resultsof the Company or ISI. The pro forma adjustments are based upon availableinformation and assumptions that the Company believes are reasonable. The proforma adjustments include adjustments for interest expense (relating primarilyto interest on the $10.0 million of principal of the unsecured debt of arelated party) and increased depreciation and amortization expense as a resultof the application of the purchase method of accounting based on the fairvalues of the tangible and intangible assets of ISI. Additionally, the proforma results of operations do not include approximately $1.4 million innon-recurring charges relating to the stock appreciation rights incurred inconnection with the acquisition.

 

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

 

Argyle completed aprivate placement (the Private Placement) in January 2006 and received netproceeds of approximately $0.9 million. Also in January 2006, theregistration statement for Argyle’s initial public offering (Public Offering)was declared effective, and the net proceeds from the sale of Argyle’s units,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 at July 31, 2007 tofund the ISI acquisition.

 

On March 14, 2007,the underwriters from Argyle’s Public Offering agreed to forfeit any and allrights or 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 16). 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 may not be released prior to January 24, 2009.

 

As part of the ISImerger, public stockholders holding 211,965 of the aggregate number of sharessold in the Public Offering elected to redeem such shares (see Note 14). Theper share redemption price was equal to $7.80 per share including interestearned thereon in the trust account, net of 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.

 

F-14

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

***Contracts Receivable***

 

Contracts receivable 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 uncollectibility of 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 it requiresestimates that are susceptible to significant revision as more informationbecomes available.

 

***Revenue Recognition***

 

The Company receives itsrevenues primarily from performance of fixed-price construction contracts andfrom service sales.

 

***Construction Contracts***

 

Construction contractsare those as defined in the American Institute of Certified Public Accountants’Statement of Position 81-1 (SOP 81-1), *Accountingfor Performance of Construction-Type and Certain Production-Type Contracts*.

 

Most of the Company’scontracts extend over a period of 12 to 16 months, which is the period theCompany considers to be its operating cycle. Such contracts generally providethat the customers accept completion of progress to date and compensate theCompany for services rendered measured in terms of units installed, hoursexpended, or some other measure of progress. Revenues from constructioncontracts are recognized on the percentage-of-completion method in accordancewith SOP 81-1. The Company recognizes revenue on signed contracts and changeorders. The Company generally recognizes revenue on unsigned change orderswhere it has written notices to proceed from the customer and where collectionis deemed probable. Percentage-of-completion for construction contracts is measuredprincipally by the percentage of costs incurred and accrued to date for eachcontract to the estimated total costs for each contract at completion. TheCompany generally considers contracts to be substantially complete upondeparture from the work site and acceptance by the customer. Contract costsinclude all direct material, labor, subcontract, equipment costs, relatedpayroll taxes and insurance costs, and any other indirect costs related tocontract performance. Changes in job performance, job conditions, estimatedcontract costs, profitability, and final contract settlements may result inrevisions to costs and income and the effects of these revisions are recognizedin the period in which the revisions are determined. Provisions for total estimatedlosses on incomplete contracts are made in the period in which such losses aredetermined.

 

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.

 

F-15

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

** **

***Service Sales***

 

Service sale revenue arerecognized when the services have been delivered to and accepted by thecustomer.  These are generally short-termprojects which are evidenced by signed service agreements or customer work ordersor purchase orders.  These salesagreements/customer orders generally provide for billing to customers based ontime at quoted hourly or project rates plus costs of materials and suppliesfurnished by the Company.

 

***Inventory***

 

Inventory is valued atthe lower of cost or market and consists primarily of finished goods. Costs offinished goods are determined using the average cost method. Inventory that wasacquired from ISI has been stated at fair value at July 31, 2007; allsubsequent purchases are recorded based on cost. At December 31, 2007, theCompany’s inventory balance was $138,000, which is included in other currentassets on the consolidated balance sheet.

 

***Property and Equipment***

 

Property and equipment isstated at cost less accumulated depreciation, except for the plant andequipment acquired in the ISI acquisition which has been recorded at fair valueat July 31, 2007 (see Note 3); all subsequent purchases are recorded basedon cost. Depreciation is calculated on the straight-linemethod.

 

The Company reviews thecarrying value of property and equipment for impairment whenever events andcircumstances indicate the carrying value of the asset may not be recoverablefrom the estimated future cash flows expected to result from its use andeventual disposition. In cases where undiscounted expected future cash flowsare less than the carrying value, an impairment loss is recognized equal to anamount 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 recorded at the lower of the net present value of the minimum leasepayments 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 consideration paid over the fair value of net assets acquired in thebusiness combination in accordance with SFAS No. 142, *Goodwilland Other Intangible Assets*. Goodwill and other indefinite-lived intangibles(trade name) are not amortized but are tested at least annually for impairment.The Company must recognize an impairment loss if, and to the extent that,goodwill exceeds fair value. The Company has determined that no impairmentexists at December 31, 2007.

 

The Company has threeprimary reporting units that provide different services and products.Accordingly, goodwill was allocated to each. Management believes that therelationship between allocation of identified tangible and intangible assets tobe in similar proportion to how goodwill is to be allocated among its reportingunits. Accordingly, each reporting division was allocated its share of goodwillbased upon its percentage of purchase price allocation related to identifiedtangible and intangible assets.

 

F-16

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

As a result, goodwill wasallocated in the approximate percentages as follows: ISI Detention 18%; MCSDetention 49%; and MCS Commercial 33%. These amounts are included in each reporting division’s segmentreporting.

 

Intangible assets thathave finite useful lives are amortized over their useful lives which range from96 to 120 months for customer relationships and 12 to 16 months for backlog.

 

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

** **
| ** **                      | ** ** | **ISI**       | ** ** | **MCS**       | ** ** | **MCS**        | ** ** | ** ** | ** ** |
|---------------------------------|------------|---------------|------------|---------------|------------|----------------|------------|------------|------------|
| ** **                      | ** ** | **Detention** | ** ** | **Detention** | ** ** | **Commercial** | ** ** | **Total**  | ** ** |
| Balance December 31,  2006 |       | $             | —     |          | $          | —         |       | $          | —     |   | $ | — |   |
| Acquisitions                    |       | 3,599         |       | 9,676         |       | 6,662          |       | 19,937     |       |
| Balance December 31,  2007 |       | $             | 3,599      |          | $          | 9,676          |       | $          | 6,662      |   | $ | 19,937 |   |

 

A summary of the activity in goodwill by segmentfor predecessor (ISI) for the year ending December 31, 2006 is as follows(in thousands):

 
| ** **                      | ** ** | **ISI**       | ** ** | **MCS**       | ** ** | **MCS**        | ** ** | ** ** | ** ** |
|---------------------------------|------------|---------------|------------|---------------|------------|----------------|------------|------------|------------|
| ** **                      | ** ** | **Detention** | ** ** | **Detention** | ** ** | **Commercial** | ** ** | **Total**  | ** ** |
| Balance December 31,  2005 |       | $             | —     |          | $          | 876            |       | $          | 379        |   | $ | 1,255 |   |
| Acquisitions                    |       | —        |       | —        |       | 110            |       | 110        |       |
| Balance December 31,  2006 |       | $             | —     |          | $          | 876            |       | $          | 489        |   | $ | 1,365 |   |

 

***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 is self-insured to certain limits under itsgroup health and dental plans.  On an annual basis, the Company estimatesits health insurance cost, for its self insured employee base at ISI, basedupon expected health insurance claims for the current year. The insurancecompany which provides both the stop loss and total aggregate insurancecoverages also provides the average or expected and maximum claims for eachclass. The average and maximum claims are based on the Company’s demographicsand prior claim history. The Company uses the average claims history for thetrailing twelve months as its basis for accruing health care cost.

 

F-17

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

** **

***Fair Value of Financial Instruments***

 

The recorded values offinancial instruments, including contracts receivable, other assets, andaccounts payable, approximate fair value due to their short maturity. Thecarrying value of the revolving line of credit approximates fair value due toits variable interest rate. The recorded value of the long-term debtapproximates fair value based on borrowing rates currently available to theCompany for financing arrangements with similar terms and average maturities.

 

***Income Taxes***

 

The Company accounts forincome taxes under the liability method in accordance with SFAS No. 109, *Accounting for Income Taxes*. Deferredincome taxes are recorded based on enacted statutory rates to reflect the taxconsequences in future years of the differences between the tax bases of assetsand liabilities and their financial reporting amounts. Deferred tax assetswhich will generate future tax benefits are recognized to the extent thatrealization of such benefits through future taxable earnings or alternative taxstrategies in the foreseeable short-term future is more likely than not. Avaluation allowance is established when necessary to reduce deferred tax assetsto the amount expected to be realized.

