Table ofContents

 

 

 

**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 THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarter Ended September 30, 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 AvenueHicksville, NY 11801****(516) 390-5300**

(Address including zipcode, and telephone number, including area code, of principal executiveoffices)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15 (d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes  x  No  o

 

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

 
| Large  Accelerated Filer  o | Accelerated  Filer  o | Non-Accelerated  Filer  o | Smaller  Reporting Company  x |
|----------------------------------|----------------------------|--------------------------------|------------------------------------|

 

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

 

Yes  o  No  x

 

As of November 13,2008, 39,483,202 shares of common stock, par value $0.001 per share, of theregistrant were outstanding.

 

 

 

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TABLE OF CONTENTS

 
| **PART I –  FINANCIAL INFORMATION** |
|-----------------------------------------------|
|                                          |
| Item 1.                                       | Condensed  Financial Statements |
|                                          | Consolidated Balance Sheets as of December 31,  2007 and September 30, 2008 (unaudited) |
|                                          | Consolidated Statements of Operations for the three  and nine months ended September 30, 2007 and 2008 (unaudited) |
|                                          | Consolidated Statements of Cash Flows for the nine  months ended September 30, 2007 and 2008 (unaudited) |
|                                          | 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 3.                                       | Defaults Upon  Senior Securities |
| Item 4.                                       | Submission of  Matters to a Vote of Security Holders |
| Item 5.                                       | Other Information |
| Item 6.                                       | Exhibits |
|                                          |   |
| **SIGNATURES**                                |

 

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**PART I**

 

**Item 1.****           Consolidated FinancialStatements**

 

AMERICAN DEFENSE SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                                                                    | ** ** | **(Unaudited)**        | ** ** | **(Audited)**         | ** ** |
| ASSETS                                                                                                                                                                                                        |       |                   |       |                  |       |
| Current Assets:                                                                                                                                                                                               |       |                   |       |                  |       |
| Cash                                                                                                                                                                                                          |       | $                      | 3,660,087  |                  | $          | 1,479,886 |   |
| Accounts receivable, net                                                                                                                                                                                      |       | 8,508,334              |       | 6,711,161             |       |
| Inventory                                                                                                                                                                                                     |       | 1,305,271              |       | 737,458               |       |
| Prepaid expenses and other current assets                                                                                                                                                                     |       | 4,445,986              |       | 1,856,236             |       |
| Deferred tax asset                                                                                                                                                                                            |       | 4,136,982              |       | 4,136,982             |       |
| Costs in excess of billings on uncompleted  contracts                                                                                                                                                         |       | 7,629,475              |       | 5,011,974             |       |
| Deposits                                                                                                                                                                                                      |       | 433,496                |       | 608,020               |       |
| Total current assets                                                                                                                                                                                          |       | 30,119,631             |       | 20,541,718            |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Property and equipment, net                                                                                                                                                                                   |       | 3,417,910              |       | 1,194,676             |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Deferred financing costs                                                                                                                                                                                      |       | 1,668,450              |       | —                |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Goodwill                                                                                                                                                                                                      |       | 1,950,000              |       | 1,680,361             |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Advances for future acquisitions                                                                                                                                                                              |       | 214,427                |       | 138,000               |       |
| Total assets                                                                                                                                                                                                  |       | $                      | 37,370,418 |                  | $          | 23,554,754 |   |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                                     |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                          |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                              |       | 5,179,320              |       | $                     | 4,381,930  |   |
| Accrued payroll                                                                                                                                                                                               |       | 527,044                |       | 205,230               |       |
| Accrued expenses                                                                                                                                                                                              |       | 371,338                |       | 599,258               |       |
| Due to Tactical Applications Group                                                                                                                                                                            |       | 125,000                |       | 1,012,741             |       |
| Deferred tax liability                                                                                                                                                                                        |       | 3,427,657              |       | 3,965,150             |       |
| Short term notes payable                                                                                                                                                                                      |       | 102,562                |       | 64,947                |       |
| Total current liabilities                                                                                                                                                                                     |       | 9,732,921              |       | 10,229,256            |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Long term notes payable                                                                                                                                                                                       |       | 27,670                 |       | 27,670                |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Preferred stock, $0.001 par value,  5,000,000 shares authorized; 15,000 shares designated as mandatorily redeemable  Series A Convertible Preferred Stock (cumulative), 15,000 shares issued and  outstanding |       | 12,444,850             |       | —                |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Investor warrant liability                                                                                                                                                                                    |       | 213,603                |       | —                |       |
| Total  liabilities                                                                                                                                                                                            |       | 22,419,044             |       | 10,256,926            |       |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| Stockholders’ equity:                                                                                                                                                                                    |       |                   |       |                  |       |
| Common stock, $0.001 par value, 100,000,000  shares authorized, 39,483,202 and 38,957,950 shares issued and outstanding as  of September 30, 2008 and December 31, 2007                             |       | 49,073                 |       | 48,379                |       |
| Additional paid-in capital                                                                                                                                                                                    |       | 10,744,369             |       | 10,265,432            |       |
| Retained earnings                                                                                                                                                                                             |       | 4,157,932              |       | 2,984,017             |       |
| Total  stockholders’ equity                                                                                                                                                                              |       | 14,951,374             |       | 13,297,828            |       |
| Total  liabilities and stockholders’ equity                                                                                                                                                              |       | $                      | 37,370,418 |                  | $          | 23,554,754 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

