**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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** **

**FORM 10-Q**

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(D)**

**OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarter Ended March 31, 2008**

 

**CommissionFile Number 000-53092**

 

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**AmericanDefense Systems, Inc.**

(Exact Name of Registrant asSpecified in Its Charter)

 

| **Delaware**                                                     | ** ** | **83-0357690**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or Other  Jurisdiction of Incorporation or  Organization) |       | (I.R.S. Employer  Identification No.) |

 

| **230 Duffy Avenue**

**Hicksville, NY 11801**

**(516)  390-5300**                                       |
|-----------------------------------------------------------------------------------------------------------|
| (Address including  zip code, and telephone number, including area code, of principal executive  offices) |

 

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  o    No  x

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company. See definitions of“large accelerated filer,” “accelerated filer,” and “smaller reporting company”in Rule 12b-2 of the Exchange Act. (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 check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

 

Yes  o    No  x

 

As of May 12,2008, 39,339,480 shares of common stock, par value $.001 per share, of theregistrant were outstanding.

 

 

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TABLE OF CONTENTS

 
| **PART I – FINANCIAL INFORMATION** |
|----------------------------------------------|
|                                         |   |
| Item 1.                                      | Condensed  Financial Statements (unaudited) |
|                                         | Consolidated  Balance Sheets as of December 31, 2007 and March 31, 2008 |
|                                         | Consolidated  Statements of Operations for the three months ended March 31, 2007 and  2008 |
|                                         | Consolidated  Statements of Cash Flows for the three months ended March 31, 2007 and  2008 |
|                                         | Notes  to Consolidated Financial Statements |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
| Item 4.                                      | Controls and  Procedures |
|                                         |   |
| **PART II –  OTHER INFORMATION**   |
|                                         |   |
| Item 1.                                      | Legal Proceedings |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds |
| Item 5.                                      | Other Information |
| Item 6.                                      | Exhibits |
|                                         |   |
| **SIGNATURES**                               |
|                                              |  |  |

 

2

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**PART I**

 

AMERICAN DEFENSE SYSTEMS,INC. AND SUBSIDIARIES

CONSOLIDATED BALANCESHEETS

 

**Item 1.    Consolidated Financial Statements**

 
| ** **                                                                                                                                                          | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                          | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| ASSETS                                                                                                                                                              |       |               |       |                  |       |
| Current Assets:                                                                                                                                                     |       |               |       |                  |       |
| Cash                                                                                                                                                                |       | $                  | 9,751,481  |                  | $          | 1,479,886 |   |
| Accounts receivable, net                                                                                                                                            |       | 4,758,135          |       | 6,711,161             |       |
| Inventory                                                                                                                                                           |       | 1,095,918          |       | 737,458               |       |
| Prepaid expenses and other current assets                                                                                                                           |       | 2,474,631          |       | 1,856,236             |       |
| Deferred tax asset                                                                                                                                                  |       | 4,136,982          |       | 4,136,982             |       |
| Costs in excess of billings on uncompleted contracts                                                                                                                |       | 8,697,869          |       | 5,011,974             |       |
| Deposits                                                                                                                                                            |       | 571,226            |       | 608,020               |       |
| Total current assets                                                                                                                                                |       | 31,486,242         |       | 20,541,718            |       |
|                                                                                                                                                                |       | —             |       |                  |       |
| Property and equipment, net                                                                                                                                         |       | 1,428,145          |       | 1,194,676             |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Deferred financing cost                                                                                                                                             |       | 1,009,190          |       | —                |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Goodwill                                                                                                                                                            |       | 1,960,361          |       | 1,680,361             |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Advances for future acquisitions                                                                                                                                    |       | 158,000            |       | 138,000               |       |
| Total assets                                                                                                                                                        |       | $                  | 36,041,938 |                  | $          | 23,554,754 |   |
|                                                                                                                                                                |       |               |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                           |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                |       |               |       |                  |       |
| Accounts payable                                                                                                                                                    |       | $                  | 6,236,151  |                  | $          | 4,381,930 |   |
| Accrued payroll                                                                                                                                                     |       | 270,519            |       | 205,230               |       |
| Accrued expenses                                                                                                                                                    |       | 1,059,519          |       | 599,258               |       |
| Due to Tactical Applications Group                                                                                                                                  |       | —             |       | 1,512,741             |       |
| Deferred tax liability                                                                                                                                              |       | 3,965,150          |       | 3,965,150             |       |
| Short term notes payable                                                                                                                                            |       | 134,515            |       | 64,947                |       |
| Total current  liabilities                                                                                                                                          |       | 11,665,854         |       | 10,729,256            |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Long term notes payable                                                                                                                                             |       | 21,328             |       | 27,670                |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Mandatorily redeemable Series A Convertible Preferred Stock (cumulative).  5,000,000 shares authorized,  15,000 shares issued and outstanding                       |       | 11,261,162         |       | —                |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Investor warrant liability                                                                                                                                          |       | 1,275,423          |       | —                |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Total liabilities                                                                                                                                                   |       | 24,223,767         |       | 10,756,926            |       |
| Stockholders’ equity:                                                                                                                                          |       |               |       |                  |       |
|                                                                                                                                                                |       |               |       |                  |       |
| Common stock, $0.001 par value, 100,000,000 shares  authorized, 39,207,950 and 38,957,950 shares issued and outstanding as of  March 31, 2008 and December 31, 2007 |       | 48,948             |       | 48,379                |       |
| Additional paid-in capital                                                                                                                                          |       | 10,481,575         |       | 9,765,432             |       |
| Accumulated (deficit)                                                                                                                                               |       | 1,287,647          |       | 2,984,017             |       |
| Total stockholders’ equity                                                                                                                                     |       | 11,818,170         |       | 12,797,828            |       |
| Total liabilities and stockholders’ equity                                                                                                                     |       | $                  | 36,041,937 |                  | $          | 23,554,754 |   |

 

The accompanyingnotes are an integral part of these financial statements.

 

3

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AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

For the three months ended March 31,

** **
| ** **                                                     | ** ** | **2008**        | ** ** | **2007**        | ** ** |
|----------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                     | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
| Contract revenues earned                                       |       | $               | 9,420,120  |            | $          | 6,163,856 |   |
|                                                           |       |            |       |            |       |
| Cost of revenues earned                                        |       | 5,466,678       |       | 3,308,327       |       |
|                                                           |       |            |       |            |       |
| Gross profit                                                   |       | 3,953,442       |       | 2,855,529       |       |
|                                                           |       |            |       |            |       |
| Operating expenses                                             |       |            |       |            |       |
| Research and development expense                               |       | 165,196         |       | 137,653         |       |
| Marketing expense                                              |       | 632,307         |       | 670,195         |       |
| General and administrative expense                             |       | 3,085,713       |       | 1,317,554       |       |
| Depreciation                                                   |       | 134,769         |       | 83,971          |       |
| Settlement of litigation                                       |       | 57,377          |       | 83,187          |       |
| Loss on disposal of fixed assets                               |       | —          |       | 136             |       |
| Total operating expenses                                       |       | 4,075,362       |       | 2,292,696       |       |
| Net operating (loss)                                           |       | (121,920        | )          | 562,833         |       |
|                                                           |       |            |       |            |       |
| Other (income) and expenses:                                   |       |            |       |            |       |
|                                                           |       |            |       |            |       |
| Loss on adjustment of fair value                               |       |            |       |            |       |
| Series A convertible preferred stock classified as a liability |       | 1,428,665       |       | —          |       |
| Loss on investor warrant liability                             |       | 107,589         |       | —          |       |
| Other income and expense                                       |       | 9,046           |       | (1,411          | )          |
| Interest expense                                               |       | 55,737          |       | 787             |       |
| Financing Charge                                               |       | 4,536           |       | —          |       |
| Interest income                                                |       | (31,123         | )          | (39,711         | )          |
| Total other (income) and expenses                              |       | 1,574,450       |       | (40,335         | )          |
| Net income (loss) before income taxes                          |       | (1,696,370      | )          | 603,168         |       |
|                                                           |       |            |       |            |       |
| Provision (benefit) for income taxes                           |       | —          |       | 3,750           |       |
|                                                           |       |            |       |            |       |
| Net income (loss)                                              |       | $               | (1,696,370 | )               | $          | 599,418 |   |
|                                                           |       |            |       |            |       |
| Net (loss) per share – basic and diluted                  |       | $               | (0.04      | )               | $          | 0.01 |   |
| Weighted average number of shares outstanding                  |       |            |       |            |       |
| During the year – basic and diluted                       |       | 39,124,616      |       | 38,801,840      |       |

 

The accompanyingnotes are an integral part of these financial statements.

 

4

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AMERICAN DEFENSE SYSTEMS, INC.

AND SUBSIDIARIES

CONSOLIDATED STATEMENTS CASH FLOWS

For the three months ended March 31,

 
| ** **                                                                             | ** ** | **2008**        | ** ** | **2007**        | ** ** |
|----------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                             | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
| Cash flows from operating activities:                                                  |       |            |       |            |       |
| Net income (loss)                                                                      |       | $               | (1,696,370 | )               | $          | 599,419 |   |
|                                                                                   |       |            |       |            |       |
| Adjustments to reconcile net income (loss) to net  cash used in  operating activities: |       |            |       |            |       |
| Change in fair value associated with preferred stock and warrants                      |       | 1,536,254       |       | —          |       |
| Stock based compensation expense                                                       |       | 33,685          |       | —          |       |
| Depreciation and amortization                                                          |       | 134,769         |       | 83,971          |       |
| Decrease in inventory valuation                                                        |       | —          |       | —          |       |
|                                                                                   |       |            |       |            |       |
| Changes in operating assets and liabilities:                                           |       |            |       |            |       |
| Restricted cash                                                                        |       | —          |       | 216,101         |       |
| Accounts receivable                                                                    |       | 1,953,026       |       | (599,289        | )          |
| Inventories                                                                            |       | (358,460        | )          | —          |       |
| Deposits and other assets                                                              |       | 36,794          |       | (35,363         | )          |
| Cost in excess of billing on uncompleted contracts                                     |       | (3,685,895      | )          | (1,392,808      | )          |
| Prepaid expenses and other assets                                                      |       | (618,395        | )          | 61,101          |       |
| Deferred tax asset                                                                     |       | —          |       | (2,471,745      | )          |
| Deferred financing costs                                                               |       | (658,500        | )          |            |       |
| Investment in affiliate                                                                |       | (20,000         | )          | (40,000         | )          |
| Accounts payable and accrued expenses                                                  |       | 1,303,390       |       | (657,503        | )          |
| Accrued liabilities                                                                    |       | 425,550         |       | 60,342          |       |
| Deferred tax liability                                                                 |       | —          |       | 2,471,745       |       |
| Due to related party                                                                   |       | (1,012,741      | )          | —          |       |
|                                                                                   |       |            |       |            |       |
| Net cash used in operating activities                                                  |       | (2,626,893      | )          | (1,704,029      | )          |
|                                                                                   |       |            |       |            |       |
| Cash flows from investing activities:                                                  |       |            |       |            |       |
| Purchase of equipment                                                                  |       | (368,238        | )          | (173,726        | )          |
| Cash paid for acquisition in excess of cash received                                   |       | (100,000        | )          | —          |       |
| Security deposits                                                                      |       | —          |       | —          |       |
|                                                                                   |       |            |       |            |       |
| Net cash used in investing activities                                                  |       | (468,238        | )          | (173,726        | )          |
|                                                                                   |       |            |       |            |       |
| Cash flows from financing activities:                                                  |       |            |       |            |       |
| Proceeds from notes payable                                                            |       | 69,568          |       | —          |       |
| Repayments of short term financing                                                     |       | (6,342          | )          | (3,397          | )          |
| Proceeds from sale of Series A Convertible                                             |       |            |       |            |       |
| Preferred Shares, net of of capitalization costs of $270,000                           |       | 11,303,500      |       | —          |       |
|                                                                                   |       |            |       |            |       |
| Net cash provided by (used in) financing activities                                    |       | 11,366,726      |       | (3,397          | )          |
|                                                                                   |       |            |       |            |       |
| NET INCREASE (DECREASE) IN CASH                                                        |       | 8,271,595       |       | (1,881,152      | )          |
|                                                                                   |       |            |       |            |       |
| CASH AT BEGINNING OF YEAR                                                              |       | 1,479,886       |       | 4,951,302       |       |
|                                                                                   |       |            |       |            |       |
| CASH AT END OF PERIOD                                                                  |       | $               | 9,751,481  |            | $          | 3,070,150 |   |
|                                                                                   |       |            |       |            |       |
| Supplemental disclosure of cash flow information:                                      |       |            |       |            |       |
| Cash paid during the year for interest                                                 |       | $               | 6,163      |            | $          | 787 |   |
| Cash paid for taxes                                                                    |       | $               | —     |            | $          | — |   |
|                                                                                   |       |            |       |            |       |
| Supplemental disclosure of non-cash financing  activities                              |       |            |       |            |       |
| Shares issued in lieu of  compensation                                                 |       | $               | —     |            | $          | — |   |
| Shares issued for consulting services                                                  |       | $               | —     |            | $          | — |   |
| Fair value of placement agent warrants                                                 |       | $               | 374,933    |            | $          | — |   |
|                                                                                   |       |            |       |            |       |
| Assets and liabilities received in American Anti-Ram, Inc.  asset purchase        |       |            |       |            |       |
| Fixed assets                                                                           |       | $               | 30,000     |            | $          | — |   |
| Inventory                                                                              |       | $               | 120,000    |            | $          | — |   |
| Goodwill                                                                               |       | $               | 280,000    |            | $          | — |   |
| Accounts payable and  accrued expense                                                  |       | $               | (30,000    | )               | $          | — |   |
| Shares issuable in  connection with acquisition                                        |       | $               | (200,000   | )               | $          | — |   |
| Cash paid to American  Anti-Ram, Inc.                                             |       | $               | (100,000   | )               | $          | — |   |
| Amounts due to American  Anti-Ram, Inc.                                           |       | $               | (100,000   | )               |       |   |