 

The Company adopted FASBInterpretation No. 48, *Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(FIN 48) on January 1, 2007. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in financial statements and requires theimpact of a tax position to be recognized in the financial statements if thatposition is more likely than not of being sustained by the taxing authority. Theadoption of FIN 48 did not have an effect on our consolidated financialposition or results of operations.  TheCompany has applied the accounting provisions of FIN 48 to its tax positionsand determined that no uncertain tax positions presently exist.

 

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

 

***Reclassifications***

 

Certain prior periodpredecessor balances have been reclassified to conform to the current periodpresentation.   The balance sheetincludes a reclassification of unapplied cash that was in accounts payable andaccrued liabilities to contract receivables for $1.0 million at December 31,2006.  The balance sheet includes areclassification of $0.3 million from accrued liabilities to prepaid assets.

 

***Recently Issued Accounting Pronouncements***

 

 In September 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 157, *Fair Value Measurements*. SFAS No. 157establishes a framework for measuring fair value and expands disclosures aboutfair value measurements. The changes to current practice resulting from theapplication of this standard relate to the definition of fair value, themethods used to measure fair value, and the expanded disclosures about fairvalue measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007 and interim periods within those fiscal years. TheCompany does not believe the adoption of the provisions of SFAS No. 157will materially impact its consolidated financial position or results ofoperations.

 

F-18

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

In February 2007,the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assetsand Liabilities*. SFAS No. 159 permits all entities to choose toelect to measure eligible financial instruments at fair value. SFAS No. 159applies to fiscal years beginning after November 15, 2007, with earlyadoption permitted for an entity that has also elected to apply the provisionsof SFAS No. 157. The Company elected not to adopt the fair value optionfor valuation of those assets and liabilities which are eligible, therefore,there is no impact on our financial position or results of operations.

 

In December 2007,the FASB issued SFAS No. 141(R), *BusinessCombinations—a replacement of FASB Statement No. 141*, whichsignificantly changes the principles and requirements for how the acquirer of abusiness recognizes and measures in its financial statements the identifiableassets acquired, the liabilities assumed, and any non-controlling interest inthe acquiree. The statement also provides guidance for recognizing andmeasuring the goodwill acquired in the business combination and determines whatinformation to disclose to enable users of the financial statements to evaluatethe nature and financial effects of the business combination. This statement iseffective prospectively, except for certain retrospective adjustments todeferred tax balances, for fiscal years beginning after December 15, 2008.We are currently evaluating the impact that SFAS No. 141(R) will haveon our accounting for acquisitions prior to the effective date of the firstfiscal year beginning after December 31, 2008.

 

In December 2007,the FASB issued SFAS No. 160, *Non-controlling Interestsin Consolidated Financial Statements — an amendment of ARB No. 51*.SFAS 160 requires non-controlling interests held by parties other than theparent in subsidiaries be clearly identified, labeled, and presented in theconsolidated statement of financial position within equity, but separate fromthe parent’s equity. SFAS No. 160 is effective for fiscal years beginningafter December 15, 2008. We are currently evaluating the impact SFAS No. 160will have on our financial position and results of operations.

 

***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.

 

***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.

 

F-19

----

 

**ARGYLE SECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

Loss contingenciesconsidered remote are generally not disclosed unless they involve guarantees,in which case the guarantees would be disclosed.

 

***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. No unaffiliated customer accounts for morethan 10% of revenues. See Related-Party Transactions footnote (see Note 19) fordiscussion of transactions with ISI*MCS, Ltd.

 

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

 

Netincome (loss) per share (basic) is calculated by dividing net income (loss) by theweighted average number of common shares outstanding during the period. Netincome (loss) per share (diluted) is calculated by adjusting the number ofshares of common stock outstanding using the treasury stock method. Under the treasury stock method, anincrease in the fair market value of the Company’s common stock results in agreater dilutive effect from outstanding warrants, options, restricted stockawards and convertible securities (common stock equivalents).

 

Thefollowing table reconciles the components of the basic and dilutednet income (loss) per share:

 
| *** ***                                          | ** ** | ** **                       | ** ** | ** **            | ** ** | **June 22, 2005** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                            | ** ** | ** **                       | ** ** | ** **            | ** ** | **(inception)**        | ** ** |
| ** **                                            | ** ** | ** **                       | ** ** | ** **            | ** ** | **through**            | ** ** |
| ** **                                            | ** ** | **Year Ended December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                            | ** ** | **2007**                         | ** ** | **2006**              | ** ** | **2005**               | ** ** |
| Weighted average common  shares outstanding - basic   |       | 5,187,086                        |       | 4,477,861             |       | 937,500                |       |
| Effect of convertible  securities                     |       | 1,026,103                        |       | —                |       | —                 |       |
| Weighted average common  shares outstanding - diluted |       | 6,213,189                        |       | 4,477,861             |       | 937,500                |       |

 

Stock options to acquire125,000 shares and promissory notes convertible into 192,500 shares of common stockwere excluded from the computation of diluted net income (loss) per share forthe year ended December 31, 2007 as the effect of including them wouldhave been anti-dilutive.

 

**Note3 — ISI Acquisition**

 

On July 31, 2007,following the stockholder approval and pursuant to the terms of the mergeragreement, Argyle acquired all of the assets and liabilities of ISI. Theacquisition was accounted for in accordance with the provisions of SFAS No. 141and 142. As a result of the merger, ISI became a wholly owned subsidiary ofArgyle. See Note 1 and Note 20 for a description of ISI operations.

 

F-20

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note3 — ISI Acquisition — (continued)**

 

At the closing of themerger, the following consideration was paid by the Company to the stockholdersand debt holders of ISI:

 

·       $18.6million in cash;

 

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

 

·       $1.9million of unsecured promissory notes convertible into shares of common stockof the Company at a conversion price of $10 per share.

 

The value of Argylecommon stock issued as merger consideration is based on the average closingprice of Argyle’s common stock for the two days prior to, including the day of,and two days subsequent to the second amendment to the merger agreement resultingin the final negotiated purchase price (June 29, 2007) of $7.78. Based onthe cash paid, common stock and convertible promissory note issued, andcapitalized merger transaction costs of $2.7 million, the transaction wasvalued for accounting purposes at $32.4 million.

 

The acquisition of ISI isaccounted for as a business combination in accordance with SFAS No. 141with Argyle as the acquirer. Under the purchase method of accounting, theassets acquired and liabilities assumed are recorded as of the acquisition dateat their respective fair values, and added to those of Argyle. The followingtable summarizes the estimated fair value of assets acquired and theliabilities assumed and related deferred income taxes at the date of theacquisition.

 

All amounts below aredepicted (in thousands):

 
| Current  assets                   |   | $       | 27,962     | ** ** |
|-----------------------------------|--------|---------|------------|------------|
| Property  and equipment           |   | 4,915   | ** ** |
| Goodwill                          |   | 19,937  | ** ** |
| Customer  relationships           |   | 11,625  | ** ** |
| Customer  backlog                 |   | 4,359   | ** ** |
| Trade  name                       |   | 3,776   | ** ** |
| Software                          |   | 300     | ** ** |
| Deposits  and other assets        |   | 229     | ** ** |
| Total  assets acquired            |   | 73,103  | ** ** |
| Current  liabilities              |   | (17,316 | **)**      |
| Deferred  income taxes            |   | (6,701  | **)**      |
| Debt                              |   | (13,681 | **)**      |
| Obligations  under capital leases |   | (2,055  | **)**      |
| Other  liabilities                |   | (991    | **)**      |
| Total  liabilities assumed        |   | (40,744 | **)**      |
| Net  assets acquired              |   | $       | 32,359     | ** ** |

 

F-21

----

 

 

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note3 — ISI Acquisition — (continued)**

 

The primary reasons forthe acquisition were the physical security solutions to commercial,governmental, and correctional customers provided by ISI. As a securitysolutions provider, ISI has the ability to interview a customer, assess needs,and determine solutions within the customer’s budget. The security systemsprovided to customers are fully integrated security systems. Using itsexpertise, ISI develops security systems specific to each customer’s needs.Most hardware and software is purchased from third parties or involves ISI’sown proprietary software. ISI does not manufacture any products. ISI makesthese disparate systems effectively communicate, react, and work together. Thiscommunication is made possible because of the proprietary development softwarethat ISI has created. ISI does not sell or license this software. ISI customersget “one-stop” shopping for customized solutions to their physical securityneeds. The customer can look to ISI as the sole source for the solution to allof its physical security needs, even if those needs require hardware andsoftware from many different manufacturers.