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AMERICAN DEFENSE SYSTEMS, INC. ANDSUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 
| ** **                                                                                            | ** ** | **For the three months ended September 30,** | ** ** | **For the nine months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2008**                                                                   | ** ** | **2007**                                                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                            | ** ** | **(Unaudited)**                                                            | ** ** | **(Unaudited)**                                                           | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Contract revenues earned                                                                              |       | $                                                                          | 13,495,301 |                                                                      | $          | 7,532,646 |   | $ | 32,051,499 |   | $ | 24,100,012 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Cost of revenues earned                                                                               |       | 9,101,568                                                                  |       | 4,593,085                                                                 |       | 20,870,141 |   | 14,205,381 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Gross profit                                                                                          |       | 4,393,733                                                                  |       | 2,939,561                                                                 |       | 11,181,358 |   | 9,894,631 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Operating expenses                                                                                    |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Research and development expense                                                                      |       | 170,784                                                                    |       | 183,184                                                                   |       | 539,936 |   | 418,809 |   |
| Marketing expense                                                                                     |       | 688,024                                                                    |       | 381,893                                                                   |       | 2,047,591 |   | 1,661,576 |   |
| General and administrative expense                                                                    |       | 1,999,335                                                                  |       | 998,927                                                                   |       | 4,655,742 |   | 2,767,112 |   |
| General and administrative salaries expense                                                           |       | 967,152                                                                    |       | 885,840                                                                   |       | 3,221,803 |   | 2,245,458 |   |
| Depreciation                                                                                          |       | 266,434                                                                    |       | 102,733                                                                   |       | 548,869 |   | 277,712 |   |
| Settlement of litigation                                                                              |       | —                                                                     |       | 92,863                                                                    |       | 57,377 |   | 178,450 |   |
| Total operating expenses                                                                              |       | 4,091,729                                                                  |       | 2,645,440                                                                 |       | 11,071,318 |   | 7,549,117 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Income (loss) from operations                                                                         |       | 302,004                                                                    |       | 294,121                                                                   |       | 110,040 |   | 2,345,514 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Other income and (expense):                                                                           |       |                                                                       |       |                                                                      |       |   |   |   |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Gain on adjustment of fair value Series A  convertible preferred stock classified as a liability |       | 126,228                                                                    |       | —                                                                    |       | 1,302,722 |   | — |   |
| Gain on investor warrant liability                                                                    |       | 52,001                                                                     |       | —                                                                    |       | 1,365,844 |   | — |   |
| Other income (expense)                                                                                |       | (332,353                                                                   | )          | 35,167                                                                    |       | (335,776 | ) | 1,780 |   |
| Interest expense                                                                                      |       | (272,730                                                                   | )          | (43,678                                                                   | )          | (582,897 | ) | (47,394 | ) |
| Interest income                                                                                       |       | 24,152                                                                     |       | 26,329                                                                    |       | 114,233 |   | 91,871 |   |
| Total other income (expense)                                                                          |       | (402,702                                                                   | )          | 17,818                                                                    |       | 1,864,126 |   | 46,257 |   |
| Net income before income taxes                                                                        |       | (100,698                                                                   | )          | 311,939                                                                   |       | 1,974,166 |   | 2,391,771 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Provision for income taxes                                                                            |       | —                                                                     |       | 537,388                                                                   |       | — |   | 537,388 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Net income (loss)                                                                                     |       | $                                                                          | (100,698   | )                                                                         | $          | (225,449 | ) | $ | 1,974,166 |   | $ | 1,854,383 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Preferred stock dividends                                                                             |       | (399,000                                                                   | )          | —                                                                    |       | (800,252 | ) | — |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Net income (loss) allocated to common stock  shareholders                                             |       | $                                                                          | (499,698   | )                                                                         | $          | (225,449 | ) | $ | 1,173,914 |   | $ | 1,854,383 |   |
|                                                                                                  |       |                                                                       |       |                                                                      |       |   |   |   |   |
| Net income (loss) per share – basic and  diluted                                                 |       | $                                                                          | (0.01      | )                                                                         | $          | (0.01 | ) | $ | 0.03 |   | $ | 0.06 |   |
| Weighted average number of shares  outstanding during the year – basic and diluted               |       | 39,442,800                                                                 |       | 37,300,000                                                                |       | 39,442,800 |   | 37,300,000 |   |