** **

The accompanying notes are an integral part of these financialstatements.

 

5

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**AMERICAN DEFENSE SYSTEMS, INC.AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**1.     NATURE OF BUSINESS AND SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

** **

**Organization—**OnMay****1, 2003, the stockholder of A. J.Piscitelli & Associates, Inc. exchanged all his issued and outstandingshares for shares of American Defense Systems, Inc. (the “Company”). AmericanDefense Systems, Inc. was incorporated under the laws of the State of Delawareon December 6, 2002. The exchange was accounted for as a recapitalization ofthe Company, wherein the stockholder retained all the outstanding stock ofAmerican Defense Systems, Inc. At the time of the acquisition American DefenseSystems, Inc. was substantially inactive. 

 

On November 15, 2007, theCompany entered into an Asset Purchase Agreement with Tactical ApplicationsGroup (TAG), a North Carolina based sole proprietorship, and its owner.  TAG has a retail establishment located inJacksonville, North Carolina that supplies tactical equipment to military andsecurity personnel.

 

In January 2008, AmericanPhysical Security Group, LLC (APSG), a wholly owned subsidiary of the Companyacquired the assets of American Anti-Ram, Inc., a manufacturer of crash testedvehicle barricades.  APSG is located inNorth Carolina.  

** **

**Nature of Business—**TheCompany designs and supplies transparent and opaque armor solutions for bothmilitary and commercial applications. These products, sold under Vistatrademarks, are used in transport and fighting vehicles, constructionequipment, sea craft and various fixed structures which require ballistic andblast attenuation. The Company also develops solutions, integrates and installsdetention and security hardware, entry control and monitoring systems,intrusion detection systems, and security glass. In addition, the Companyprovides engineering and consulting services to the detention and securityindustry. The primary customers of the Company are United States governmentagencies, general contractors who have contracts with governmental entities,and private industry.  

 

The Company also suppliestactical equipment to military and security personnel, as well as vehicleanti-ram barriers.  

 

The accompanying interimunaudited condensed financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Article 8 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for complete financial statements.In our opinion, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included. Operatingresults for the three-month period ended March 31, 2008 are not necessarilyindicative of the results that may be expected for the year ending December 31,2008. For further information, refer to the financial statements and footnotesthereto included in our Form 10 Report for the fiscal year ended December 31,2007.

 

**Principles of Consolidation—**The consolidated financial statements include the accounts of American DefenseSystems, Inc. and its wholly-owned subsidiaries, A.J Piscitelli &Associates, Inc. and American Physical Security Group, LLC.  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

**Use of Estimates—**Thepreparation of financial statements and related disclosures in conformity withaccounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes. Estimates areused for revenue recognition, income taxes and accrued liabilities amongothers. Actual results could differ materially from those estimates.

 

Significant estimates forall periods presented include cost in excess of billings and accruedcontingency losses in connection with litigation.

 

**Cash and Cash Equivalents—**TheCompany considers all highly liquid investments with maturities of three monthsor less at the time of purchase to be cash equivalents.

 

**Concentrations—**Cashand cash equivalents are maintained in financial institutions. Deposits heldwith banks may exceed the amount of insurance provided on such deposits.Generally, these deposits may be redeemed upon demand and therefore bearminimal risk. 

** **

The Company receivedcertain of its components from sole suppliers. Additionally, the Company relieson a limited number of contract manufacturers and suppliers to providemanufacturing services for its products. The inability of any contractmanufacturer or supplier to fulfill supply requirements of the Company couldmaterially impact future operating results.

 

6

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**AMERICAN DEFENSE SYSTEMS, INC.AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

For the three monthsended March 31, 2008 and 2007, the Company derived 99% of its revenues fromvarious U. S. government entities.

 

**Inventories—**Inventoriesare stated at the lower of cost or market, with cost determined using thefirst-in, first-out method. 

 

**Equipment—**Equipmentis stated at cost less accumulated depreciation. Depreciation is provided usinga straight-line method over an estimated useful life of three to five years.Expenditures for repairs and maintenance are charged to expense as incurred. 

 

**Goodwilland Indefinite-Lived Intangible Assets—**In accordance with SFAS No. 142, “Goodwilland Other Intangible Assets,” goodwill, represents the excess of thepurchase price and related costs over the value assigned to net tangible andidentifiable intangible assets of businesses acquired and accounted for underthe purchase method, acquired inbusiness combinations is assigned to reporting units that are expected tobenefit from the synergies of the combination as of the acquisition date. Underthis standard, goodwill and intangibles with indefinite useful lives are nolonger amortized.  The Company assessesgoodwill and indefinite-lived intangible assets for impairment annually duringthe fourth quarter, or more frequently if events and circumstances indicateimpairment may have occurred in accordance with SFAS No. 142. If the carryingvalue of a reporting unit’s goodwill exceeds its implied fair value, theCompany records an impairment loss equal to the difference. SFAS No. 142 alsorequires that the fair value of indefinite-lived purchased intangible assets beestimated and compared to the carrying value. The Company recognizes animpairment loss when the estimated fair value of the indefinite-lived purchasedintangible assets is less than the carrying value.  The Company has recorded goodwill associatedwith the asset purchase agreements with TAG and APSG in the amount of$1,860,361 and $1,680,361 as of March 31, 2008 and December 31, 2007.  No impairment loss was recognized as of March31, 2008 or December 31, 2007.

** **

**Long-Lived Assets—**TheCompany reviews long-lived assets and certain identifiable assets related tothose assets for impairment whenever circumstances and situations change, suchthat there is an indication that the carrying amounts may not be recoverable.If the undiscounted cash flows of the long-lived assets are less than thecarrying amount, their carrying amounts are reduced to fair value, and animpairment loss is recognized. 

** **

**Revenue and Cost Recognition—**The Company recognizes revenue in accordance with the provisions of StaffAccounting Board (SAB) No. 104, “*Revenue Recognition”*,which states that revenue is realized and earned when all of the followingcriteria are met:(a) persuasive evidence of the arrangement exists, (b) delivery has occurred orservices have been rendered, (c) the seller’s price to the buyer is fixed anddeterminable and (d) collectibility is reasonably assured.  Under this provision, revenue is recognizedupon delivery and acceptance of the order. 

 

Contract Revenue- The Company recognizes revenues and reports profits from long-termconstruction contracts, its principal business, under the completed contractmethod. These contracts generally extend for periods in excess of one year.Contract costs are accumulated as deferred assets and billings and/or cashreceived are charged to a deferred revenue account, during the periods ofconstruction, but no revenues, costs or profits are recognized in operationsuntil the period upon completion of the contract. Costs include directmaterial, direct labor, and project-related overhead. A contract is consideredcomplete, when all costs except insignificant items have been incurred, and theinstallation is operating according to specifications, or has been accepted bythe customer. Corporate general and administrative expenses are charged to theperiods as incurred. Provisions for estimated contract losses, if any, are madein the period that such losses are determined. Claims are included in revenueswhen received and claims related to unpaid amounts recorded as accounts payableto subcontractors are included in revenues if the dispute is resolved to thebenefit of the Company.

 

All costs associated with uncompleted purchase orders under contractare recorded on the balance sheet as a deferred current asset called “Costs inExcess of Billings on Uncompleted Contracts.” Upon completion of purchase order, costs are then reclassified from thebalance sheet to the statement of operations as costs of revenue.  All billings associated with uncompletedpurchase orders under contract are recorded on the balance sheet as a deferredcurrent liability called “Billings in Excess of Costs on UncompletedContracts”.  Upon completion of thepurchase order, all such billings would be reclassified from the balance sheetto the statement of operations as revenues. Due to the structure of the Company’s contracts, billing is not doneuntil the purchase order is complete, therefore there are no amounts recordedas deferred liabilities as of March 31, 2008 or 2007.  Contract retentions are included in accountsreceivable.

 

7

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**AMERICAN DEFENSE SYSTEMS, INC.AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

Retail revenue - The Companyrecognizes revenue from its retail location upon point of sale.  Due to the nature of the merchandise sold,the Company does not accept returns and, therefore, no provision for returnshas been recorded as of March 31, 2008 or 2007.

 

**Advertising Costs**—The Company expenses all advertising costsas incurred.

 

**Earnings per Share—**Basicearnings (loss) per share is computed using the weighted-average number ofcommon shares outstanding during the period. Diluted net income per share iscomputed using the weighted-average number of common shares and dilutivepotential common shares outstanding during the period. Diluted net loss pershare is computed using the weighted-average number of common shares andexcludes dilutive potential common shares outstanding, as their effect isanti-dilutive. Dilutive potential common shares would primarily consist ofemployee stock options and restricted common stock.

** **

**Income Taxes—**TheCompany accounts for income taxes according to Statement of FinancialAccounting Standard (SFAS) 109 “Accounting for Income Taxes” which requires anasset and liability approach to financial accounting for income taxes. Deferredincome tax assets and liabilities are computed annually for the differencebetween the financial statement and tax bases of assets and liabilities thatwill result in taxable or deductible amounts in the future, based on enactedtax laws and rates applicable to the periods in which the differences areexpected to affect taxable income. Valuation allowances are established whennecessary to reduce deferred tax assets to the amount expected to be realized.Income tax expense is the tax payable or refundable for the period, plus orminus the change during the period in deferred tax assets and liabilities.