 

The purchased intangiblesand goodwill are not deductible for tax purposes. However, purchase accountingallows for the establishment of deferred tax liabilities on purchasedintangibles (other than goodwill), which will be reflected as a tax benefit onour future consolidated statements of income in proportion to and over theamortization period of related intangible assets.

 

We have not identifiedany material unrecorded pre-acquisition contingencies where the related asset,liability, or impairment is probable and the amount can be reasonablyestimated. Prior to the end of the one-year purchase price allocation period,if information becomes available that would indicate it is probable that suchevents had occurred and the amounts can be reasonably estimated, such itemswill be included in the final purchase price allocation and may adjustgoodwill.  During the fourth quarter of2007, the Company increased goodwill by $174,000,  as a result of $103,000 of additionaltransaction costs ($58,000 in investment banker fees and $45,000 in accountingand legal fees), a $69,000 increase in current liabilities and a $72,000increase in income taxes offset by a $70,000 decrease in current assets.

 

**Note4 — Contract Receivables**

 

Contract receivablesconsist of the following (in thousands):

** **

| ** **                                                       | ** ** | ** **            | ** ** | **Predecessor**       | ** ** |
|------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                       | ** ** | ** **            | ** ** | **(ISI)**             | ** ** |
| ** **                                                       | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                       | ** ** | **2007**              | ** ** | **2006**              | ** ** |
| Completed contracts and  contracts in progress                   |       | $                     | 12,126     |                  | $          | 11,475 |   |
| Retainage                                                        |       | 2,333                 |       | 1,956                 |       |
| Completed contracts and  contracts in progress - related parties |       | 8,468                 |       | 4,669                 |       |
| Retainage - related  parties                                     |       | 2,419                 |       | 1,593                 |       |
| Contract receivables                                             |       | $                     | 25,346     |                  | $          | 19,693 |   |

 

 

F-22

----

 

**ARGYLE SECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

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

** **

| ** **                                                                  | ** ** | ** **            | ** ** | **Predecessor**       | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                                                  | ** ** | ** **            | ** ** | **(ISI)**             | ** ** |
| ** **                                                                  | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                                                                  | ** ** | **2007**              | ** ** | **2006**              | ** ** |
| Amended contract amount                                                     |       | $                     | 196,030    |                  | $          | 137,847 |   |
| Revenue recognized to date                                                  |       | 109,179               |       | 71,592                |       |
| Unearned contract amount -  backlog                                         |       | $                     | 86,851     |                  | $          | 66,254 |   |
| Costs incurred to date                                                      |       | $                     | 89,863     |                  | $          | 60,946 |   |
| Estimated costs to  complete                                                |       | 70,496                |       | 55,359                |       |
| Estimated total cost                                                        |       | $                     | 160,359    |                  | $          | 116,305 |   |
| Billings to date                                                            |       | $                     | 109,658    |                  | $          | 72,946 |   |
| Costs and estimated  earnings in excess of billings on incomplete contracts |       | $                     | 7,665      |                  | $          | 3,871 |   |
| Billing in excess of costs  and estimated earnings on incomplete contracts  |       | $                     | 5,733      |                  | $          | 6,005 |   |

 

Backlog is the aggregatecontract amount less revenue recognized using percentage-of-completionaccounting as described in Note 2 of these consolidated financial statements.The Company recognizes as backlog only those contracts on which it has receivedsigned contracts or executed letters of intent to award a contract from itscustomers. The Company also verifies funding is in place on the contracts priorto inclusion in backlog.

 

The various subsidiarycompanies often function as subcontractors to other subsidiary companies. Theabove schedule is computed on a consolidated basis. Intercompany contractamounts and billings have been eliminated, and costs and estimated earnings inexcess of billings and billings in excess of costs and estimated earnings havebeen recomputed based on actual combined costs of the companies.

 

**Note6 — Property and Equipment**

** **

Property and equipmentconsists of the following (in thousands):

 

| ** **                         | ** ** | ** **       | ** ** | ** **            | ** ** | ** **            | ** ** | **Predecessor** | ** ** |
|------------------------------------|------------|------------------|------------|-----------------------|------------|-----------------------|------------|-----------------|------------|
| ** **                         | ** ** | **Estimated**    | ** ** | ** **            | ** ** | ** **            | ** ** | **(ISI)**       | ** ** |
| ** **                         | ** ** | **Useful Lives** | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **In Years**     | ** ** | **2007**              | ** ** | **2006**              | ** ** | **2006**        | ** ** |
| Buildings                          |       | 10  - 40         |       | 1,888                 |       | —                |       | 2,278           |       |
| Leasehold improvements             |       | 12               |       | 593                   |       | —                |       | 479             |       |
| Furniture, fixtures and  equipment |       | 3  - 10          |       | 1,254                 |       | 7                     |       | 2,492           |       |
| Vehicles                           |       | 3  - 7           |       | 2,188                 |       | —                |       | 2,047           |       |
|                               |       |             |       | 5,923                 |       | 7                     |       | 7,296           |       |
| Less - accumulated  depreciation   |       |             |       | 736                   |       | 2                     |       | 3,326           |       |
| Property and equipment,  net       |       |             |       | $                     | 5,187      |                  | $          | 5               |       | $ | 3,970 |   |
|                                    |            |                  |            |                       |            |                       |            |                 |            |  |  |  |

 

Depreciation expenserelating to property and equipment was $0.7 million and $2,000 for the yearsended December 31, 2007 and 2006, respectively.  Deprecation and amortization expense was $0.5million, $1.0 million and $1.0 million for the Predecessor period January 1,2007 through July 31, 2007 and for the years ended December 31, 2006and 2005, respectively.

 

 

F-23

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note 7****—****Intangible Assets and OtherAssets**

 

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

** **

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

 

Amortizationexpense was $2.0 million for the year ended December 31, 2007.  As of December 31, 2007,intangible assets not subject toamortization included trade names of $3.8 million. Estimated amortizationexpense for the next five years and thereafter is as follows (in thousands):

** **
| **Years ending December 31:** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2008                               |       | $          | 4,291      |   |
| 2009                               |       | 1,332      |       |
| 2010                               |       | 1,291      |       |
| 2011                               |       | 1,232      |       |
| 2012                               |       | 1,232      |       |
| Thereafter                         |       | 4,951      |       |
|                               |       | $          | 14,329     |   |

 

Predecessor(ISI) December 31, 2006 deposits, deferred transaction costs, and otherassets are shown net of accumulated amortization of $0.7 million.

 

**Note8 — Long-Term Debt**

 

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

** **
| ** **                                | ** ** | ** **            | ** ** | **Predecessor**       | ** ** |
|-------------------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                                | ** ** | ** **            | ** ** | **(ISI)**             | ** ** |
| ** **                                | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| **Collateral**                            | ** ** | **2007**              | ** ** | **2006**              | ** ** |
| Notes payable:                            |       |                  |       |                  |       |
| Vehicles and equipment                    |       | $                     | 190        |                  | $          | 470 |   |
| Unsecured debt - related party            |       | 5,952                 |       | 13,448                |       |
| Unsecured convertible debt - stockholders |       | 1,925                 |       | —                |       |
| Unsecured debt - stockholders             |       | —                |       | 98                    |       |
| Line of credit                            |       | 7,979                 |       | 4,959                 |       |
|                                      |       | $                     | 16,046     |                  | $          | 18,975 |   |
| Less - current maturities                 |       | 81                    |       | 406                   |       |
| Long term debt                            |       | $                     | 15,965     |                  | $          | 18,569 |   |

 

 

F-24

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

***Vehicles and Equipment***

 

Amountsinclude notes related to Company vehicles and various equipment lines. Vehicleand equipment notes are staggered in regards to their maturity, each amortizingover 36 — 48 month periods. Interest rates on the individual notes range from fixed rate of 7% up toPrime plus 1.0%. Included with the equipment is a note related to the phonesystem with a fixed rate of interest at 9.0% which matures in 2008.  The weighted average interest rate for theseborrowings was 8.2% and 9.6% at December 31, 2007 and December 31,2006 (predecessor).

 

***Unsecured Debt — Related Party***

 

All notes are unsecuredand subordinated to the line of credit facility. The unsecured note agreementcontains prepayment options with prepayment penalties. Interest accrues at11.58% per annum and is payable quarterly. The total debt of $6.0 million isdue and payable in one single payment on January 31, 2010. There are bothfinancial and restrictive covenants associated with the note agreement. As of December 31,2007, the Company was in compliance with all covenants.