 

The accompanying notes are an integral partof these consolidated financial statements.

 

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AMERICAN DEFENSE SYSTEMS, INC.

AND SUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

For the nine months ended September 30,

 
| ** **                                                                                                       | ** ** | **2008**        | ** ** | **2007**        | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                                                       | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
|                                                                                                             |       |            |       |            |       |
| Cash flows  from operating activities:                                                                           |       |            |       |            |       |
| Net income                                                                                                       |       | $               | 1,974,166  |            | $          | 1,854,383 |   |
|                                                                                                             |       |            |       |            |       |
| Adjustments  to reconcile net income to net cash used in operating activities:                                   |       |            |       |            |       |
| Change in  fair value associated with preferred stock and warrants                                               |       | (2,668,556      | )          | —          |       |
| Stock based  compensation expense                                                                                |       | 75,820          |       | 495,000         |       |
| Amortization  of deferred financing costs                                                                        |       | 292,631         |       | —          |       |
| Discount on  Series A preferred stock                                                                       |       | 288,098         |       | —          |       |
| Depreciation  and amortization                                                                                   |       | 548,869         |       | 277,712         |       |
|                                                                                                             |       |            |       |            |       |
| Changes in  operating assets and liabilities:                                                                    |       |            |       |            |       |
| Restricted  cash                                                                                                 |       | —          |       | 216,101         |       |
| Accounts  receivable                                                                                             |       | (1,797,173      | )          | (971,677        | )          |
| Inventories                                                                                                      |       | (567,813        | )          | 18,050          |       |
| Deposits and  other assets                                                                                       |       | 174,697         |       | (353,750        | )          |
| Cost in  excess of billing on uncompleted contracts                                                              |       | (2,617,501      | )          | (2,723,013      | )          |
| Prepaid  expenses and other assets                                                                               |       | (2,589,750      | )          | (1,102,899      | )          |
| Deferred  financing costs                                                                                        |       | (1,668,450      | )          | —          |       |
| Advances for  future acquisitions                                                                                |       | (76,427         | )          | —          |       |
| Investment  in affiliate                                                                                         |       | (1,387,741      | )          | (40,000         | )          |
| Accounts  payable and accrued expenses                                                                           |       | 569,470         |       | (1,099,836      | )          |
| Accrued  liabilities                                                                                             |       | 321,814         |       | 1,060,356       |       |
| Due to  related party                                                                                            |       | (38,286         | )          | —          |       |
|                                                                                                             |       |            |       |            |       |
| Net cash  used in operating activities                                                                           |       | (9,166,132      | )          | (2,369,573      | )          |
|                                                                                                             |       |            |       |            |       |
| Cash flows  from investing activities:                                                                           |       |            |       |            |       |
| Purchase of  equipment                                                                                           |       | (2,772,104      | )          | (642,126        | )          |
| Cash paid  for acquisition in excess of cash received                                                            |       | (100,000        | )          | —          |       |
|                                                                                                             |       |            |       |            |       |
| Net cash  used in investing activities                                                                           |       | (2,872,104      | )          | (642,126        | )          |
|                                                                                                             |       |            |       |            |       |
| Cash flows  from financing activities:                                                                           |       |            |       |            |       |
| Proceeds  from notes payable                                                                                     |       | 84,311          |       | 140,859         |       |
| Repayments  of short term financing                                                                              |       | (19,026         | )          | (19,912         | )          |
| Proceeds  from the sale of common stock                                                                          |       | 203,152         |       | —          |       |
| Proceeds  from sale of Series A Convertible Preferred Shares, net of of  capitalization costs of $1,050,000 |       | 13,950,000      |       | —          |       |
|                                                                                                             |       |            |       |            |       |
| Net cash  provided by financing activities                                                                       |       | 14,218,437      |       | 120,947         |       |
|                                                                                                             |       |            |       |            |       |
| NET INCREASE  (DECREASE) IN CASH                                                                                 |       | 2,180,201       |       | (2,890,752      | )          |
|                                                                                                             |       |            |       |            |       |
| CASH AT  BEGINNING OF YEAR                                                                                       |       | 1,479,886       |       | 4,951,302       |       |
|                                                                                                             |       |            |       |            |       |
| CASH AT END  OF PERIOD                                                                                           |       | $               | 3,660,087  |            | $          | 2,060,550 |   |
|                                                                                                             |       |            |       |            |       |
| Supplemental  disclosure of cash flow information:                                                               |       |            |       |            |       |
| Cash paid  during the year for interest                                                                          |       | $               | 11,744     |            | $          | 47,694 |   |
| Cash paid  for taxes                                                                                             |       | $               | —     |            | $          | — |   |
|                                                                                                             |       |            |       |            |       |
| Supplemental  disclosure of non-cash financing activities                                                        |       |            |       |            |       |
| Stock  options issued in lieu of compensation                                                                    |       | $               | 75,820     |            | $          | — |   |
| Stock issued  in lieu of compensation                                                                            |       | $               | —     |            | $          | 495,000 |   |
| Dividends  payable                                                                                               |       | $               | 800,252    |            | $          | — |   |
| Fair value  of placement agent warrants                                                                          |       | $               | 511,742    |            | $          | — |   |
|                                                                                                             |       |            |       |            |       |
| Assets and  liabilities received in acquisition of American Anti-Ram, Inc.                                  |       |            |       |            |       |
| 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   | )               | $          | — |   |
| Amounts due  to American Anti-Ram, Inc.                                                                     |       | $               | (100,000   | )               | $          | — |   |