 

The Corporation adoptedthe provisions of FASB Interpretation (“FIN”) No. 48, “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement 109,”effective January 1, 2007. FIN 48 prescribes a recognition threshold and ameasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Benefits fromtax positions should be recognized in the financial statements only when it ismore likely than not that the tax position will be sustained upon examinationby the appropriate taxing authority that would have full knowledge of allrelevant information. A tax position that meets the more-likely-than-notrecognition threshold is measured at the largest amount of benefit that is greaterthan fifty percent likely of being realized upon ultimate settlement. Taxpositions that previously failed to meet the more-likely-than-not recognitionthreshold should be recognized in the first subsequent financial reportingperiod in which that threshold is met. Previously recognized tax positions thatno longer meet the more-likely-than-not recognition threshold should bederecognized in the first subsequent financial reporting period in which thatthreshold is no longer met. FIN 48 also provides guidance on the accounting forand disclosure of unrecognized tax benefits, interest and penalties. Adoptionof FIN 48 did not have a significant impact on the Company’s financialstatements.

 

The Company files incometax returns in the U.S. federal jurisdiction and various states. The Companyhas not been subject to U.S. federal income tax examinations by tax authoritiesnor state authorities since its inception in 2000.

** **

**Fair Value of FinancialInstruments—**Fair value of certain of the Company’s financialinstruments including cash and cash equivalents, accounts receivable, accruedcompensation, and other accrued liabilities approximate cost because of theirshort maturities. 

** **

**Recentaccounting pronouncements**

 

*Business Combinations*

 

In December, 2007, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 141 (revised 2007), “Business Combinations”(hereinafter “SFAS No. 141 (revised 2007)”). This statement establishesprinciples and requirements for how an acquirer a) recognizes and measures inits financial statements the identifiable assets acquired, the liabilitiesassumed and any noncontrolling interest in the acquiree, b) recognizes andmeasures the goodwill acquired in the business combination or a gain from abargain purchase and c) determines what information to disclose to enable usersof the financial statements to evaluate the nature and financial effects of thebusiness combination. The scope of SFAS No. 141 (revised 2007) is broader than thescope of SFAS No. 141, which it replaces. The effective date of SFAS No. 141(revised 2007) is for all acquisitions in which the acquisition date is on orafter the beginning of the first annual reporting period beginning

 

8

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**AMERICAN DEFENSE SYSTEMS, INC.AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

on or after December 15,2008. The adoption of this statement has no immediate material effect on theCompany’s consolidated financial condition or results of operations. 

 

*Noncontrolling Interests inConsolidated Financial Statements – an amendment of ARB 51*

 

In December, 2007, theFASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated FinancialStatements – an amendment of ARB No. 51” (hereinafter “SFAS No. 160”). Thisstatement establishes accounting and reporting standards that require a) theownership interests in subsidiaries held by parties other than the parent beclearly identified, labeled and presented in the consolidated statement offinancial position with equity, but separate from the parent’s equity, b) theamount of consolidated net income attributable to the parent and to thenoncontrolling interest be clearly identified and presented on the face of theconsolidated statement of income, c) changes in a parent’s ownership interestwhile the parent retains its controlling financial interest in its subsidiarybe accounted for consistently, d) when a subsidiary is deconsolidated, anyretained noncontrolling equity investment in the former subsidiary be initiallymeasured at fair value and e) entities provide sufficient disclosures thatclearly identify and distinguish between the interests of the parent and theinterests of the noncontrolling owners. The effective date of this standard isfor fiscal years and interim periods beginning on or after December 15, 2008.The adoption of this statement had no immediate material effect on the Company’sconsolidated financial condition or results of operations.

 

*Disclosureabout Derivative Instruments and Hedging Activities*

 

In March 2008, the FASBissued SFAS No. 161, “Disclosureabout Derivative Instruments and Hedging Activities*,*” anamendment of FASB Statement No. 133, (SFAS 161). This statement requires thatobjectives for using derivative instruments be disclosed in terms of underlyingrisk and accounting designation. The Company is required to adopt SFAS 161 onJanuary 1, 2009. The Company is currently evaluating the potential impact ofSFAS No. 161 on the Company’s consolidated financial statements.

 

*Determinationof the Useful Life of Intangible Assets*

 

In April 2008, the FASB issued FSP FAS 142-3, “Determination of theUseful Life of Intangible Assets,”, which amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of intangible assets under FASB 142 “Goodwill and Other IntangibleAssets”.  The intent of this FSP is toimprove the consistency between the useful life of a recognized intangibleasset under SFAS 142 and the period of the expected cash flows used to measurethe fair value of the asset under FASB 141 (revised 2007) “BusinessCombinations” and other U.S. generally accepted accounting principles.  The Company is currently evaluating thepotential impact of FSP FAS 142-3 on its consolidated financial statements.

* *

**2.     COSTS IN EXCESS OF BILLINGS (BILLINGS INEXCESS OF COSTS) ON UNCOMPLETED CONTRACTS AND CONTRACTS RECEIVABLE**

** **

Costs in excess ofbillings on uncompleted contracts represent accumulated contract costs thatexceeded billings and/or cash received on uncompleted contracts at March 31,2008 and 2007. 

 

For the periodspresented, the cost in excess of billings on uncompleted contracts consisted ofthe following as of March 31, 2008 and December 31, 2007

 
| ** **                                          | ** ** | **2008** | ** ** | **2007** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|
| Uncompleted contract costs                          |       | $        | 8,697,689  |     | $          | 5,011,974 |   |
| Billings and / or receipts on uncompleted contracts |       | —   |       | —   |       |
| Cost in excess of billings on uncompleted contracts |       | $        | 8,697,689  |     | $          | 5,011,974 |   |

 

The Companyrecords accounts receivable related to its long-term contracts, based onbillings or on amounts due under the contractual terms. Accounts receivableconsist primarily of receivables from completed long-term contracts andprogress billings on uncompleted contracts. Allowance for doubtful accounts isbased upon a review of outstanding receivables, historical collectioninformation, and existing economic conditions. Any amounts consideredrecoverable under the customer’s surety bonds are treated as contingent gainsand recognized only when received.

 

9

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**AMERICAN DEFENSE SYSTEMS, INC.AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

Accountsreceivable throughout the year may decrease based on payments received, creditsfor change orders, or back charges incurred. At March 31, 2008 and December 31,2007, the Company had $4,758,135 and $6,711,161, respectively, of accountsreceivable, of which the Company considers all to be fully collectible.

 

There was no baddebt expense recorded for the three months ended March 31, 2008 and 2007.

** **

**3.             COMMITMENTS AND CONTINGENCIES**

** **

**LegalProceedings—**

** **

OnJuly 10, 2007, the Company filed a lawsuit against a former subcontractor,Southern California Gold Products d/b/a Gypsy Rack, the subcontractor’sPresident and owner, Glenn Harris, and a designer, James McAvoy in the UnitedStates District Court, Eastern District of New York. Defendants moved to changevenue to the Central District of California based upon insufficient contacts tothe State of New York and on October 12, 2007 the matter was transferredto the United States District Court for the Central District of California,Case Number 07-CV-02779. On February 21, 2008, pursuant to the court’sorder, we filed an amended complaint. The amended complaint names only SouthernCalifornia Gold Products and James McAvoy as defendants and asserts six countsas follows: misappropriation of trade secrets and confidential information;breach of contract; unfair competition; conversion; violation of the LanhamAct; and interference with prospective economic advantage. The amendedcomplaint seeks to enjoin the defendants from misappropriating, disclosing, orusing our confidential information and trade secrets, and recall and surrenderall products and trade secrets wrongfully misappropriated or converted by thedefendants. It also seeks compensatory damages in an amount to be establishedat trial together with prejudgment and post judgment interest, exemplarydamages, disgorgement, restitution with interest, attorney’s fees and the costsof suit.

 

OnDecember 6, 2006, the former Chief Financial Officer commenced anaction against the Company for breach of contract arising from his terminationof employment in the Eastern District of Ohio. The matter was transferred ondefendant’s motion to the United States District Court, Eastern District of NewYork. Mr. Lassak seeks damages in excess of $500,000 inclusive ofinterest.  In April 2008, the parties reached a settlement of$200,000 in this matter.

 

OnFebruary 29, 2008, a former employee commenced an action against us forbreach of contract arising from his termination of employment in the SupremeCourt of the State of New York, Nassau County. The Complaint seeks damages ofapproximately $87,000. We filed an answer to the complaint and will becommencing discovery.  Meritorious defenses to the claims exist and weintend to vigorously defend this action.

 

OnMarch 4, 2008, the Company’s former General Counsel, commenced an actionwith the United States Department of Labor, Occupational Safety and Health andSafety Administration, alleging retaliation in contravention of theSarbanes-Oxley Act. Mr. Cusack seeks damages in excess of $3,000,000. Webelieve the allegations to be without merit and intend to vigorously defendagainst the action. On March 7, 2008, Mr. Cusack also commenced asecond action against the Company for breach of contract and related issuesarising from his termination of employment in New York State Supreme Court,Nassau County. No amounts have been accrued for damages as the Company believesmeritorious defenses to the claims exist and intends to vigorously defend thisaction.

 

**4.             STOCKHOLDERS’ EQUITY**

 

**Warrants**- As an inducement to the February 2005 private offering, the Company alsoissued 2,778,950 warrants to purchase stock at $1.00 per share to thesesubscribers. These warrants will expire on August 31, 2006. In addition,purchase warrants for up to 555,790 shares of common stock at the purchaseprice of $1.10 per share were issued to the underwriter. These warrants willexpire September 1, 2010.

 

The following is asummary of stock warrants outstanding at March 31, 2008 and December 31,2007.

 
| ** **                | ** ** | ** **   | ** ** | ** **              | ** ** | **Value if** | ** ** |
|---------------------------|------------|--------------|------------|-------------------------|------------|-------------------|------------|
| ** **                | ** ** | **Warrants** | ** ** | **Exercise Price** | ** ** | **Exercised**     | ** ** |
| Beginning balance         |       | 3,334,740    |       | —                  |       | $                 | 3,390,319  |   |
| Issued - Private offering |       | —       |       | —                  |       | —            |       |
| Issued - Underwriter      |       |         |       |                    |       |              |       |
| Exercised                 |       | (1,791,375   | )          | 1.00                    |       | (1,791,375        | )          |
| Forfeited or expired      |       | (987,200     | )          | 1.00                    |       | (1,543,365        | )          |
| Ending balance            |       | 555,790      |       |                    |       | $                 | 611,369    |   |

 

10

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**AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

In accordance withStatement of Financial Accounting Standards (SFAS) No. 123 “Accounting forStock-Based Compensation,” and SFAS No. 148 “Accounting for Stock-BasedCompensation – Transition and Disclosure”, the Company accounts for the stockwarrants using the fair value method.

 

The Black-Scholes methodoption pricing model was used to estimate fair value as of the date of grantusing the following assumptions:

 
| Risk-Free           |   | 3.22%                       |
|---------------------|--------|-----------------------------|
| Expected volatility |   | 10 –  20%              |
| Expected life       |   | 1.5  Years – 5.5 Years |
| Expected dividends  |   | —                      |

** **

Based on theassumptions noted above, the fair market value of the warrants was valued at$330,475, which has been reflected in the Statement of Stockholders’ Equity asof December 31, 2005.  No value wasattributed to warrants in 2006 or 2007.