 

Predecessor (ISI)received proceeds received from the lender during 2004 totaling $15.3 million,$11.3 million of which was allocated to debt and $4.0 million to common stockwarrants based on an assessment of fair values. The total debt of $15.3 million was due and payable in one singlepayment in October 2011.  The notepayable discount of $4.0 million was accreted as interest expense on theeffective interest rate method based on the 2011 maturity date.  Total accretion recognized by Predecessor(ISI) for each of the years ended December 31, 2006, 2005, and 2004 was$0.7 million, $0.7 million, and $110,136 respectively.

 

Additional funds totaling $0.7 million wereadvanced from the lender during 2005 for the purchase of a company in a similarline of business.

 

The lender warrants werefor 52.4532 shares of common stock, which equated to giving the warrant holder30% of the Company’s shares after exercise of the warrant.  Subsequent issuances of stockholderappreciation rights to key employees caused the percentage to be diluted to29.1%.  The warrants had an exerciseprice of $1.00 per share and was exercisable in whole or in part at any timethrough October 2014.  The warrantscontained put privileges, effective October 2011 or prior to that dateupon the occurrence of certain events, which could cause settlement in cashversus Company shares; therefore, the warrants was recorded as aliability.  Determination of the putprice was based on the greater of five times earnings before income tax,depreciation, and amortization plus cash positions of the Company or market valueof the Company.

 

The warrants wereexercised in 2007 in conjunction with Argyle’s acquisition of ISI.

 

***Unsecured Convertible Debt — Stockholders***

 

As part of the mergerconsideration, the Company issued unsecured convertible debt to thestockholders in the amount of $1.9 million which bears interest at 5% perannum, paid semiannually. The notes mature five years from the date of issuanceon July 31, 2012. The notes may be converted in whole or in part intoshares of the Company’s common stock at the election of the note holder at ashare price of $10.00 any time after January 1, 2008. The debt may beredeemed by the Company at $10.00 per share any time after January 1,2009.

 

 

F-25

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

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

 

***Unsecured Debt — Stockholders***

 

In April 2007,Argyle’s officers and directors, an affiliate of Argyle’s Chairman and Co-ChiefExecutive Officer, and certain of Argyle’s consultants, pursuant to a note andwarrant acquisition agreement, loaned Argyle an aggregate of $0.3 million andin exchange received promissory notes in the aggregate principal amount of $0.3million and warrants to purchase an aggregate of 37,500 shares of Argyle’scommon stock. The warrants are exercisable at $5.50 per share of common stockand expire on January 24, 2011.

 

The warrants also may beexercised on a net-share basis by the holders of the warrants. The Company hasestimated, based upon a Black-Scholes model, that the fair value of thewarrants on the date of issue was approximately $2.48 per warrant (a totalvalue of approximately $93,000) using an expected life of 2 years, volatilityof 2.39%, and a risk-free rate of 5%. However, because the Company’s warrantshave a limited trading history, the volatility assumption was based oninformation currently available to management. The promissory notes had aninterest at a rate of 4% per year and were repayable 30 days after theconsummation of a business combination. The notes and the associated accruedinterest were paid in full in August 2007.

 

In November 2005Sam Youngblood and Don Carr loaned $66,000 and $32,000, respectively to ISI(predecessor) to acquire a company in a similar line of business (IPI).  The notes were to mature in October 2011and bear interest rate of 12% per annum to be paid quarterly.   The loans were repaid in 2007 as part of thepurchase price consideration paid by Argyle for ISI.

 

***Line of Credit Facility***

 

At December 31,2007, the Company had a line of credit facility totaling $9.0 million. The lineof credit is secured by all tangible and intangible assets of ISI excludingvehicles. The line calls for all accounts receivable collections to bedeposited directly to a lockbox. Interest is payable quarterly and iscalculated at the lender’s base rate (greater of prime or federal funds rate)plus 0.5% or 350 basis points in excess of LIBOR for the applicable period. Theoutstanding balance on the line at December 31, 2007 was $8.0 million due December 31,2009 (extended to 2010 in January 2008 as described below) with aninterest rate of prime plus 0.5%. The weighted average interest rate for 2007was 7.2%.  The agreement contains bothfinancial and restrictive covenants, including a restriction on the payment ofdividends. At December 31, 2007, the Company was in compliance with suchcovenants. The Company has agreed to pay an annual commitment fee of 0.5% peryear on the unused borrowing capacity, which was $1.0 million at December 31,2007. In January 2008, the Company increased its line of credit facilityto $12.0 million and added a new acquisition loan facility in the amount of$4.3 million.  The line of creditfacility matures in January 2010 and the acquisition loan facility maturesin June 2011.

 

Aggregate maturitiesrequired on all debt at December 31, 2007 are as follows (in thousand):

** **
| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2008                              |       | $          | 81         |   |
| 2009                              |       | 48         |       |
| 2010                              |       | 15,901     |       |
| 2011                              |       | 16         |       |
| 2012                              |       | —     |       |
| Thereafter                        |       | —     |       |
|                              |       | $          | 16,046     |   |

 

At December 31,2006, the predecessor (ISI) had an outstanding balance of $5.0 million on itsline of credit facility.

 

 

F-26

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note9 — Capital Leases**

 

ISI sold its owner-occupiedreal estate to a partnership owned by ISI’s stockholders during 2004 andentered into a leaseback of the properties with the partnership. ISI enteredinto a second lease on another property owned by the same partnership in 2006.Both leases were triple net leases. A triple net lease is a lease agreement ona property where the tenant or lessee agrees to pay all real estate taxes,building insurance, and maintenance (the three ‘Nets’) on the property inaddition to any normal fees that are expected under the agreement (rent, etc.).In such a lease, the tenant or lessee is responsible for all costs associatedwith repairs or replacement of the structural building elements of theproperty.

 

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.

 

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

 
| ** **                     | ** ** | ** **            | ** ** | **Predecessor**       | ** ** |
|--------------------------------|------------|-----------------------|------------|-----------------------|------------|
| ** **                     | ** ** | ** **            | ** ** | **(ISI)**             | ** ** |
| ** **                     | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| **Collateral**                 | ** ** | **2007**              | ** ** | **2006**              | ** ** |
| Buildings                      |       | $                     | 1,888      |                  | $          | 2,278 |   |
| Less accumulated  amortization |       | (69                   | )          | (346                  | )          |
| Net                            |       | $                     | 1,819      |                  | $          | 1,932 |   |

 

The Company reassessedthese leases for proper classification under SFAS No. 13, *Accounting for Leases*, and determined theyremain properly classified as capital leases. The following is a schedule byyears of future minimum lease payments under capital leases together with thepresent value of net minimum lease payments at December 31, 2007:

** **
| **Year Ending December 31:**                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|
| 2008                                                              |       | $          | 288        |   |
| 2009                                                              |       | 288        |       |
| 2010                                                              |       | 288        |       |
| 2011                                                              |       | 288        |       |
| 2012                                                              |       | 288        |       |
| Thereafter                                                        |       | 1,917      |       |
| Future minimum lease payments                                     |       | $          | 3,357      |   |
| Less - amount of minimum  lease payments attributable to interest |       | (1,356     | )          |
| Present value of net  minimum lease payments                      |       | $          | 2,001      |   |
| Current portion of  capitalized lease obligations                 |       | $          | 97         |   |
| Long-term portion of  capitalized lease obligations               |       | 1,904      |       |
|                                                              |       | $          | 2,001      |   |

 

 

F-27

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note10 — Commitments**

 

The Company leases officespace and equipment under operating leases expiring through 2011.   The corporate office lease space of Argyleexpired as of July 31, 2007 and Argyle operated under a month-to-monthlease arrangement until it was renewed in January 2008.  The new lease expands the space fromapproximately 2,500 square feet to 6,500 square feet for a total expense in2008 of $121,000.  Rental expense was$193,000, and $61,000 for the years ended December 31, 2007 and 2006,respectively, and $185,000 for the seven months ended July 31, 2007(Predecessor) and $190,000 and $155,000 for the years ended December 31,2006 and 2005, respectively (Predecessor).