 

The accompanying notes are an integral partof these consolidated financial statements

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****              NATUREOF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

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

 

On November 15,2007, the Company entered into an Asset Purchase Agreement with TacticalApplications Group (TAG), a North Carolina based sole proprietorship, and itsowner.  TAG has a retail establishmentlocated in Jacksonville, North Carolina that supplies tactical equipment tomilitary and security personnel.

 

In January 2008,American Physical Security Group, LLC (APSG), a wholly owned subsidiary of theCompany, acquired the assets of American Anti-Ram, Inc., a manufacturer ofcrash tested vehicle barricades.  APSG islocated in North Carolina.

 

**Nature ofBusiness—**The Company designs and supplies transparent andopaque armor solutions for both military and commercial applications. Theseproducts, sold under Vista trademarks, are used in transport and fightingvehicles, construction equipment, sea craft and various fixed structures whichrequire ballistic and blast attenuation. The Company also develops solutions,integrates and installs detention and security hardware, entry control andmonitoring systems, intrusion detection systems, and security glass. Inaddition, the Company provides engineering and consulting services to thedetention and security industry. The primary customers of the Company areUnited States government agencies, general contractors who have contracts withgovernmental entities, and private industry.

 

The Company alsosupplies tactical equipment to military and security personnel, as well asvehicle anti-ram barriers.