 

**StockOption Plan –** On December 3, 2007, the Company adoptedthe American Defense Systems, Inc. 2007 Incentive Compensation Plan.  Under this plan, stock options may be grantedto employees, officers, consultants or others who provide services to theCompany.  On December 14, 2007 andFebruary 20, 2008, 1,645,000 and 72,000 stock options, respectively, weregranted to directors, officers and employees of the Company.

 

The Black-Scholes methodoption pricing model was used to estimate fair value as of the date of grantusing the following assumptions:

 
| Risk-Free           |   | 4.23%                          |   |
|---------------------|--------|--------------------------------|--------|
| Expected volatility |   | 45%                            |   |
| Forfeiture rate     |   | 10%                            |   |
| Expected life       |   | 5  Years                       |   |
| Expected dividends  |   | —     |   |

** **

Based on theassumptions noted above, the fair market value of the options issued was valuedat $409,860, of which $33,685 and $0 have been expensed in the Statement ofOperations as of March 31, 2008 and 2007, respectively.

 

In February 2008,72,000 stock options were granted to officers, directors, employees,consultants and other persons who provide services to the Company.

 

The Black-Scholes methodoption pricing model was used to estimate fair value as of the date of grantusing the following assumptions:

 
| Risk-Free           |   | 4.23%                          |   |
|---------------------|--------|--------------------------------|--------|
| Expected volatility |   | 45%                            |   |
| Forfeiture rate     |   | 10%                            |   |
| Expected life       |   | 5  Years                       |   |
| Expected dividends  |   | —     |   |

 

Based on theassumptions noted above, the fair market value of the options issued was valuedat $64,960, of which $0 has been expensed in the Statement of Operations as ofMarch 31, 2008.

 

**Sharesissued in connection with Asset Purchase Agreement –** In January 2008,the Company, through its wholly owned subsidiary American Physical SecurityGroup, LLC, acquired the assets of American Anti-Ram, Inc., a manufacturerof crash tested vehicle barricades.  Thepurchase price for this acquisition is expected to be $600,000.  Of this amount, $100,000 has been paid incash and 100,000 shares of stock were issued, valued at $2 per share.  The Company will pay another $100,000 by theend of 2008.  The remaining purchaseprice will be negotiated based on performance. The Company acquired approximately $120,000 in net assets in thisacquisition.

 

**5.             ACQUISITION**

** **

In January 2008,the Company, through its wholly owned subsidiary American Physical SecurityGroup, LLC, acquired the assets of American Anti-Ram, Inc., a manufacturerof crash tested vehicle barricades.  Thepurchase price for this acquisition is expected to be $600,000.  Of this amount, $100,000 has been paid incash and 100,000 shares of stock were issued, valued at $2 per share.  The Company will pay another $100,000 by theend of 2008.  The remaining purchaseprice will be negotiated based on performance.

 

The Companyacquired approximately $120,000 in net assets in this acquisition.  As of March 31, 2008, the Company haspaid $300,000 toward the anticipated purchase price.  The remaining balance due of $100,000 underagreement has been accrued as of March 31, 2008.

 

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**6.****                                     ****SERIES ACONVERTIBLE PREFERRED STOCK, INVESTOR WARRANTS AND PLACEMENT AGENT WARRANTS**

 

We entered into a Securities PurchaseAgreement (“Purchase Agreement”) on March 7, 2008 to sell shares of our Series AConvertible Preferred Stock (“Series A Preferred”) and warrants (“InvestorWarrants”) to purchase shares of our common stock, and to conditionally sellshares of our common stock, to three investors. The investors agreed topurchase an aggregate of 15,000 shares of Series A Preferred and InvestorWarrants to purchase up to 3,750,000 shares of common stock, and toconditionally purchase 100,000 shares of common stock. The aggregate purchaseprice for the Series A Preferred and Investor Warrants is $15,000,000 andthe aggregate purchase price for the common stock is $500,000.

 

An initial closing under the PurchaseAgreement was held on March 7, 2008 in which an aggregate of 10,975 sharesof Series A Preferred and Investor Warrants to purchase up to 2,743,706shares of common stock were issued for an aggregate purchase price of$10,975,000. After the payment of investor expenses of $60,000 and the $658,500cash portion of the placement agent fee described below, we received netproceeds of $10,256,500. A subsequent closing with respect to the remaining4,025 shares of Series A Preferred and warrants to purchase up to1,006,294 shares of common stock occurred on April 4, 2008.

 

In connection with sale of the Series APreferred and Investor Warrants under the Securities Purchase Agreementdescribed above, our placement agent for the transaction is entitled to a cashfee equal to 6.0% of the gross proceeds and warrants to purchase that number ofshares of common stock equal to 6.0% of the number of shares of common stockissued in the financing. For the initial closing above, the placement agentreceived a cash payment of $658,500 (6.0% of $10,975,000) and warrants topurchase 493,872 shares of common stock (6.0% of the sum of (i) 5,487,500,the initial number of shares of common stock into which the Series A Preferredissued in the March 7, 2008 closing may be converted and (ii) 2,743,706,the initial number of shares of common stock that may be purchased under theInvestor Warrants issued in the March 7, 2008 closing). At the April 4,2008 closing, the placement agent received an additional cash payment of$241,500 (6.0% of $4,025,000) and warrants to purchase up to 181,128 shares of commonstock (6.0% of the sum of (1) 2,012,500, the initial number of shares of commonstock into which the Series A Preferred issued in the April 4, 2008closing may be converted and (2) 1,006,294, the initial number of sharesof common stock that may be purchased under the Investor Warrants issued in theApril 4, 2008 closing).

 

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**Series A Convertible Preferred Stock**

 

The provisions for the Series APreferred are as follows:

 

Dividends on Series A Preferred

 

The shares of Series APreferred accrue a cumulative dividend at a rate of 9% per annum of theConversion Amount, as defined below. Dividends on the Series A Preferredshall be cumulative, shall accrue, whether or not declared, and be payablequarterly in cash or, at the Company’s option, payable in common stock at 10%.

 

Liquidation Preference

 

In the event ofthe liquidation, dissolution or winding up of the affairs of the Company,whether voluntary or involuntary (a “Liquidation”), the holders of shares ofthe Series A Preferred then outstanding shall be entitled to receive anamount per Series A Preferred equal to 110% of the Conversion Amount.

 

VotingRights

 

Holder’s of Series APreferred are entitled to vote on an “as if” converted basis and vote with thecommon stockholders as required. Voting rights are subject to the maximumownership percentage of 9.99%.

 

Holder’s Right to Convert

 

At any time theholder of any such shares of Series A Preferred may, at such holder’soption, elect to convert all or any portion of their whole number of shares of Series APreferred held by such person into common stock at the Conversion Rate, whichis equal to the Conversion Amount divided by the Conversion Price. TheConversion Amount shall initially be equal to the Stated Value ($1,000 pershare) times the number of shares subject to conversion. The Conversion Priceis the Initial Conversion Price ($2.00). The Conversion Price shall be reducedby (i) 4% of the Initial Conversion Price on or after May 30, 2008 ifthe Company’s common stock is not listed on an Eligible Market and (ii) afurther 1.5% of the Initial Conversion Price on each 30th daythereafter until the Company’s common stock is so listed; provided, however,that all decreases shall in no event be more than 10% of the Initial ConversionPrice. The Conversion Price is also subject to certain standard anti-dilutionadjustment provisions.

 

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Redemption at Option of Holders

 

Triggering Event –Upon the occurrence of a Triggering Event, each holder may, at such holder’soption, subject to the Limitation on Damages, require the Company to redeem allor a portion of such holder’s Series A Stock shares at a price perPreferred Share equal to the greater of (i) 110% of the Conversion Amount(or, in the case of the Triggering Events set forth in Sections 3(a)(v) and3(a)(vi), 100% of the Conversion Amount) and (ii) the product of (A) theConversion Rate in effect at such time and (B) the Closing Sale Price ofthe Company’s common stock on the trading day immediately preceding suchTriggering Event (the “Triggering Event Redemption Price”).

 

Failure toSatisfy Equity Condition - If the Equity Conditions are not satisfied as of December 31,2008, then on any date thereafter that any Equity Condition (as defined in the Series APreferred Certificate) is not satisfied the Holders shall have the right, inits sole discretion, to require that the Company redeem all of or any portionof such Holder’s Series A Preferred shares at a price equal to 100% of theConversion Amount.

 

Redemption by Company

 

Mandatory Redemption– If any Series A Preferred shares remain outstanding on the MaturityDate, which is December 31, 2010, the Company shall redeem all such Series APreferred shares on the Maturity Date for an amount in cash per Preferred Shareequal to the Conversion Amount.

 

Optional Redemption– At any time on or after the (i) 2nd anniversary of the PublicCompany Date (the date on which the Company’s securities are initiallyregistered under the Exchange Act), (A) the median price of the WeightedAverage Price of the Company’s common stock over any consecutive 30 Trading Dayperiod is greater than $3.00 per share, (B) the median trading volume forsuch period is greater than 75,000 shares and (C) there shall not havebeen any Equity Conditions Failure or (ii) 6-month anniversary of aQualified Public Offering and there shall not have been any Equity ConditionsFailure, the Company shall have the right to redeem any or all of the Series APreferred shares to cash in an amount equal to 100% of the Conversion Amount.

 

Accounting for the Series A Preferred

 

The Companyaccounted for the transaction in accordance with SFAS 150 “Accounting forCertain Financial Instrument with Characteristics of both Liabilities andEquity”. SFAS 150 provides guidance on how financial instruments should beclassified and measured when characteristics of both liabilities and equityexist and requires that an entity classify a financial instrument that iswithin its scope as a liability because the financial instrument embodies anobligation of the issuer. The mandatory redemption provision incorporated intothe Series A Preferred causes the stock to fall within the 

 

14

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scope of SFAS 150since the Company must redeem the stock by December 31, 2010 bytransferring cash to the Holders.

 

The proceeds fromthe issuance of the Series A Preferred and accompanying common stockwarrants, net of direct costs including the fair value of warrants issued toplacement agent in connection with the transaction, must be allocated to theinstruments based upon relative fair value upon issuance. In addition, underSFAS 150, paragraph 20, “mandatorily redeemable instruments must be measuredinitially at fair value”. Therefore, after the initial recording of the Series AStock based upon net proceeds received, the carrying value of the Series APreferred must be adjusted to the fair value at the date of issuance, with thedifference recorded as a loss. The initial valuation of the Series APreferred is as follows:

 
| **Security**             | ** ** | **Face Value** | ** ** | **Fair Value** | ** ** | **Allocation of  proceeds** | ** ** | **Fair value in  excess of  proceeds** | ** ** |
|--------------------------|------------|---------------------|------------|---------------------|------------|----------------------------------|------------|-------------------------------------------------------|------------|
| Series A  Preferred |       | $                   | 10,975,000 |                | $          | 11,093,379                       |       | $                                                     | 9,832,497  |   | $ | 1,260,882 |   |
| Warrants                 |       | —              |       | 1,289,013           |       | 1,142,503                        |       | 146,510                                               |       |
|                     |       |                |       |                |       |                             |       |                                                  |       |
|                     |       | $                   | 10,975,000 |                | $          | 12,382,392                       |       | $                                                     | 10,975,000 |   | $ | 1,407,392 |   |

 

The Series APreferred has been included as a noncurrent liability until December 31,2009, at which time it will be included as a current liability.

 

As of March 31,2008, the Company has recorded an additional loss on adjustment of fair valueof their Series A Preferred of $167,783. The total loss on adjustment asof March 31, 2008 is $1,428,665.