 

Minimum rentalcommitments at December 31, 2007 are as follows (in thousands):

** **

| **Year Ending December 31:** | ** ** | ** ** | ** ** |
|-----------------------------------|------------|------------|------------|
| 2008                              |       | $          | 211        |   |
| 2009                              |       | 130        |       |
| 2010                              |       | 89         |       |
| 2011                              |       | 46         |       |
| 2012                              |       | 6          |       |
| Thereafter                        |       | —     |       |
| Total commitment  outstanding     |       | $          | 482        |   |

 

In August 2007 theCompany entered into a letter of credit facility with a financial institution.The letter 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

 

**Note11 — Self Insurance**

** **

ISI is self-insured tocertain limits under its group health and dental plans. Stop-loss coverage isprovided for claims above $75,000 per employee up to a maximum $0.9 million.Operations are charged with the cost of claims reported and an estimate ofclaims incurred but not reported based on prior experience. The determinationof such claims and expenses and the appropriateness of the related liabilityare continually reviewed and updated. Total claims payable and claims incurredbut not reported were $0.3 million at December 31, 2007 and $0.3 millionat December 31, 2006 for the Predecessor. ISI has not yet met itsstop-loss limit for 2007.

** **

**Note12 — Offerings**

** **

***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 andexpiring January 24, 2011. The warrants are redeemable by the Company at aprice of $.01 per warrant upon 30 days’ notice, only in the event that the lastsale price of the common stock is at least $11.50 per share for any 20 tradingdays within a 30-trading-day period ending three business days before a noticeof 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.

 

 

F-28

----

 

**ARGYLE SECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note13 — Common Stock Reserved for Issuance**

 

As of December 31,2007, 5,879,342 shares of common stock were reserved for issuance upon exerciseof redeemable warrants and 375,000 shares of common stock were reserved forissuance pursuant to the underwriters’ unit purchase option described in Note17. In addition, warrants were issued in connection with the April 2007notes to stockholders entitling the holder to exercise the warrants for a totalof 37,500 shares of stock. In 2007, the company granted certain employeesincentive stock options (ISOs) and non-qualified stock options entitling theholder to exercise options for a total of 125,000 shares of stock and 130,000shares of restricted stock (see Note 17).

 

**Note14 — 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 stockholders inAugust 2007. The 211,965 shares of common stock were cancelled as of August 2007.

 

**Note15 — 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. No shares of preferred stock are currently issued oroutstanding.

 

In connection with themerger, and immediately prior to the merger, one of ISI’s unsecured debtholders converted $10.0 million of long-term debt with ISI into shares of ISIpreferred stock. Upon closing of the purchase of ISI, the same debt holderreceived $10.0 million for the preferred stock of ISI.

 

**Note16 — Agreement with Underwriters**

 

In March 2007, theunderwriters from Argyle’s Public Offering agreed to forfeit any and all rightsor claims to a pro-rata portion of the deferred underwriting costs andassociated accrued interest with respect to any shares of common stock that areredeemed in connection with the proposed acquisition. This fee was chargedagainst additional paid-in capital and was payable upon a successful businesscombination. Based on the redemption of 211,965 shares, $80,000 related tothese waived underwriter fees were paid to redemptive stockholders. Uponclosing of the purchase of ISI, Argyle paid approximately $1.4 million forservices performed related to Argyle’s Public Offering.

 

**Note17 — 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) requiresall share-based payments to employees, including grants of employee stockoptions, to be recognized in the financial statements based on their fairvalues. Following is a description of the various grants made and the impact tothe financial statements.

 

 

F-29

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note17 — Stockholders’ Equity and Stock-Based Compensation — (continued)**

** **

***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.

 

***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 andexpiring January 24, 2011. The options to purchase the 187,500 units andthe Securities underlying such units were deemed compensation by the NationalAssociation of Securities Dealers (NASD) and were therefore subject to a180-day lock-up pursuant to Rule 2710(g) (1) of the NASD ConductRules.

 

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 currently availableto management. The volatility estimate was derived using historical data ofpublic companies in the proposed industry. Argyle believes the volatilityestimate calculated from these companies was a reasonable benchmark to use inestimating the expected volatility of our units; however, the use of an indexto estimate volatility may not necessarily be representative of the volatilityof the underlying securities.

 

 

F-30

----

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note17 — Stockholders’ Equity and Stock-Based Compensation — (continued)**

** **

***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**

 

In 2007, the Companyissued 130,000 shares of restricted stock under the 2007 Incentive Plan.  These awards vest one-third on December 31of each of 2008, 2009 and 2010.

 

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, 2006        |       | —        |       | $                | —     |          |       |   |
| Granted                                     |       | 130,000       |       | 7.39             |       |          |       |
| Vested                                      |       | —        |       | —           |       |          |       |
| Forfeited                                   |       | —        |       | —           |       |          |       |
| Nonvested at  December 31, 2007        |       | 130,000       |       | $                | 7.39       |          | 3.0        |   |
| Expected to vest at  December 31, 2007 |       | 130,000       |       | $                | 7.39       |          | 3.0        |   |
| Vested at  December 31, 2007           |       | —        |       | $                | —     |          | —     |   |

 

During the year ended December 31,2007, the Company recognized $189,000 in compensation expense, net of taxbenefit of $64,000, related to the Company’s issuance of restricted stock.  As of December 31, 2007, there was$772,000 of unrecognized compensation costs, net of estimated forfeitures,related to the Company’s non-vested restricted stock, which is expected to berecognized over a weighted average period of 3 years.

 

 

F-31

----

**ARGYLE SECURITY, INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**December 31, 2007**

** **

**Note17 — Stockholders’ Equity and Stock-Based Compensation — (continued)**

** **

**PerformanceShare Awards**

 

In 2007, the Companyissued 115,000 shares of performance awards under the 2007 Incentive Plan.  These awards vest on December 31, 2010if certain performance goals to be determined by the Board of Directors areachieved.  The Company has not estimatedthe fair value of the performance share awards as the performance goals havenot yet been determined by the Board of Directors.  No compensation expense was recognized duringthe year ended December 31, 2007 related to the performance share awards.

 

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

** **

| ** **                                  | ** ** | ** **    | ** ** | ** **       | ** ** | **Average**   | ** ** | ** **    |
|---------------------------------------------|------------|---------------|------------|------------------|------------|---------------|------------|---------------|
| ** **                                  | ** ** | ** **    | ** ** | **Weighted**     | ** ** | **Remaining** | ** ** | ** **    |
| ** **                                  | ** ** | ** **    | ** ** | **Average Fair** | ** ** | **Vesting**   | ** ** | **Average**   |
| ** **                                  | ** ** | **Number of** | ** ** | **Value**        | ** ** | **Term**      | ** ** | **Intrinsic** |
| **Performance Units**                       | ** ** | **Units**     | ** ** | **Per Unit**     | ** ** | **(Years)**   | ** ** | **Value**     |
| Nonvested at  December 31, 2006        |       | —        |       | $                | —     |          |       |          |   |
| Granted                                     |       | 115,000       |       | —           |       |          |       |          |
| Vested                                      |       | —        |       | —           |       |          |       |          |
| Forfeited                                   |       | —        |       | —           |       |          |       |          |
| Nonvested at  December 31, 2007        |       | 115,000       |       | $                | —     |          | 3.0        |          | $ | — |
| Expected to vest at  December 31, 2007 |       | 115,000       |       | $                | —     |          | 3.0        |          | $ | — |
| Vested at  December 31, 2007           |       | —        |       | $                | —     |          | —     |          | $ | — |

 

**Incentiveand Nonqualified Stock Options**

 

In 2007, the Companyawarded a grant of 125,000 stock options to various employees, of which 91,000were ISO and 34,000 were non-qualified. The options have a strike price of$7.80 and vest December 31 in three equal tranches on each of 2008, 2009and 2010.