 

The accompanyinginterim unaudited consolidated financial statements have been prepared inaccordance with generally accepted accounting principles for interim financialinformation and with the instructions to Form 10-Q and Article 8 ofRegulation S-X. Accordingly, they do not include all of the information andfootnotes required by generally accepted accounting principles for completefinancial statements. In our opinion, all adjustments (consisting of normalrecurring accruals) considered necessary for a fair presentation have beenincluded. Operating results for the nine-month period ended September 30,2008 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2008. For further information, refer to thefinancial statements and footnotes thereto included in the Company’s Form 10registration statement filed with the SEC on April 22, 2008.

 

**Principlesof Consolidation—** The consolidated financial statementsinclude the accounts of American Defense Systems, Inc. and its wholly-ownedsubsidiaries, A.J Piscitelli & Associates, Inc. and AmericanPhysical Security Group, LLC. All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

**Use ofEstimates—**The preparation of financial statements and relateddisclosures in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. Estimates are used for revenue recognition, income taxes and accruedliabilities among others. Actual results could differ materially from thoseestimates.

 

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Significantestimates for all periods presented include cost in excess of billings andaccrued contingency losses in connection with litigation.

 

**Cash andCash Equivalents—**The Company considers all highly liquidinvestments with maturities of three months or less at the time of purchase tobe 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 Companyreceived certain of its components from sole suppliers. Additionally, theCompany relies on a limited number of contract manufacturers and suppliers toprovide manufacturing services for its products. The inability of any contractmanufacturer or supplier to fulfill supply requirements of the Company couldmaterially impact future operating results.

 

For the ninemonths ended September 30, 2008 and 2007, the Company derived 99% of itsrevenues from various 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 thecarrying value of a reporting unit’s goodwill exceeds its implied fair value,the Company records an impairment loss equal to the difference. SFAS No. 142also requires that the fair value of indefinite-lived purchased intangibleassets be estimated and compared to the carrying value. The Company recognizesan impairment loss when the estimated fair value of the indefinite-livedpurchased intangible assets is less than the carrying value.  [The Company has recorded goodwill associatedwith the TAG and American Anti-Ram, Inc. asset purchases in the amount of$1,950,000 and $1,680,361 as of September 30, 2008 and December 31,2007.  Of the total $1,950,000 ofgoodwill recorded, $1,680,361 relates to the TAG acquisition in 2007 and$269,639 relates to the acquisition of American Anti-Ram in 2008.  No impairment loss was recognized as of September 30,2008 or December 31, 2007.

 

**Long-LivedAssets—**The Company reviews long-lived assets and certainidentifiable assets related to those assets for impairment whenevercircumstances and situations change, such that there is an indication that thecarrying amounts may not be recoverable. If the undiscounted cash flows of thelong-lived assets are less than the carrying amount, their carrying amounts arereduced to fair value, and an impairment 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) deliveryhas occurred or services have been rendered, (c) the seller’s price to thebuyer is fixed and determinable and (d) collectibility is reasonablyassured.  Under this provision, revenueis recognized upon delivery and acceptance of the order.

 

Contract Revenue- The Company recognizes revenues and reports profits from long-termconstruction equipment contracts, its principal business, under the completedcontract method. These contracts generally extend for periods in excess of oneyear. Contract costs are accumulated as deferred assets and billings and/orcash received are 

 

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charged to adeferred revenue account, during the periods of construction, but no revenues,costs or profits are recognized in operations until the period upon completionof the contract. Costs include direct material, direct labor, andproject-related overhead. A contract is considered complete, when all costsexcept insignificant items have been incurred, and the product or installationis operating according to specifications, or has been accepted by the customer.Corporate general and administrative expenses are charged to the periods asincurred. Provisions for estimated contract losses, if any, are made in theperiod that such losses are determined. Claims are included in revenues whenreceived and claims related to unpaid amounts recorded as accounts payable tosubcontractors are included in revenues if the dispute is resolved to thebenefit of the Company.

 

All costs associated with uncompleted purchase ordersunder contract are recorded on the balance sheet as a deferred current assetcalled “Costs in Excess of Billings on Uncompleted Contracts.”  Upon completion of purchase order, costs arethen reclassified from the balance sheet to the statement of operations ascosts of revenue.  All billingsassociated with uncompleted purchase orders under contract are recorded on thebalance sheet as a deferred current liability called “Billings in Excess ofCosts on Uncompleted Contracts”.  Uponcompletion of the purchase order, all such billings would be reclassified fromthe balance sheet to the statement of operations as revenues.  Due to the structure of the Company’scontracts, billing is not done until the purchase order is complete, thereforethere are no amounts recorded as deferred liabilities as of September 30,2008 or 2007.  Contract retentions areincluded in accounts receivable.