 

Investor Warrants

 

In connection with the initial closing underthe Purchase Agreement, Investor Warrants to purchase up to 2,743,706 shares ofcommon stock at $2.40 per share were issued in addition to the 10,975 shares ofSeries A Preferred.

 

The terms of the Investor Warrants providethe following:

 

(a)                                 Exerciseprice of $2.40 per share. If not listed on an eligible market on or before May 30,2008, the exercise price shall be reduced $.10 and shall be further decreasedby $.04 on each 30th day thereafter until such listing occurs,subject to a maximum of $.24

 

(b)                                TheInvestor Warrants are immediately exercisable upon issuance through the datethat is 36 months after the Public Company date.

 

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(c)                                 Acashless exercise is available at the option of the holders as of the PublicCompany date.

 

(d)                                Inthe event of a Fundamental Transaction, the holders may request that theCompany repurchase the Warrant from the holders by paying a cash amount equalto the Black-Scholes Value of the remaining unexercised portion on the date ofthe Fundamental Transaction. Fundamental Transactions are defined within theterms of the Investor Warrant Agreement.

 

(e)                                 TheCompany, at its option, has the right to require that the holder exercise allor a portion of their Investor Warrants under terms that are defined within theInvestor Warrant Agreement.

 

The Investor Warrants were accounted for asfollows:

 

(a)         The warrants meet thecriteria under SFAS 133 “Accounting for Derivative Instruments and HedgingActivities”. Under SFAS 133, the warrants are recorded at fair value upon thedate of issuance, with changes in the fair value recognized as a gain or lossas they occur. At the initial date of issuance, the Company recorded aderivative liability of $1,289,013, which represents the fair value of theInvestor Warrants and a loss on Investor Warrants of $146,510. This liabilitywas subsequently adjusted to fair value as of March 31, 2008 and acorresponding fair value adjustment of $38,921 reduced the derivative liability.The total loss on Investor Warrants as of March 31, 2008 was $107,589.

 

(b)        The warrants meet thecriteria under EITF 01-6 “The Meaning of Indexed to a Company’s Own Stock”,which provides guidance as to whether a contract is indexed to a Company’s ownstock. However, since the warrants do not meet the criteria for reporting as anequity instruments under EITF 00-19 “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, thefair value of the Investor Warrants is included as a noncurrent liability.

 

In valuing the Investor Warrantsassociated with the Series A Preferred the Company used the Black-Scholesoption pricing model with the following range of assumptions:

 
| Expected Life        |   | 3.10 Years |   |
|----------------------|--------|------------|--------|
| Risk-Free Rate       |   | 2.13%      |   |
| Expected  Volatility |   | 40%        |   |
| Dividend Rate        |   | 0%         |   |

 

The resulting value per warrant was$.47. The fair value associated with the 2,743,706 Investor Warrants was$1,289,013.

 

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Placement Agent Warrants

 

In connection with the sale of the Series APreferred and Investor Warrants, the placement agent was entitled to receivewarrants (Placement Agent Warrants) to purchase a total of 6% of the number ofcommon stock issued in the financing or 493,872 shares. The Placement AgentWarrants were accounted for as a transaction cost associated with the issuanceof the Series A Preferred. The Placement Agent Warrants recorded at fairvalue at the date of issuance. Under EITF 00-19 “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock”, the Company satisfies the criteria for classification of the PlacementAgent Warrants as equity. The Company has recorded the corresponding amountrecorded as a Deferred Financing Cost. Since the Series A Preferred andInvestor Warrants are classified as liabilities, the carrying value of thePlacement Agent Warrants has been recorded as an other asset and is amortizedas additional financing costs over the term of the Series A Preferredusing the interest method. At the date of issuance, the Company recorded$1,033,433 in deferred financing costs and amortized $25,331 as interestexpense as of March 31, 2008.

 

In valuing the Placement AgentWarrants associated with the Series A Preferred the Company used theBlack-Scholes option pricing model with the following range of assumptions:

 
| Expected Life        |   | 4 Years |   |
|----------------------|--------|---------|--------|
| Risk-Free Rate       |   | 2.45%   |   |
| Expected  Volatility |   | 45%     |   |
| Dividend Rate        |   | 0%      |   |

 

The resulting value per warrant was$.76. The fair value associated with the 493,872 Placement Agent Warrants was$374,993.

 

**7.****                                     ****SUBSEQUENT EVENT**

 

On April 4, 2008, a subsequentclosing took place under the agreement entered into on March 7, 2008 tosell shares of Series A Preferred. The Company received gross proceeds of$4,025,000.

 

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**Item 2.    Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

*The following discussion and analysis of ourfinancial condition and results of operations should be read in conjunctionwith our consolidated financial statements and related notes that appearelsewhere in this repor**t and in ourregistration statement on Form 10 (SEC No. 0-53092).*

 

*Except for statements of historical fact, certaininformation described in this report contains “forward-looking statements” thatinvolve substantial risks and uncertainties. You can identify these statementsby forward-looking words such as “anticipate,” “believe,” “could,” “estimate,” “expect,”“intend,” “may,” “should,” “will,” “would” or similar words. The statementsthat contain these or similar words should be read carefully because thesestatements discuss our future expectations, contain projections of our futureresults of operations or of our financial position, or state other “forward-looking”information. We believe that it is important to communicate our futureexpectations to our investors. However, there may be events in the future thatwe are not able accurately to predict or control. Further, we urge you to becautious of the forward-looking statements which are contained in this reportbecause they involve risks, uncertainties and other factors affecting ouroperations, market growth, service and products. The factors listed in thesection captioned “Risk Factors” within Item 1A, “Description of Business,” inour Form 10 Registration Statement filed with the SEC on April 22,2008, as well as other cautionary language in such Form 10,  describe such risks, uncertainties and eventsthat may cause our actual results and achievements, whether expressed orimplied, to differ materially from the expectations we describe in ourforward-looking statements. The occurrence of any of the events described asrisk factors could have a material adverse effect on our business, results ofoperations and financial position.*

 

**Overview**

 

We are a provider ofcustomized transparent and opaque armor solutions for tactical and non-tacticaltransport vehicles and construction equipment used by the military. We focusprimarily on research and development, design and engineering, fabrication andproviding component integration. Our armor solutions are used in retrofitapplications for equipment already in service, and we work with originalequipment manufacturers to provide armor solutions for new equipment purchasedby the military.

 

We also sell tacticalproducts such as body armor, nylon holsters, vests and packs, weapons,ammunition, weapons parts and accessories through a retail outlet, and physicalsecurity products consisting primarily of vehicle anti-ram barriers such asbollards, steel gates and steel wedges that deploy out of the ground.

 

Our technical expertiseis in the development of lightweight composite ballistic, blast and bulletmitigating materials used to fortify and enhance capabilities of existing andin-service equipment and structures. We serve primarily the defense market andour sale are highly concentrated within the U.S. government. Our customersinclude various branches of the U.S. military through the U.S. Department ofDefense (or DoD) and to a much lesser extent other U.S. government, lawenforcement and correctional agencies as well as private sector customers.

 

We have experiencedsignificant growth, with revenues of $4.8 million, $25.3 million and $36.5million in 2005, 2006 and 2007, respectively, and $9.4 million in the quarterended March 31, 2008. The principal factor contributing to our recentgrowth has been increased demand by the U.S. military for lightweight ballisticand blast resistant transparent and opaque armor that protects soldiers,sailors and marines.

 

Our recent historicalrevenues have been generated primarily from three large contracts. To continueexpanding our business, we are seeking to broaden our customer base and todiversify our product and service offerings. Our strategy to increase our revenue,grow our company and increase stockholder value involves the following keyelements:

 

·increase exposure to military platforms in the U.S.and internationally;

 

·form strategic partnerships with original equipmentmanufacturers (OEMs);

 

·develop strategic alliances;

 

·capitalize on increased homeland security requirementsand non-military platforms; and

 

·focus on an advanced research and development programto capitalize on increased demand for new armor materials.

 

We are pursuing each ofthese growth strategies simultaneously, and expect one or more of them toresult in additional revenue opportunities within the next 12 months. Pleasesee “Business—Our Growth Strategy” in our Form 10 filed April 22,2008 for additional information.

** **

**Sourcesof Revenues**

 

We derive our revenues byfulfilling orders under master contracts awarded by branches of the UnitedStates military, law enforcement and corrections agencies and private companiesinvolved in the defense market. Under these contracts, we provide customizedtransparent and opaque armor products for transport and construction vehiclesused by the military, group protection kits and spare parts.  We also derive revenues from retail sales ofour tactical products and sales of our physical security products.

 

Our contract backlog asof March 31, 2008 and 2007 was $48 million and $35 million, respectively.  Of our $48 million contract backlog at March31, 2008, we estimate that $30 million, $10 million and $8 million will befilled during the remainder of 2008 and in 2009 and 2010, respectively. Accordingly,in order to maintain our current growth rate or even our current revenuelevels, we will need to win more contracts with the U.S. government and othercommercial entities, achieve significant penetration into criticalinfrastructure and public safety protection markets, and successfully furtherdevelop our relationships with OEM’s and strategic partners. Notwithstandingthe possible significant troop reductions in Afghanistan and Iraq, we expectthat demand in those countries for armored military construction vehicles willcontinue in order to repair significant war damage and for nation-buildingpurposes. In addition, we are exploring interest in armored constructionequipment in other countries with mine-infested regions.

 

We continue toaggressively bid on projects and are in preliminary talks with a number ofinternational firms to pursue long-term government and commercial contracts,including with respect to Homeland Security. As described above in the sectionentitled “Business—Our Growth Strategy” of our Form 10 filed April 22,2008, we expect to engage in vehicle prototype work with an OEM during thesecond and third quarters of 2008. If such prototype work is obtained and issuccessful, it could lead to a substantial manufacturing opportunity that wouldbegin towards the end of 2008 and first half of 2009. While no assurances canbe given that we will obtain a sufficient number of contracts or that anycontracts we do obtain will be of significant value or duration, we areconfident that we will continue to have the opportunity to bid and wincontracts as we have in 2006 and 2007.

 

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**Cost ofRevenues and Operating Expenses**

 

*Cost ofRevenues.* Cost ofrevenues consists of parts, direct labor and overhead expense incurred for thefulfillment of orders under contract. These costs are charged to expense uponcompletion and acceptance of an order. Costs of revenue also includes the costsof protyping and engineering, which are expensed upon completion of an order aswell. These costs are included as costs of revenue because they are incurred tomodify products based upon government specifications and are reimbursable costswithin the contract. These costs for the production of goods under contract areexpensed when they are complete. We allocate overhead expenses such as employeebenefits, computer supplies, depreciation for computer equipment and officesupplies based on personnel assigned to the job. As a result, indirect overheadexpenses are included in cost of revenues and each operating expense category.

* *

*Salesand Marketing.*Expenses related to sales and marketing consist primarily of compensation forour sales and marketing personnel, sales commissions and incentives, tradeshows and related travel.

 

As our revenues increase,we plan to continue to invest heavily in sales and marketing by increasing thenumber of direct sales personnel in order to add new customers and increasesales to our existing customers. We also plan to expand our marketingactivities in order to build brand awareness and generate additional leads forour growing sales personnel. We expect that in 2008, sales and marketingexpenses will increase in absolute dollars but will decrease as a percentage ofrevenues.