 

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

 

| ** **                                             | ** ** | ** **    | ** ** | ** **           | ** ** | **Average**   | ** ** | ** **    |
|--------------------------------------------------------|------------|---------------|------------|----------------------|------------|---------------|------------|---------------|
| ** **                                             | ** ** | ** **    | ** ** | **Weighted**         | ** ** | **Remaining** | ** ** | ** **    |
| ** **                                             | ** ** | ** **    | ** ** | **Average Exercise** | ** ** | **Vesting**   | ** ** | **Average**   |
| ** **                                             | ** ** | **Number of** | ** ** | **Price**            | ** ** | **Term**      | ** ** | **Intrinsic** |
| **Stock Options**                                      | ** ** | **Shares**    | ** ** | **Per Share**        | ** ** | **(Years)**   | ** ** | **Value**     |
| Outstanding at  December 31, 2006                 |       | —        |       | $                    | —     |          |       |          |   |
| Granted                                                |       | 125,000       |       | 7.80                 |       |          |       |          |
| Exercised                                              |       | —        |       | —               |       |          |       |          |
| Forfeited                                              |       | —        |       | —               |       |          |       |          |
| Outstanding at  December 31, 2007                 |       | 125,000       |       | $                    | 7.80       |          | 3.0        |          | $ | — |
| Vested and expected to  vest at December 31, 2007 |       | 125,000       |       | $                    | 7.80       |          | 3.0        |          | $ | — |
| Exercisable at  December 31, 2007                 |       | —        |       | $                    | —     |          | —     |          | $ | — |

 

 

F-32

----

 

 

**ARGYLE SECURITY, INC.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note17 — Stockholders’ Equity and Stock-Based Compensation — (continued)**

 

The Company hasestimated, based upon a Black-Scholes model, that the fair value of the stockoptions on the date of grant was approximately $2.10 per unit, (a total valueof approximately $0.3 million), using an expected life of three years, volatilityof 49%, and a risk-free rate of 4%. However, because the shares did not have atrading history, the volatility assumption was based on information currentlyavailable to management. The volatility estimate was derived using historicaldata of public companies in the related industry. The Company believes thevolatility estimate calculated from these companies was a reasonable benchmarkto use in estimating the expected volatility of our units; however, the use ofan index to estimate volatility may not necessarily be representative of thevolatility of the underlying securities.

 

During the year ended December 31,2007, the Company recognized $47,000 in compensation expense, net of taxbenefit of $16,000, related to the Company’s stock options.  As of December 31, 2007, there was$215,000 of unrecognized compensation costs, net of estimated forfeitures,related to the Company’s non-vested stock options, which is expected to berecognized over a weighted average period of 3 years.

 

**Predecessor(ISI) Stockholder Appreciation Rights**

 

Predecessor (ISI) madeverbal agreements with certain key employees to provide incentive compensationfor enhancement of Company and stockholder value and to share in the futureeconomic success of the Company.  Underthese agreements, the Company committed to issue common stock shares to keyemployees if the Company was sold or merged, the employees were employed by theCompany at the time of sale, and the sale price of the Company exceeds $6.0million.  The shares were to be issuedimmediately prior to the sale or merger and the rights terminate at issuance ofthe stock. (Stock was issued in conjunction with Argyle acquisition of ISI).

 

In accordance with EITF No. 96-5,Recognition of Liabilities for Contractual Termination Benefits or ChangingBenefit Plan Assumptions in Anticipation of a Business Combination,compensation cost will be recognized when a business combination has beenconsummated.

 

Common shares committedto the employees at December 31, 2006 were estimated to have a fair valueof $0.6 million.

 

 

F-33

----

 

 

**ARGYLESECURITY, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note18 — Income Taxes**

 

A reconciliation ofincome taxes at the U.S. federal statutory rate to the effective tax ratefollows (in thousands):

** **
| ** **                                   | ** **   | ** **                        | ** ** | ** ** | ** **         | ** **                                   | ** **         | **Predecessor (ISI)**                          | ** **         |
|----------------------------------------------|--------------|-----------------------------------|------------|------------|--------------------|----------------------------------------------|--------------------|------------------------------------------------|--------------------|
| ** **                                   | ** **   | ** **                        | ** ** | ** ** | ** **         | **Inception Through December 31, 2005** | ** **         | **January 1, Through July 31, 2007** | ** **         | ** ** | ** ** | ** ** | ** ** |
| ** **                                   | ** **   | ** **                        | ** ** | ** ** | ** **         | ** **                                   | ** **         | ** **                                     | ** **         | ** ** | ** ** |
| ** **                                   | ** **   | **Years Ended December 31,** | ** ** | ** ** | ** **         | **Years Ended December 31,**            | ** **         |
| ** **                                   | ** **   | **2007**                          | ** ** | **2006**   | ** **         | ** **                                   | ** **         | **2006**                                       | ** **         | **2005** | ** ** |
| Taxes at federal statutory  rate             |         | $                                 | 132        |       | $                  | 90                                           |               | $                                              | (3                 | ) | (402 | ) | $ | (234 | ) | $ | (581 | ) |
| Increase (decrease)  resulting from:         |         |                              |       |       |     |                                         |     |                                           |     |   |    |   |     |
| Permanent differences                        |    | (2                                | )          | —     |               | —                                       |               | (609                                           | )                  | 213 |   | 101 |   |
| Change in valuation allowance                |         | —                            |       | (3         | )                  | 3                                            |               | 10                                             |               | 22 |   | (22 | ) |
| Long-term contract adjustments               |         | 39                                |       | —     |               | —                                       |               | —                                         |               | (20 | ) | (25 | ) |
| State income tax, net of federal tax benefit |         | —                            |       | —     |               | —                                       |               | 52                                             |               | — |   | — |   |
| Other                                        |         | —                            |       | 4          |               | —                                       |               | (104                                           | )                  | 12 |   | 2 |   |
| Tax expense (benefit)                        |         | $                                 | 169        |       | $                  | 91                                           |               | $                                              | —             |   | $ | (1,053 | ) | $ | (7 | ) | $ | (525 | ) |
|                                              |              |                                   |            |            |                    |                                              |                    |                                                |                    |  |  |  |  |  |  |  |  |  |  |

 

The provision for incometax is comprised of the following (in thousands):

** **
| ** **                        | ** **         | ** **                        | ** ** | ** ** | ** **         | ** **                                   | ** **         | **Predecessor (ISI)**                                               | ** **         |
|-----------------------------------|--------------------|-----------------------------------|------------|------------|--------------------|----------------------------------------------|--------------------|---------------------------------------------------------------------|--------------------|
| ** **                        | ** **         | ** **                        | ** ** | ** ** | ** **         | **Inception Through December 31, 2005** | ** **         | **January 1,**

** Through**

**July 31,**

**2007** | ** **         | ** ** | ** ** | ** ** | ** ** |
| ** **                        | ** **         | ** **                        | ** ** | ** ** | ** **         | ** **                                   | ** **         | ** **                                                          | ** **         | ** ** | ** ** |
| ** **                        | ** **         | **Years Ended December 31,** | ** ** | ** ** | ** **         | **Years Ended December 31,**            | ** **         |
| ** **                        | ** **         | **2007**                          | ** ** | **2006**   | ** **         | ** **                                   | ** **         | **2006**                                                            | ** **         | **2005** | ** ** |
| Federal:                          |     |                              |       |       |     |                                         |     |                                                                |     |   |   |   |     |
| Current                           |               | $                                 | 308        |       | $                  | 119                                          |               | $                                                                   | —             |   | $ | 53 |   | $ | — |   | $ | (450 | ) |
| Deferred                          |               | (215                              | )          | (28        | )                  | —                                       |               | (1,065                                                              | )                  | (7 | ) | (78 | ) |
| Total                             |               | $                                 | 93         |       | $                  | 91                                           |               | $                                                                   | —             |   | $ | (1,012 | ) | $ | (7 | ) | $ | (528 | ) |
| State:                            |               |                              |       |       |               |                                         |               |                                                                |               |   |   |   |   |
| Current                           |               | $                                 | 97         |       | $                  | —                                       |               | $                                                                   | —             |   | $ | 84 |   | $ | — |   | $ | 3 |   |
| Deferred                          |               | (21                               | )          | —     |               | —                                       |               | (125                                                                | )                  | — |   | — |   |
| Total                             |               | $                                 | 76         |       | $                  | —                                       |               | $                                                                   | —             |   | $ | (41 | ) | $ | — |   | $ | 3 |   |
| Total provision for income  taxes |               | $                                 | 169        |       | $                  | 91                                           |               | $                                                                   | —             |   | $ | (1,053 | ) | $ | (7 | ) | $ | (525 | ) |
|                                   |                    |                                   |            |            |                    |                                              |                    |                                                                     |                    |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

F-34

----

 

 

**ARGYLESECURITY, INC.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note18 — 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):