 

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 September 30, 2008.  Since the Company did own the retail locationas of September 30, 2007, there were no such sales or related provisionfor returns recorded for the nine months then ended.

 

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

 

**Earningsper Share—**Basic earnings (loss) per share is computed usingthe weighted-average number of common shares outstanding during the period.Diluted net income per share is computed using the weighted-average number ofcommon shares and dilutive potential common shares outstanding during theperiod. Diluted net loss per share is computed using the weighted-averagenumber of common shares and excludes dilutive potential common sharesoutstanding, as their effect is anti-dilutive. Dilutive potential common shareswould primarily consist of employee stock options and restricted common stock.

 

**IncomeTaxes—**The Company accounts for income taxes according toStatement of Financial Accounting Standard (SFAS) 109 “Accounting for IncomeTaxes” which requires an asset and liability approach to financial accountingfor income taxes. Deferred income tax assets and liabilities are computedannually for the difference between the financial statement and tax bases ofassets and liabilities that will result in taxable or deductible amounts in thefuture, based on enacted tax laws and rates applicable to the periods in whichthe differences are expected to affect taxable income. Valuation allowances areestablished when necessary to reduce deferred tax assets to the amount expectedto be realized. Income tax expense is the tax payable or refundable for theperiod, plus or minus the change during the period in deferred tax assets andliabilities.

 

The Corporationadopted the provisions of FASB Interpretation (“FIN”) No. 48, “Accountingfor Uncertainty 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 isgreater than fifty percent likely of being realized upon ultimate settlement.Tax positions that previously failed to meet the more-likely-than-notrecognition threshold should be recognized in the first subsequent financialreporting period in which that threshold is met. Previously recognized taxpositions that no longer meet the more-likely-than-not recognition thresholdshould be derecognized in the first subsequent financial reporting period inwhich that threshold is no longer met. FIN 48 also provides guidance on theaccounting for and disclosure of unrecognized tax benefits, interest andpenalties. Adoption of FIN 48 did not have a significant impact on the Company’sfinancial statements.

 

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The Company filesincome tax returns in the U.S. federal jurisdiction and various states. TheCompany has not been subject to U.S. federal income tax examinations by taxauthorities nor state authorities since its inception in 2000.

 

**FairValue of Financial Instruments—**Fair value of certain of theCompany’s financial instruments including cash and cash equivalents, accountsreceivable, accrued compensation, and other accrued liabilities approximatecost because of their short maturities.

 

**Recentaccounting pronouncements**

 

*Business Combinations*

 

In December, 2007,the Financial 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 apurchase and c) determines what information to disclose to enable users of thefinancial statements to evaluate the nature and financial effects of thebusiness combination. The scope of SFAS No. 141 (revised 2007) is broaderthan the scope of SFAS No. 141, which it replaces. The effective date ofSFAS No. 141 (revised 2007) is for all acquisitions in which theacquisition date is on or after the beginning of the first annual reportingperiod beginning on or after December 15, 2008. The adoption of thisstatement is not expected to have an immediate material effect on the Company’sconsolidated financial condition or results of operations.

 

*NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB 51*

 

In December, 2007,the FASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements — an amendment of ARB No. 51” (hereinafter “SFAS No. 160”).This statement establishes accounting and reporting standards that require a)the ownership interests in subsidiaries held by parties other than the parentbe clearly 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 is not expected to have an immediatematerial effect on the Company’s consolidated financial condition or results ofoperations.

 

*Disclosureabout Derivative Instruments and Hedging Activities*

 

In March 2008,the FASB issued SFAS No. 161, *“*Disclosureabout Derivative Instruments and Hedging Activities*,”* an amendment of FASB Statement No. 133, (SFAS 161).This statement requires that objectives for using derivative instruments bedisclosed in terms of underlying risk and accounting designation. The Companyis required to adopt SFAS 161 on January 1, 2009. The Company is currentlyevaluating the potential impact of SFAS No. 161 on the Company’sconsolidated financial statements.