* *

*Researchand Development.*Research and development expenses are incurred as we perform ongoingevaluations of materials and processes for existing products, as well as thedevelopment of new products and processes. Such expenses typically includecompensation and employee benefits of engineering and testing personnel,materials, travel and costs associated with design and required testingprocedures associated with our product line. We expect that in 2008, researchand development expenses will increase in absolute dollars as we upgrade andextend our service offerings and develop new protections products, but willremain relatively consistent or decrease slightly as a percentage of revenues.Research and development costs are charged to expense as incurred.

* *

*Generaland Administrative.*General and administrative expenses consist of compensation and relatedexpenses for executive, finance, accounting, administrative, legal,professional fees, other corporate expenses and allocated overhead. We expectthat in 2008, general and administrative expenses will increase in absolutedollars but decrease as a percentage of revenues.

** **

**CriticalAccounting Policies**

 

Our consolidatedfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States. The preparation of these consolidatedfinancial statements requires us to make estimates and assumptions that affectthe reported amounts of assets, liabilities, revenues, costs and expenses andrelated disclosures. On an ongoing basis, we evaluate our estimates andassumptions. Our actual results may differ from these estimates under differentassumptions or conditions.

 

We believe that of oursignificant accounting policies, which are described in Note 2 to theconsolidated financial statements, the following accounting policies involve agreater degree of judgment and complexity. Accordingly, these are the policieswe believe are the most critical to aid in fully understanding and evaluating ourconsolidated financial condition and results of operations.

* *

*Revenueand Cost Recognition.* We recognize revenue in accordance with the provisions of theSecurities and Exchange Commission (SEC) Staff Accounting Board (SAB) No. 104,“*Revenue Recognition”*, whichstates that revenue is realized and earned when all of the following criteriaare met: (a) persuasive evidence of the arrangement exists, (b) deliveryhas occurred or services have been rendered, (c) the seller’s price to thebuyer is fixed and determinable and (d) collectability is reasonablyassured. Under this provision, revenue is recognized upon delivery andacceptance of the order.

 

We recognize revenue andreport profits from purchases orders filled under master contracts under thecompleted contract method. Purchase orders received under master contracts mayextend for periods in excess of one year. Contract costs are accumulated asdeferred assets and billings and/or cash received are charged to a deferredrevenue account during the periods of construction. However, no revenues, costsor profits are recognized in operations until the period upon completion of theorder. An order is considered complete when all costs, except insignificantitems, have been incurred, installation is operating according to specificationor the shipment has been accepted by the customer. Provisions for estimatedcontract losses are made in the period that such losses are determined. As of March 31,2008 and December 31, 2007, there were no such provisions made.

 

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All costs associated withuncompleted purchase orders under contract are recorded on the balance sheet asa deferred asset called “Costs in Excess of Billings on Uncompleted Contracts.”Upon completion of a purchase order, such associated costs are thenreclassified from the balance sheet to the statement of operations as costs ofrevenue.

 

All billings associatedwith uncompleted purchase orders under contract are recorded on the balancesheet as a deferred liability called “Billings in Excess of Costs onUncompleted Contracts”. Upon completion of a purchase order, all suchassociated billings would be reclassified from the balance sheet to thestatement of operations as revenues. Due to the structure of our contracts,billing is not done until the purchase order is complete, therefore there areno amounts recorded as deferred liabilities as of March 31, 2008 or December 31,2007.

* *

*Stock-BasedCompensation.*Stock based compensation consists of stock issued to employees and contractorsfor services rendered. We accounted for the stock issued using the estimatedcurrent market price per share at the date of issuance. Such cost was recordedas compensation in our statement of operations at the date of issuance.

 

We have recently adoptedour 2007 Incentive Compensation Plan pursuant to which we intend to issuestock-based compensation from time to time, in the form of stock, stock optionsand other equity based awards. Our policy for accounting for such compensationin the form of stock options is as follows:

 

We have adopted theprovisions of Statement of Financial Accounting Standard No. 123(R), *Share-Based Payment*(SFAS No. 123R).In accordance with SFAS No. 123R, we will use the Black-Scholes optionpricing model to measure the fair value of our option awards granted after June 15,2005. The Black-Scholes model requires the input of highly subjectiveassumptions including volatility, expected term, risk-free interest rate anddividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB) No. 107(SAB No. 107) which provides supplemental implementation guidance for SFASNo. 123R.

 

Because we have onlyrecently become a public entity and there are no assurances that our commonstock will trade or be quoted on any established trading market, we will have alimited trading history, if any. The expected term of an award is based on the “simplified”method allowed by SAB No. 107, whereby the expected term is equal to themidpoint between the vesting date and the end of the contractual term of theaward. The risk-free interest rate will be based on the rate on U.S. Treasuryzero coupon issues with maturities consistent with the estimated expected termof the awards. We have not paid and do not anticipate paying a dividend in theforeseeable future and accordingly, use an expected dividend yield of zero.Changes in these assumptions can affect the estimated fair value of optionsgranted and the related compensation expense which may significantly impact ourresults of operations in future periods.

 

Stock-based compensationexpense recognized will be based on the estimated portion of the awards thatare expected to vest. We will apply estimated forfeiture rates based onanalyses of historical data, including termination patterns and other factors.

 

We recognized $33,685 and$6,800 in stock compensation expense as of March 31, 2008 and December 31,2007, respectively.

 

**Series AConvertible Preferred Stock, Investor Warrants and Placement Agent Warrants**

 

*Series A Preferred Stock*.  The Company accounted for its Series AConvertible Preferred Stock (or Series A Preferred) in accordance withSFAS 150 “Accounting for Certain Financial Instrument with Characteristics ofboth Liabilities and Equity”.  SFAS 150provides guidance on how financial instruments should be classified andmeasured when characteristics of both liabilities and equity exist and requiresthat an entity classify a financial instrument that is within its scope as aliability because the financial instrument embodies an obligation of theissuer.  The mandatory redemptionprovision incorporated into the Series A Preferred causes the stock tofall within the scope of SFAS 150 since we must redeem the stock by December 31,2010 by transferring cash to the holders of the Series A Preferred.

 

The proceeds from the issuance of the Series A Preferred andaccompanying common stock warrants, net of direct costs including the fairvalue of warrants issued to the Placement Agent in connection with thetransaction, must be allocated to the instruments based upon relative fairvalue upon issuance.  In addition, underSFAS 150, paragraph 20, “mandatorily redeemable instruments must be measuredinitially at fair value”.   Therefore,after the initial recording of the Series A Preferred based upon netproceeds received, the carrying value of the Series A Preferred must beadjusted to the fair value at the date of issuance, with the differencerecorded as a loss.

 

*InvestorWarrants.*  The warrants issued with the Series APreferred (or Investor Warrants) meet the criteria under SFAS 133 “Accountingfor Derivative Instruments and Hedging Activities”.  Under SFAS 133, the warrants are recorded atfair value upon the date of issuance, with changes in the value fair valuerecognized as a gain or loss as they occur.  At the initial date of issuance, we recorded a derivative liability of$1,289,013, which represents the fair value of the Investor Warrants.  This liability was subsequently adjusted tofair value as of March 31, 2008 and a corresponding fair value adjustmentof $38,921 reduced the derivative liability.

 

The Investor Warrantsmeet the criteria under EITF 01-6 “The Meaning of Indexed to a Company’s OwnStock”, which provides guidance as to whether a contract is indexed to a company’sown stock.    However, since the warrantsdo not meet the criteria for reporting as an equity instruments under EITF00-19 “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, the fair value of the InvestorWarrants is included as a noncurrent liability.

 

*Placement Agent Warrants.* The warrants issued to the Placement Agent with respect to the sale ofthe Series A Preferred and Investor Warrants (or Placement Agent Warrants)were accounted for as a transaction cost associated with the issuance of the Series APreferred.  The Placement Agent Warrantsare recorded at fair value at the date of issuance.  Under EITF 00-19 “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock”, we satisfy the criteria for classification of the Placement AgentWarrants as equity.   We have recordedthe corresponding amount recorded as a Deferred Financing Cost.  Since the Series A Preferred andInvestor Warrants are classified as liabilities, the carrying value of thePlacement Agent Warrants has been recorded as an other asset and is amortizedas additional financing costs over the term of the Series A Preferredusing the interest method.  At the dateof issuance, we recorded $1,033,433 in deferred financing costs and amortized$25,331 as interest expense as of March 31, 2008.

 

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***Comparison of theThree Months Ended March 31, 2008 versus March 31, 2007***

 

*Revenues.*  Revenues for the three monthsended March 31, 2008 was approximately $9.4 million, an increase ofapproximately $3.2 million, or 52%, over revenues of approximately $6.2 millionin the comparable period in 2007.  Thisincrease was due primarily Marine Corp sole source contract #m6785407D5023during the first quarter of 2008 versus the same quarter in 2007.   The revenue increase also was due toadditional sales generated from our tactical application retail outlet and ourphysical security product business, which were not in existence in 2007.

 

*Cost of Revenues.* Cost of revenues for the threemonths ended March 31, 2008 was approximately $5.5 million, an increase ofapproximately $2.2 million, or 67%, over cost of revenue of $3.3 million in thecomparable period in 2007.  This increasewas related to our increased production costs under the Marine Corp. salescontract mentioned above.  The costs ofrevenue also increased due to additional costs of sales from our tacticalapplication retail outlet and our physical security product business, whichwere not in existence in 2007.

 

*Gross profit margin*.   The gross profit margin forthe three months ended March 31, 2008 and March 31, 2007 wereapproximately $4 million and $2.9 million, respectively.  The gross profitmargin percentage was 42% and 53% for the three months ended March 31,2008 and March 31, 2007, respectively. The decrease in gross profit margin percentage was due to  higher costs associated with productionassociated with the Marine Corp. sales contract and lower gross profit marginsassociated with our tactical application retail outlet and our physicalsecurity product business.

 

*Sales and Marketing Expenses.*  Sales and marketing expensesfor the three months ended March 31, 2008 and March 31, 2007 wereapproximately $632,000 and $670,000, respectively, representing a decrease of$40,000, or 6%.  The decrease was dueprimarily  to a decrease in trade showexpenses that resulted from reducing its travel costs associated with theseshows.

 

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*Research and Development Expenses.*  Research and developmentexpenses for the three months ended March 31, 2008 and March 31, 2007were approximately $165,000 and $138,000, respectively.  The increase of $27,000 or 20% from 2007 to2008 was the result of additional testing and improvements of existingproducts, such as helmets and vests.

 

*General and Administrative Expenses.*  General and administrativeexpenses for the three months ended March 31, 2008 and March 31,2007were approximately $3.1 million and $1.3 million, respectively.  The increase of $1.7 million, or 130%, wasprimarily due to the increase in employee related costs associated with ourexpansion and increase in personnel of approximately $300,000.  Due to our expansion, we also incurredincreases in other expenses, such as general and liability insurance, rent andgeneral supplies, which approximated $420,000. We also incurred additional general and administrative expensesassociated with the facilities for our tactical application retail outlet andour physical security product business of approximately $600,000.  We also incurred significant legal, mergerand acquisition, and accounting costs associated with the registration of ourcommon stock with the SEC under the Securities Exchange Act of 1934 and ourasset acquisition during the first quarter of 2008, which were approximately$200,000.

 

*Depreciation expense.*  Depreciation expense wasapproximately $135,000 and $83,000 for the three months ended March 31,2008 and March 31, 2007, respectively. The increase of $52,000, or 63%, was the result of our expansion during2007, which resulted in higher depreciation expense.  In addition, we acquired additional propertyand equipment associated with our tactical application retail outlet and ourphysical security product business and, as a result, incurred higherdepreciation costs.