 

| ** **                             | ** ** | ** **            | ** ** | ** **            | ** ** | **Predecessor** | ** ** |
|----------------------------------------|------------|-----------------------|------------|-----------------------|------------|-----------------|------------|
| ** **                             | ** ** | ** **            | ** ** | ** **            | ** ** | **(ISI)**       | ** ** |
| ** **                             | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                             | ** ** | **2007**              | ** ** | **2006**              | ** ** | **2006**        | ** ** |
| Deferred tax liabilities:              |       |                  |       |                  |       |            |       |
| Intangibles (non-amortizable)          |       | $                     | 6,880      |                  | $          | —          |       | $ | — |   |
| Property and equipment                 |       | 419                   |       | —                |       | 353             |       |
| Contract receivables                   |       | 168                   |       | —                |       | 135             |       |
| Prepaids                               |       | 38                    |       | —                |       | —          |       |
| Other                                  |       | —                |       | 16                    |       | —          |       |
| Total deferred tax  liabilities        |       | 7,505                 |       | 16                    |       | 488             |       |
| Deferred tax assets:                   |       |                  |       |                  |       |            |       |
| Net operating loss                     |       | 558                   |       | —                |       | —          |       |
| Realized capital loss                  |       | —                |       | —                |       | 88              |       |
| Allowance for doubtful accounts        |       | 371                   |       | —                |       | 140             |       |
| Stock-based compensation               |       | 139                   |       | 44                    |       | —          |       |
| Other                                  |       | 131                   |       | —                |       | 100             |       |
| Total gross deferred tax  assets       |       | 1,199                 |       | 44                    |       | 328             |       |
| Valuation allowance                    |       | —                |       | —                |       | (88             | )          |
| Total deferred tax assets              |       | 1,199                 |       | 44                    |       | 240             |       |
| Net deferred tax  liabilities (assets) |       | $                     | 6,306      |                  | $          | (28             | )          | $ | 248 |   |

 

At December 31,2007, net deferred tax liabilities include a deferred tax asset of $139,000relating to stock based compensation expense under FAS 123(R).  Full realization of this deferred tax assetrequires stock options to be exercised at a price equaling or exceeding the sumof the strike price plus the fair value of the option at the grant date. Theprovisions of FAS 123(R) do not allow a valuation allowance to be recordedunless the Company’s future taxable income is expected to be insufficient torecover the asset. Accordingly, there can be no assurance that the price of ourcommon shares will rise to levels sufficient to realize the entire tax benefitcurrently reflected in our balance sheet. However, to the extent thatadditional tax benefits are generated in excess of the deferred taxesassociated with compensation expense previously recognized, the potentialfuture impact on income would be reduced.

 

The valuation allowanceis related to capital losses incurred by the Company which were partially usedin 2007. The remaining balance expired as of December 31, 2007.  At December 31, 2007, the Company hadnet operating loss carryovers of $1.5 million that expire July 31, 2027.

 

The Company adopted FASBInterpretation No. 48, *Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109*(FIN 48) on January 1, 2007. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in financial statements and requires theimpact of a tax position to be recognized in the financial statements if thatposition is more likely than not of being sustained by the taxing authority.The adoption of FIN 48 did not have an effect on our consolidated financialposition or results of operations.  TheCompany has applied the accounting provisions of FIN 48 to its tax positionsand determined that no uncertain tax positions presently exist.

 

Argyle and ISI will file a consolidated U.S. Federalincome tax return for the period after July 31, 2007.  All prior tax returns filed by Argyle areopen to examination by federal, state and local taxing authorities.  ISI is no longer subject to U.S. Federalincome tax examinations for years before 2004 and is no longer subject to stateand local income tax examinations by authorities for years before 2003.  To date, no material adjustments have beenproposed with respect to ongoing and completed examinations.

 

 

F-35

----

 

 

**ARGYLESECURITY, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2007**

 

**Note19 — Related-Party Transactions**

 

Other receivables include$42,000 of receivables from related parties, all of which is attributable toISI. Amounts represent monies or other assets advanced to employees. Amountshave been paid on these receivables and management believes they are fullycollectible.

 

**The Company leases various properties from Green WingManagement, Ltd., an entity owned and controlled by the Chief Executive Officerand President of ISI under capital leases. The leases on these properties were amended as part of the acquisitionof ISI to reflect a term of 12 years ending in 2019 and to require that anappraisal be completed by a qualified appraiser to determine the market rate ofthe leases. The rental rate to be paid on these properties, after theacquisition 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.** During the year ended December 31,2007, the Company made lease payments of $120,000 under these leases.  See Note 9 for the remaining payments dueunder 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 revenue based on the ISI*MCS, Ltd.’s contract amount,net of the 2% fee. Contract receivables from ISI*MCS, Ltd. at December 31,2007 totaled $10.9 million, which is disclosed as contract receivables -related party on the face of the consolidated balance sheet since ISI*MCS, Ltd.is not consolidated in the balance sheet. Contract revenues reported by theCompany from ISI*MCS, Ltd. were $15.0 million for the period August 1,2007 to December 31, 2007.  ISI*MCS,Ltd. revenues reported by the predecessor (ISI) were $16.7 million for theseven months ended July 31, 2007 and $19.9 million and $14.5 million forthe years ended December 31, 2006 and 2005, respectively.  Argyle has agreed to indemnify theshareholders of ISI*MCS, Ltd. from claims brought by the bonding companyagainst their personal guarantees for those contracts that have not been paidin full as of the closing of the merger. The merger agreement provides thatthese indemnification obligations will survive for a period of four years afterthe closing date of the merger and the obligations are not subject to cap, ormaximum amount.

 

Subsequent to July 31,2007, ISI will receive 100% of the remaining contract amounts and ISI*MCS, Ltd.will forego its 2% fee. Remaining amounts to be billed on these contracts as ofDecember 31, 2007 totaled $31.6 million. All future contracts, bonded andun-bonded, will be contracted directly by ISI without involvement by ISI*MCS,Ltd.

 

**UnsecuredDebt — Related Party**

 

As part of the ISI mergertransaction, debt totaling $16.0 million was owed to a shareholder of ISI, ofwhich $10.0 million was paid prior to its original terms. The shareholderbecame a shareholder of Argyle as part of the merger and holds 486,237 sharesof Argyle common stock as of July 31, 2007 and as such, became a relatedparty. At December 31, 2007, the remaining debt to the shareholder (seeNote 8) totals $6.0 million.

 

 

F-36

----

 

 

**ARGYLESECURITY, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**December 31,2007**

 

**Note20 — Segment Information**

 

The Company’s segmentsare strategic business units that offer different products and services and aremanaged accordingly. Under GAAP segment reporting rules, management analyzesthe various operating segments based on segment income before income taxes. Thecustomers and long-lived assets of the reportable segments are in the UnitedStates. The Company has three reportable segments that reflect the currentmanagement of its business: (1) ISI Detention; (2) MCS Detention; and(3) MCS Commercial.

 

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. Whether actingas prime contractor or as a subcontractor for projects spanning all levels ofsecurity, ISI Detention’s product offerings include security locking systems,security hollow metal doors and wall panels, security windows, security glassand glazing, security furnishings and accessories, design support, and fullinstallation capabilities.

 

MCS Detention specializesin turnkey installations for public- and privately-owned/operated detentionfacilities. MCS Detention designs, assembles, supplies, installs, and maintainsaccess control, video, and integrated electronic control systems forcorrectional and government facilities throughout the United States. It alsoprovides the above goods and services to detention market integrators,electrical contractors, and competitors of ISI that lack their own in-houseelectronic solutions

 

MCS Commercial has builta parallel business to MCS Detention targeting commercial and industrialfacilities.  MCS Commercial currentlyoperates out of its own San Antonio headquarters and five regional offices. Theoffices in Austin, Houston, and Denver resulted from acquisitions made by ISI.

 

The results for the yearended December 31, 2007 represent the five months of activity for theCompany since the date of the acquisition of ISI on July 31, 2007. Thepredecessor information for the year ended December 31, 2006 and 2005represent the full results for those respective time periods.