 

*Determinationof the Useful Life of Intangible Assets*

 

In April 2008,the FASB issued FSP FAS 142-3, “Determination of the Useful Life of IntangibleAssets,” which amends the factors that should be considered in developingrenewal or extension assumptions used to determine the useful life ofintangible assets under FASB 142 “Goodwill and Other Intangible Assets”. The intent of this FSP is to improve the consistency between the useful life ofa recognized intangible asset under SFAS 142 and the period of the expectedcash flows used to measure the fair value of the asset under FASB 141 (revised2007) “Business Combinations” and other U.S. generally accepted accountingprinciples.  The Company is currently evaluating the potential impact ofFSP FAS 142-3 on its consolidated financial statements.

 

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*TheHierarchy of Generally Accepted Accounting Principles*

 

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy ofGenerally Accepted Accounting Principles” (FAS No.162).  SFAS No. 162 identifies the sources ofaccounting principles and the framework for selecting the principles used inthe preparation of financial statements. SFAS No. 162 is effective 60 days following the SEC’s approval ofthe Public Company Accounting Oversight Board amendments to AU Section 411,“The Meaning of Present Fairly in Conformity with Generally Accepted AccountingPrinciples”.  The implementation of thisstandard will not have a material impact on the Company’s consolidatedfinancial position and results of operations.

 

*Accounting for Convertible Debt Instruments That May Be Settled inCash upon Conversion*

*(Including Partial Cash Settlement)*

 

InMay 2008, the FASB issued FSP Accounting Principles Board (“APB”) Opinion No. 14-1,“Accounting for Convertible Debt Instruments That May Be Settled in Cashupon Conversion (Including Partial Cash Settlement).” The FSP clarifies theaccounting for convertible debt instruments that may be settled in cash(including partial cash settlement) upon conversion.  The FSP requires issuers to accountseparately for the liability and equity components of certain convertible debtinstruments in a manner that reflects the issuer’s nonconvertible debt(unsecured debt) borrowing rate when interest cost is recognized.  The FSP requires bifurcation of a componentof the debt, classification of that component in equity and the accretion ofthe resulting discount on the debt to be recognized as part of interest expensein our consolidated statement of operations. The FSP requires retrospective application to the terms of instrumentsas they existed for all periods presented. The FSP is effective for us as of January 1, 2009 and earlyadoption is not permitted.  The Companyis currently evaluating the potential impact of FSP APB 14-1 upon itsconsolidated financial statements.

 

*Determining Whether an Instrument (or an Embedded Feature) Is Indexedto an entity’s Own Stock*

 

InJune 2008, the FASB ratified EITF Issue No. 07-5, “DeterminingWhether an Instrument (or an Embedded Feature) Is Indexed to an Entity’s OwnStock” (EITF 07-5).  EITF 07-5 providesthat an entity should use a two step approach to evaluate whether anequity-linked financial instrument (or embedded feature) is indexed to its ownstock, including evaluating the instrument’s contingent exercise and settlementprovisions.  It also clarifies on theimpact of foreign currency denominated strike prices and market-based employeestock option valuation instruments on the evaluation.  EITF 07-5 is effective for fiscal yearsbeginning after December 15, 2008. The Company is currently assessing the impact of EITF 07-5 on itsconsolidated financial position and results of operations.

 

*Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities*

 

InJune 2008, the FASB issued FSP Emerging Issues Task Force (“EITF”) Issue No. 03-6-1,“Determining Whether Instruments Granted in Share-Based Payment TransactionsAre Participating Securities.” The FSP addresses whether instruments granted inshare-based payment transactions are participating securities prior to vestingand, therefore, need to be included in the earnings allocation in computingearnings per share under the two-class method. The FSP affects entities thataccrue dividends on share-based payment awards during the awards’ serviceperiod when the dividends do not need to be returned if the employees forfeitthe award. This FSP is effective for fiscal years beginning after December 15,2008. The Company is currently assessing the impact of FSP EITF 03-6-1 on itsconsolidated financial position and results of operations.