 

*Other (income) and expense.* We experienced a loss on adjustment of fair value with respect to our Series AConvertible Preferred Stock which was classified as a liability of $1.4 millionand a loss on the related investor warrants of $107,000 as of March 31,2008.  These securities were notoutstanding during the quarter ended March 30, 2007 and accordingly therewas no such loss as of March 31, 2007.  As a result of our agreement to sell our Series A ConvertiblePreferred Stock and warrants to purchase common stock, we incurred losses whichoccurred upon the valuation of the stock. Such valuation took into account the features, rights and obligations ofthe convertible preferred stock, which ultimately resulted in a higher fairvalue than the proceeds received.   Sincethe Series A Convertible Preferred Stock and related Investor Warrants arerequired to be recorded at fair value, we recorded a loss on such securities.

 

**Liquidityand Capital Resources**

 

As March 31, 2008, our principal sources of liquiditywere cash and cash equivalents totaling approximately $9.8 million, netaccounts receivable of approximately $4.8 million and costs in excess ofbillings of approximately $8.7 million.  The primary sources of ourliquidity during 2008 have come from operations and proceeds received from thesale of our shares of Series A Convertible Preferred Stock and warrants to purchaseour common stock.  

 

On March 7, 2008, we entered into an agreement to sellshares of our Series A Convertible Preferred Stock and warrants to purchase ourcommon stock, and to conditionally sell shares of our common stock, to threeinvestors. The aggregate purchase price of the preferred stock and warrants is$15.0 million and the aggregate purchase price of the common stock is$0.5 million.  An initial closing onthe sale of the preferred stock and warrants was held on March 7, 2008 inwhich we received gross proceeds of $10,975,000. A subsequent closing tookplace on April 4, 2008 in which we received gross proceeds of $4,025,000. Inaddition, if we successfully list our common stock on the American StockExchange, The NASDAQ Global Market, The NASDAQ Global Select Market, The NASDAQCapital Market, or the New York Stock Exchange on or prior to June 30,2008, the three investors will purchase 100,000 shares of our common stock foran aggregate purchase price of $500,000.

 

In May 2007, weentered into a loan agreement with Commerce Bank, N.A. pursuant to which wehave access to a $12.0 million revolving credit facility, and had access to aterm loan of up to $3.0 million through October 2007.  As of the endof March 31, 2008, approximately $120,000 was outstanding under the term loan.  There were no other draws upon the term loan.  The credit facilityis secured by all of our assets, and bears interest at a variable rate equal toLIBOR plus a margin of between 1.75% and 2.45%.  We have not yet drawn onany funds available under the revolving credit facility.

 

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As of March 31,2007, our principal sources of liquidity were cash and cash equivalentstotaling approximately $5.2 million, net accounts receivable of approximately$4.2 million and costs in excess of billings of approximately $1.4million.  The primary source of our liquidity and capital resources hascome from operations.

 

We believe that our current cash, cash equivalents andshort-term investments together with our expected cash flows from operationswill be sufficient to meet our anticipated cash requirements for workingcapital and capital expenditures for at least the next 12 months.

 

It is possible, however,that implementation of our growth strategy could result in additional businessrequiring us to expand our operations.  In particular, as a result ofon-going discussions to enter into relationships with original equipmentmanufacturers of tactical wheeled vehicles and construction and material handlingequipment, we expect to engage in additional vehicle prototype work during thesecond and third quarters of 2008 that could lead to significant manufacturingopportunities for us commencing towards the end of 2008 and the first half of2009.  If such prototype work is obtained and the manufacturingopportunities realized, we believe we would need additional operatingfacilities, equipment and employees.

 

These facility andresource requirements could necessitate additional funding beyond our operatingcash flow and available credit.  We are exploring a number of capitalraising alternatives to plan for this possibility.  There can be noassurances that any outside funding will be available to us or, if available,on reasonably acceptance terms.

 

*CashFlows from Operating Activities.*Net cash used in operating activities wasapproximately $2.6 million for the three months ended March 31, 2008 comparedto net cash  used in operating activitiesof approximately $1.7 million as of March 31, 2007.  Net cash used inoperating activities in 2008 consisted primarily of  changes in ouroperating assets and liabilities of approximately $2.3 million, includingchanges in accounts receivable, cost in excess of billing, prepaid expense,accounts payable and accrued liabilities.  The changes in accountsreceivable and costs in excess of billing of $1.95 million and $(3.6) million,respectively, reflects the increased payments received from our customers andincreases in projects in process as of March 31, 2008.   Our prepaidexpenses increased approximately $618,000 due to amounts paid in advance inconnection with our intent to enter the public market and obtain outsidefinancing.  Net cash used in operating activities for the three monthsended March 31, 2007 consisted primarily of changes in operating assets andliabilities of approximately $2.4 million, including changes in accountsreceivable, cost in excess of billing, accounts payable and accruedliabilities.  These changes in accounts receivable and cost in excess ofbilling resulted from the increase in projects completed and invoiced tocustomers.  In addition, the changes in accounts payable and accruedliabilities reflect the related increase in expenses incurred, with no fundspaid out.

 

As of March 31, 2008, wehad net operating loss carryforwards of approximately $4.8 millionavailable to reduce future taxable income. In the future, we may utilize ournet operating loss carryforwards and would begin making cash tax payments atthat time. In addition, the limitations on utilizing net operating losscarryforwards and other minimum taxes may also increase our overall taxobligations. We expect that if we generate taxable income and/or we are notallowed to use net operating loss carryforwards, our cash generated fromoperations will be adequate to meet our income tax obligations.

 

*NetCash Used In Investing**Activities.*  Netcash used in investing activities for the three months ended March 31, 2008 and2007 was approximately $468,000 and $174,000, respectively.  Net cash usedin investing activities during these periods consisted primarily of cash paidfor the acquisition of equipment and leasehold improvements and cash paid outfor the acquisition of assets in excess of cash received.

 

*NetCash Provided by Financing**Activities.* Net cash provided by (used in) financing for the three months ended March 31,2008 and 2007 was approximately $11 million and ($3,400), respectively. Netcash provided by financing activities during 2008 consisted primarily of proceedsof $10.9 million received from the sale of Series A Preferred Stock and approximately $70,000 received from theterm loan, offset by repayments of short term financing of approximately$6,300.  Net cash used in financing activities during 2007 consisted ofrepayments of short term financing of approximately $3,400.

 

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**Item 4.****           Controls and Procedure**

** **

**Evaluation of Disclosure Controls and Procedures**

 

Our management carried out anevaluation required by Rule  13a-15 under the Securities Exchange Act of1934, as amended (the “Exchange Act”), under the supervision and with theparticipation of our President and Chief Executive Officer (“CEO”) and ChiefFinancial Officer (“CFO”), of the effectiveness of our disclosure controls andprocedures as defined in Rule  13a-15 and 15d-15 under the Exchange Act (“DisclosureControls”). Based on the evaluation, our CEO and CFO concluded that, subject tothe limitations noted herein, as of March 31, 2008, our DisclosureControls are effective in timely alerting them to material information requiredto be included in our reports filed with the SEC.

** **

**Management’s Assessment of the Effectiveness of InternalControls**

 

This quarterly report does not include a reportof management’s assessment regarding internal controls over financial reportingor an attestation report of our registered independent public accounting firmdue to a transition period established by rules of the Securities andExchange Commission for newly formed public companies.

** **

**Limitations on the Effectiveness of Controls**

 

Our management, including our CEO and CFO, does not expect that ourDisclosure Controls and internal controls will prevent all error and all fraud.A control system, no matter how well conceived and operated, can provide onlyreasonable, not absolute, assurance that the objectives of the control systemare met. Further, the design of a control system must reflect the fact thatthere are resource constraints, and the benefits of controls must be consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, with American Defense Systemshave been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty and that breakdowns can occurbecause of simple error or mistake. Additionally, controls can be circumventedby the individual acts of some persons, by collusion of two or more people orby management override of the controls.

 

The design of any system of controls also is based in part upon certainassumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions; over time, a control may become inadequate becauseof changes in conditions or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand may not be detected.

** **

**PART II**

** **

**Item 1.****           Legal Proceedings**

 

OnJuly 10, 2007, we filed a lawsuit against a former subcontractor, SouthernCalifornia Gold Products d/b/a Gypsy Rack, the subcontractor’s President andowner, Glenn Harris, and a designer, James McAvoy, in the United States DistrictCourt, Eastern District of New York. Defendants moved to change venue to theCentral District of California based upon insufficient contacts to the State ofNew York and on October 12, 2007 the matter was transferred to the UnitedStates District Court for the Central District of California, Case Number07-CV-02779. On February 21, 2008, pursuant to the court’s order, we filed anamended complaint. The amended complaint names only Southern California GoldProducts and James McAvoy as defendants and asserts six counts as follows:misappropriation of trade secrets and confidential information; breach ofcontract; unfair competition; conversion; violation of the Lanham Act; andinterference with prospective economic advantage. The amended complaint seeks toenjoin the defendants from misappropriating, disclosing, or using ourconfidential information and trade secrets, and recall and surrender allproducts and trade secrets wrongfully misappropriated or converted by thedefendants. It also seeks compensatory damages in an amount to be establishedat trial together with prejudgment and post judgment interest, exemplarydamages, disgorgement, restitution with interest, attorney’s fees and the costsof suit. Defendants filed an answer to the amended complaint on April 16, 2008.A joint report to the court has been filed requesting a trial date of July 21,2009.

 

On December 6,2006,  Stephen Lassak, our former Chief Financial Officer commenced anaction for breach of contract arising from his termination of employment, whichwas in the United States District Court, Eastern District of New York.  The parties have reached a settlement in thismatter.

 

On February 29,2008, Roy Elfers, a former employee commenced an action against us for breachof contract arising from his termination of employment in the Supreme Court ofthe State of New York, Nassau County. The Complaint seeks damages ofapproximately $87,000. We filed an answer to the complaint and will becommencing discovery.  Meritorious defenses to the claims exist and weintend to vigorously defend this action.

 

On March 4,2008, Thomas Cusack, our former General Counsel, commenced an action with theUnited States Department of Labor, Occupational Safety and Health and SafetyAdministration, alleging retaliation in contravention of the Sarbanes-OxleyAct. Mr. Cusack seeks damages in excess of $3,000,000.  On April 2, 2008, we filed a response tothe charges.  We believe the allegationsto be without merit and intend to vigorously defend against the action.  On March 7, 2008, Mr. Cusack alsocommenced a second action against the Company for breach of contract andrelated issues arising from his termination of employment in New York StateSupreme Court, Nassau County.  On May 7,2008, we served a motion to dismiss the complaint.  Meritorious defenses to the claims exist andwe intend to vigorously defend this action.

 

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** **

**Item 2.****           UnregisteredSales of Equity Securities and Use of Proceeds**

 

The following is a summary of transactions by our company involvingsales of its securities that were not registered under the Securities Act of1933 (or Securities Act).

 

(a)  Private Placement:

 

On March 7, 2008, we entered into anagreement to sell shares of our Series A Convertible Preferred Stock (“Series APreferred”) and warrants (“Investor Warrants”) to purchase our common stock,and to conditionally sell shares of our common stock, to three investors.  The investors have agreed to purchase anaggregate of 15,000 shares of Series A Preferred and Investor Warrants topurchase up to 3,750,000 shares of common stock, and to conditionally purchase100,000 shares of common stock.  Theaggregate purchase price of the preferred stock and warrants is$15.0 million and the aggregate purchase price of the common stock is$0.5 million.