 

 

F-37

----

 

 

**ARGYLE SECURITY, INC.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note20 — Segment Information — (continued)**

 
| ** **                          | ** ** | **Year Ended**        | ** ** | **Predecessor (ISI)**            | ** ** |
|-------------------------------------|------------|-----------------------|------------|----------------------------------|------------|
| ** **                          | ** ** | **December 31,** | ** ** | **Year Ended December 31,** | ** ** |
| ** **                          | ** ** | **2007**              | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| **Industry Segment (in thousands)** |       |                  |       |                             |       |   |   |
| Net revenues:                       |       |                  |       |                             |       |   |   |
| ISI Detention                       |       | $                     | 23,985     |                             | $          | 32,267 |   | $ | 14,307 |   |
| MCS Detention                       |       | 13,322                |       | 13,435                           |       | 10,891 |   |
| MCS Commercial                      |       | 12,516                |       | 22,538                           |       | 17,348 |   |
| Corporate                           |       | —                |       | —                           |       | — |   |
| Eliminations                        |       | (5,770                | )          | (10,488                          | )          | (3,312 | ) |
| Total                               |       | $                     | 44,053     |                             | $          | 57,752 |   | $ | 39,234 |   |
| Operating income (loss):            |       |                  |       |                             |       |   |   |
| ISI Detention                       |       | $                     | 1,133      |                             | $          | 428 |   | $ | (563 | ) |
| MCS Detention                       |       | 653                   |       | 1,501                            |       | 1,804 |   |
| MCS Commercial                      |       | 214                   |       | 994                              |       | 220 |   |
| Corporate                           |       | (2,505                | )          | —                           |       | — |   |
| Eliminations                        |       | 726                   |       | —                           |       | — |   |
| Total                               |       | $                     | 221        |                             | $          | 2,923 |   | $ | 1,461 |   |
| Total assets:                       |       |                  |       |                             |       |   |   |
| ISI Detention                       |       | $                     | 67,378     |                             | $          | 23,550 |   | $ | 17,627 |   |
| MCS Detention                       |       | 8,052                 |       | 2,307                            |       | 1,705 |   |
| MCS Commercial                      |       | 5,519                 |       | 5,171                            |       | 3,254 |   |
| Corporate                           |       | 3,570                 |       | —                           |       | — |   |
| Eliminations                        |       | (3,371                | )          | 589                              |       | — |   |
| Total                               |       | $                     | 81,148     |                             | $          | 31,617 |   | $ | 22,586 |   |
| Capital expenditures:               |       |                  |       |                             |       |   |   |
| ISI Detention                       |       | $                     | 552        |                             | $          | 219 |   | $ | 131 |   |
| MCS Detention                       |       | 223                   |       | 364                              |       | 131 |   |
| MCS Commercial                      |       | 229                   |       | 181                              |       | 36 |   |
| Corporate                           |       | 25                    |       | —                           |       | — |   |
| Total                               |       | $                     | 1,028      |                             | $          | 764 |   | $ | 298 |   |

 

 

F-38

----

 

 

**ARGYLESECURITY, INC.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note21 — Supplemental Disclosures of Cash Flow Information**

 
| ** **                                                               | ** ** | ** **                       | ** ** | ** **                  | ** ** | ** **             | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|------------------------|------------|
| ** **                                                               | ** ** | ** **                       | ** ** | ** **                  | ** ** | **June 22, 2005** | ** ** |
| ** **                                                               | ** ** | ** **                       | ** ** | ** **                  | ** ** | **(inception)**        | ** ** |
| ** **                                                               | ** ** | ** **                       | ** ** | ** **                  | ** ** | **through**            | ** ** |
| ** **                                                               | ** ** | **Year Ended December 31,** | ** ** | **December 31,**       | ** ** |
|                                                                     | ** ** | **2007**                         | ** ** | **2006**                    | ** ** | **2005**               | ** ** |
| Cash paid for interest                                                   |       | $                                | 912        |                        | $          | 3                      |       | $ | — |   |
| Cash paid for income taxes                                               |       | 149                              |       | —                      |       | —                 |       |
| **Supplemental schedule of  non-cash investing activities:**             |       |                             |       |                        |       |                   |       |
| Financed purchases of  property and equipment                            |       | $                                | 161        |                        | $          | —                 |       | $ | — |   |
| Accrual for deferred  transaction costs                                  |       | 45                               |       | 435                         |       | —                 |       |
| **Supplemental schedule of  non-cash financing activities:**             |       |                             |       |                        |       |                   |       |
| Reduction in deferred  interest liability                                |       | $                                | 101        |                        | $          | —                 |       | $ | — |   |
| Reduction in deferred  underwriter liability                             |       | 185                              |       | —                      |       | —                 |       |
| Reduction in common stock  subject to redemption                         |       | 5,736                            |       | —                      |       | —                 |       |
| Issuance of warrants  associated with notes to related parties           |       | 93                               |       | —                      |       | —                 |       |
| Accrual of offering costs                                                |       | —                           |       | 7                           |       | 128                    |       |
| Accrual of deferred  underwriting costs                                  |       | —                           |       | 1,098                       |       | —                 |       |
|                                                                     |       |                             |       |                        |       |                   |       |
|                                                                     | ** ** | **Predecessor (ISI)**            |       |
|                                                                     | ** ** | **January 1, 2007**         |       |                        |       |                   |       |
|                                                                     | ** ** | **through**                      | ** ** | **Year Ended December 31,** |       |
|                                                                     | ** ** | **July 31, 2007**           | ** ** | **2006**                    | ** ** | **2005**               | ** ** |
|                                                                     |       |                             |       |                        |       |                   |       |
| Cash paid for interest                                                   |       | $                                | 1,846      |                        | $          | 2,563                  |       | $ | 2,258 |   |
| 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 accounting |       | 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                            |       | —                      |       | —                 |       |
|                                                                     |       |                             |       |                        |       |                   |       |

 

 

F-39

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**ARGYLESECURITY, INC.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note22— Quarterly Financial Data (Unaudited)**

 

The unaudited consolidated results of operations by quarter are summarizedbelow (in thousands expect per share data). For comparative purposes,net loss per share for the predecessor was calculated using the weightedaverage number of common shares outstanding for the Company as ofDecember 31, 2007 and does not reflect the actual basic and dilutedweighted shares outstanding at the end of the applicable periods.

 

 
| ** **                                                                                                      | ** ** | **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                                           |       | 1                                     |       | (1 | ) | (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   |       | $                                     | —     |   | $ | — |   | $ | (0.02 | ) | $ | 0.04 |   |
| Net income (loss) per share exclusive of shares and related interest  subject to potential redemption - diluted |       | $                                     | —     |   | $ | — |   | $ | (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 | ) |
|                   |            |                                       |            |  |  |  |  |  |  |  |  |  |  |

 

 

F-40

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**ARGYLESECURITY, INC.  NOTES TO CONSOLIDATED FINANCIAL STATEMENTSDecember 31, 2007**

 

**Note23— Subsequent Events**

 

On January 2, 2008 an additional $5.0 million inunsecured debt was funded by the same related party for which $6.0 million isdue. The aforementioned debt is due on January 31, 2010 with interestthereon at 11.58% per annum, payable quarterly in arrears beginning March 31,2008, deferred interest at the rate of 8.42% per annum, and default interest at2% per annum. Argyle and each of ISI’s subsidiaries are parties to the NotePurchase Agreement as guarantors.

 

On January 1, 2008, MCFSA, Ltd. (“MCFSA”), all ofthe partnership interests of which are directly or indirectly wholly owned byISI, acquired substantially all of the business assets and liabilities of FireQuest. Fire Quest is engaged in the business of alarm system sales andservice.  In consideration for the saleof its assets to MCFSA, Fire Quest received cash in the amount of $750,000 anda promissory note in the aggregate principal amount of $250,000 (“Fire QuestPromissory Note”). The Promissory Notes will bear interest at 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 Peterson Promissory Notes) in the aggregate principalamount of $3.0 million. The aggregate principal amount of the PetersonPromissory Notes may be reduced depending on the occurrence of certain eventsdescribed in the Asset Purchase Agreement. The payment of the PetersonPromissory Notes is guaranteed by and secured by the assets of ISI and theCompany, bears interest at 6% per year and will become due and payable on December 31,2012.

 

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 Security, LLC (Com-Tec), resulting in Com-Tec becoming a wholly ownedsubsidiary of ISI-Controls. Com-Tec is engaged in the business of customdesign, manufacture and installation of electronic security and communicationsystems.

 

In consideration for thesale of the Com-Tec units to ISI-Controls, the holders of units in Com-Tec (theSeller) received cash in the amount of $3.0 million and a secured subordinatedpromissory note in the aggregate principal amount of $3.5 million (the Com-TecPromissory Note). The Com-Tec Promissory Note is guaranteed by and secured bythe assets of ISI and the Company, bears interest at 7% per year and willbecome due and payable on April 1, 2011.

 

On January 25, 2008,the Board of Directors approved the issuance of certain equity-based awardsunder the Company’s 2007 Omnibus Securities and Incentive Plan. The Companygranted an aggregate of 85,000 shares of the Company’s restricted common stockto certain of its executive officers and directors. In addition, the Companygranted stock options to purchase an aggregate of 100,000 shares of the Company’scommon stock at an exercise price equal to the fair market value of the Company’scommon stock to certain of its employees. The Company also granted an aggregateof 55,000 performance units to certain of its officers, subject to terms andconditions to be set forth in a performance unit agreement and in accordancewith the Company’s 2007 Omnibus Securities and Incentive Plan.

 

 

F-41

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