 

Each share of Series A Preferred is initially convertible into 500shares of common stock at a conversion price of $2.00 per share (“ConversionPrice”).  If the common stock is notlisted on the American Stock Exchange, The NASDAQ Global Market, The NASDAQGlobal Select Market, The NASDAQ Capital Market, or The New York Stock Exchange, Inc.(each, an “Eligible Market”) on or prior to May 30, 2008, the ConversionPrice will be reduced by 4% and on each 30th day after such date that thelisting has not occurred, the Conversion Price will be further reduced by 1.5%,but in no event will the total reductions exceed 10% of the initial ConversionPrice.

 

The holders of Investor Warrants may purchaseshares of our common stock at an exercise price of $2.40 per share until thedate that is 36 months after the date we become a reporting company under the1934 Act.  The exercise price is subject to reduction by the amount of$0.10 if our common stock is not listed on an Eligible Market on or prior to May 30,2008 and $0.04 on each 30th day after such date that our commonstock is not so listed, not to exceed a total reduction of $0.24.  We have the right to require holders of thewarrants to exercise such warrants at any time after the 2ndanniversary of the date we become a public reporting company under the 1934 Actif the trading price and volume of our common stock achieves certain benchmarksor at any time after the six month anniversary of a qualified public offering,in each case provided certain other conditions are satisfied.

 

An initial closing on the sale of the preferredstock and warrants was held on March 7, 2008 in which we received grossproceeds of $10,975,000.  A subsequentclosing took place on April 4, 2008 in which we received gross proceeds of$4,025,000.  In addition, if wesuccessfully list our common stock on an Eligible Market on or prior to June 30,2008, the three investors will purchase 100,000 shares of our common stock foran aggregate purchase price of $500,000. In connection with the foregoingfinancing, we also paid a portion of the related placement agent fees in theform of warrants to purchase 675,000 shares of our common stock.  The warrants issued to the placementagent are exercisable for 5 years from the date of issue at an exercise priceof $2.00 per share.

 

With respect to the sales of our securities described above, we relied on the exemption provided by Section 4(2) ofthe Securities Act and Regulation D promulgated thereunder.  Thepurchasers of securities are accredited investors and acquired securities fortheir own account for investment purposes only and not for resale unlessregistered under the Securities Act or pursuant an exemption from suchregistration.

 

(b) Other Issuances of Common Stock

 

(1)  On January 16,2008, we issued 25,000 shares of our common stock to a member of our board ofdirectors for consulting services.

 

(2)  On January 28,2008, we issued 100,000 shares to a third party in connection with the purchaseof its assets.

 

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(3)  On February 1, 2008, we issued 150,000 shares ofour common stock to two of our employees in connection with promotions.

 

The foregoinggrants were exempt from registration under the Securities Act, pursuant to Rule 701thereof, on the basis that the transactions were pursuant to compensatorybenefit plans and contracts relating to compensation as provided under Rule 701,and/or Section 4(2) and/or Regulation D as transactions by an issuer not involving apublic offering.

 

(c) 2007Incentive Compensation Plan.

 

In February 2008,we granted Non-Qualified Stock Option awards covering an aggregate of 72,000shares of common stock to our officers, directors, employees, consultants andother persons who provide services to our company or any related entitiespursuant to our 2007 Incentive Compensation Plan (“Plan”).  Pursuant to the Plan, the exercise price foreach option is $2.00 per share and each option vests at a rate of 20% per year,beginning on the first anniversary of the date of grant. Each of the stockoption awards was madein reliance upon the exemption from the registration provisions of theSecurities Act set forth in Rule 701 in that the securities were offeredand sold either pursuant to written compensatory benefit plans or contractsrelating to compensation.

 

(d) Repurchase of Common Stock:

 
| **Period**                   | ** ** | **Total Number of  Shares of Common  Stock Purchased** | ** ** | **Average Price Paid  Per Share ($ )** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number  of Shares that May  Yet Be Purchased  Under the Plans or  Programs** | ** ** |
|------------------------------|------------|---------------------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------|------------|
| March 1 - March 31 |       | 200,000                                                                         | (1)        | 0.625                                                           |       | —                                                                                                                           |       | —                                                                                                                              |       |
| Total                        |       | 200,000                                                                         |       | 0.625                                                           |       | —                                                                                                                           |       | —                                                                                                                              |       |

 

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(1)  The Company repurchased 200,000 shares of its Common Stockfor an aggregate price of $125,000 pursuant to a Settlement Agreement and related StockRepurchase and Lock-Up Agreement, each dated March 18, 2008.

** **

**Item 5.  Other Information**

 

(a)  **Board of Directors**

 

Our board ofdirectors is currently composed of nine directors.  Our certificate of incorporation divides ourboard of directors into three staggered classes of directors of the same ornearly the same number. At each annual meeting of stockholders, a class ofdirectors will be elected for a three-year term to succeed the directors of thesame class whose terms are then expiring. As a result, a portion of our boardof directors will be elected each year. The expected terms of these threeclasses and the directors in each class are as follows:

 

·                  the Class I directors’ initialterm will expire at the annual meeting of stockholders to be held in 2009 (ourinitial Class I directors include Alfred Gray, Christopher Brady  and Pasquale D’Amuro);

 

·                  the Class II directors’ initialterm will expire at the annual meeting of stockholders to be held in 2010 (ourinitial Class II directors include Gary Sidorsky, Richard Torykian andVictor Trizzino); and

 

·                  the Class III directors’ initialterm will expire at the annual meeting of stockholders to be held in 2011 (ourinitial Class III directors include Anthony Piscitelli, Fergal Foley andStephen Seiter ).

 

The division ofour board of directors into three classes with staggered three-year terms maydelay or prevent a change of our management or a change in control.

 

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**BoardCommittees**

 

Our board ofdirectors have created the following committees: audit committee, compensationcommittee and nominating and corporate governance committee.  The members of each committee is set forthbelow.

 

AuditCommittee:

 

VictorTrizzino (Chairman)Stephen SeiterChristopher Brady

 

Compensation Committee:

 

Alfred Gray (Chairman)Pasquale D’AmuroStephen Seiter

 

Nominating and Corporate Governance Committee:

 

Stephen Seiter (Chairman)Victor TrizzinoAlfred Gray

 

All of our audit,compensation and nominating and corporate governance committee members areindependent as such term is defined under the rules of the American StockExchange. In addition, all of our audit committee members meet the independencestandards under the Securities Exchange Act of 1934, and one member of thecommittee qualifies as an “audit committee financial expert” as defined underthat Act.

 

***Audit Committee***

 

Our auditcommittee has responsibility for, among other things, assisting our board ofdirectors in its oversight of:

 

·                  the integrity of our financialstatements;

·                  our independent registered publicaccounting firm’s qualifications and independence;

·                  the performance of our independentregistered public accounting firm; and

·                  any related person transactions.

 

The audit committeehas the sole and direct responsibility for appointing, evaluating and retainingour independent registered public accounting firm and for overseeing theirwork. All audit services to be provided to us and all non-audit services, otherthan de minimis non-audit services, to be provided to us by our independentauditors will be approved in advance by our audit committee.

 

The auditcommittee will have the power to investigate any matter brought to itsattention within the scope of its duties and to retain counsel for this purposewhere appropriate.

 

***Compensation Committee***

 

Our compensationcommittee has responsibility for, among other things:

 

·                  reviewing and recommending approvalof compensation of our executive officers;

·                  administering our equity incentivecompensation plans; and

·                  reviewing and making recommendationsto our board of directors with respect to incentive compensation and equityplans.

 

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***Nominating and Corporate Governance Committee***

 

Our nominating andcorporate governance committee has responsibility for, among other things:

 

·                  identifying and recommending nomineesfor election to our board of directors;

·                  developing and recommending to ourboard of directors our corporate governance principles; and

·                  overseeing the evaluation of ourboard of directors and management.

 

(b)  **Director Nominees bySecurity Holders**

 

Our Nominating andCorporate Governance Committee does not have a specific policy forconsideration of nominees recommended by security holders. However, securityholders can recommend a prospective nominee for the Board of Directors bywriting to our corporate Secretary at our corporate headquarters and providingthe information required by the our bylaws, along with any additionalsupporting materials the security holder considers appropriate. As of March 31,2008, there have been no recommended nominees from security holders.

 

(c)   **Modification of Advisory Board Agreement with Thomas Berthel.**

 

As described inour Form 8-K dated May 6, 2008, Thomas Berthel, a former member ofour board of directors, entered into an Advisory Board Agreement effective May 1,2008.  Such agreement accorded Mr. Berthelthe right, subject to certain exceptions, to attend meetings of our board ofdirectors.  We have entered into asubsequent amendment to the Advisory Board Agreement in which such right toattend meetings has been deleted.  A copyof the amendment is attached hereto as an exhibit to this report.

** **

**Item 6.****           Exhibits**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                                |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                       |
| 3.1                     |       | Form of Amended and Restated Certificate of Incorporation(3)                                                                                                                                          |
| 3.2                     |       | Form of Amended and Restated Bylaws(1)                                                                                                                                                                |
| 4.1                     |       | Form of 2008 investor warrant(1)                                                                                                                                                                      |
| 4.2                     |       | Form of 2008 placement agent warrant(1)                                                                                                                                                               |
| 4.3                     |       | Form of Series A Convertible Preferred Stock Certificate(1)                                                                                                                                      |
| 10.1                    |       | Securities Purchase Agreement, dated March 7, 2008(1)                                                                                                                                                 |
| 10.2                    |       | Form of Lock-Up Agreement for Anthony Piscitelli, Gary Sidorsky,  Fergal Foley, Victor La Sala, John Rutledge and Curtis Taufman(1)                                                                   |
| 10.3                    |       | Consulting Services Agreement between the Registrant and Berthel  Fisher & Company Financial Services, Inc. dated  February 29, 2008(2).                                                |
| 10.4                    |       | Side letter between the Registrant and West Coast Opportunity Fund, LLC  dated March 28, 2008(2).                                                                                                     |
| 31.1*                   |       | Certification of  Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended. *                |
| 31.2*                   |       | Certification of  Chief Financial Officer pursuant to Rule 13a-14(a) and Rule 15d-14(a),  promulgated under the Securities Act of 1934, as amended. *                                       |
| 32.1*                   |       | Certification of  Chairman and Chief Executive Officer and Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. * |
| 99.1*                   |       | Amendment No. 1 to Advisory Board Agreement between the Registrant  and Thomas J. Berthel dated May 1, 2008.                                                                                     |

 

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*               Filedherewith.

 

(1)   Incorporated by reference to an exhibit toAmendment No. 1 to the Form 10, filed on March 21, 2008.

 

(2)  Incorporated by reference to an exhibit to Amendment No. 2to the Form 10, filed on April 11, 2008.

 

(3)          Incorporatedby reference to an exhibit to Amendment No. 3 to the Form 10, filedon April 22, 2008.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                    | AMERICAN DEFENSE  SYSTEMS, INC. |
|-------------------------|---------------------------------|
|                    |                            |
|                    |                            |
| Date: May 15, 2008 | By:                             | /s/ Gary  Sidorsky |
|                    |                            | Chief Financial  Officer |
|                         |                                 |  |  |

 

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** **

**Index to Exhibits**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                              |
|-------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                     |
| 31.1                    |       | Certification of  Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended.                |
| 31.2                    |       | Certification of  Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Act of 1934, as  amended.                                      |
| 32.1                    |       | Certification of  Chairman and Chief Executive Officer and Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 99.1                    |       | Amendment No. 1 to Advisory Board Agreement between the Registrant  and Thomas J. Berthel dated May 1, 2008.                                                                                   |

 

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