 

**2.****              COSTSIN EXCESS OF BILLINGS (BILLINGS IN EXCESS OF COSTS) ON UNCOMPLETED CONTRACTSAND CONTRACTS RECEIVABLE**

 

Costs in excess ofbillings on uncompleted contracts represent accumulated contract costs thatexceeded billings and/or cash received on uncompleted contracts at September 30,2008 and 2007.

 

For the periodspresented, the cost in excess of billings on uncompleted contracts consisted ofthe following as of September 30, 2008 and December 31, 2007:

 

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| ** **                                          | ** ** | **September 30,  2008** | ** ** | **December 31,  2007** | ** ** |
|-----------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Uncompleted contract costs                          |       | $                            | 7,629,475  |                        | $          | 5,011,974 |   |
| Billings and / or receipts on uncompleted contracts |       | —                       |       | —                      |       |
| Cost in excess of billings on uncompleted contracts |       | $                            | 7,629,475  |                        | $          | 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 collection information,and existing economic conditions. Any amounts considered recoverable under thecustomer’s surety bonds are treated as contingent gains and recognized onlywhen received.

 

Accountsreceivable throughout the year may decrease based on payments received, creditsfor change orders, or back charges incurred. At September 30, 2008 and December 31,2007, the Company had $8,508,334 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 nine months ended September 30, 2008 and2007.

 

**3.****                                      COMMITMENTSAND 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, the Company filed an amended complaint. The amended complaint names onlySouthern California Gold Products and James McAvoy as defendants and assertssix counts as follows: misappropriation of trade secrets and confidentialinformation; breach of contract; unfair competition; conversion; violation ofthe Lanham Act; and interference with prospective economic advantage. Theamended complaint seeks to enjoin the defendants from misappropriating,disclosing, or using the Company’s confidential information and trade secrets,and recall and surrender all products and trade secrets wrongfullymisappropriated or converted by the defendants. It also seeks compensatorydamages in an amount to be established at trial together with prejudgment andpost judgment interest, exemplary damages, disgorgement, restitution withinterest, attorney’s fees and the costs of suit.  Defendants filed an answer to the amendedcomplaint on April 16, 2008. Shortly after the filing ofthe amended answer, Defendants made a motion for summary judgment on, amongothers, the grounds of collateral estoppel and res judicata. The Company filedopposition to the motion.  The Defendants motion and a subsequentapplication for an immediate interlocutory appeal were denied.  Amediation settlement conference was held on October 31, 2008, which wasunsuccessful.  Responses tointerrogatories and document production is due on or about November 17,2008.

 

OnDecember 6, 2006, the Company’s former Chief Financial Officercommenced an action against the Company for breach of contract arising from histermination of employment in the Eastern District of Ohio. The matter wastransferred on defendant’s motion to the United States District Court, EasternDistrict of New York.  The Complaintsought damages in excess of $500,000 inclusive of interest.  In April 2008,the parties reached a settlement of $200,000 in this matter and the case wasdismissed on October 3, 2008.

 

OnFebruary 29, 2008, a former employee commenced an action against theCompany for breach of contract arising from his termination of employment inthe Supreme Court of the State of New York, Nassau County. The Complaint seeksdamages of approximately $87,000. The Company filed an answer to the complaintand will be commencing discovery.  Meritorious defenses to the claimsexist and the Company intends to vigorously defend this action.

 

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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. The Complaint seeks damages in excess of $3,000,000. On October 2,2008, the Company filed a response to the charges.  The Company believes the allegations to bewithout merit and intends to vigorously defend against the action.  On March 7, 2008, a second action wascommenced against the Company for breach of contract and related issues arisingfrom his termination of employment in New York State Supreme Court, NassauCounty.  On May 7 2008, the Companyserved a motion to dismiss the complaint, and in or about September 26, 2008, the Court dismissedseveral claims (tortious interference with a contract, tortious interferencewith economic opportunity, fraudulent inducement to enter into a contract andbreach of good faith and fair dealing). The remaining claims are breach of contract claims and claims seekingthe lifting of the restriction of his stock. On October 13, 2008, the former General Counsel filed an amendedcomplaint as to the remaining claims, and on November 5, 2008, the Companyfiled an answer to the complaint and filed counterclaims for fraud.  The parties are to commence documentarydiscovery, which will be followed by depositions.  Meritorious defenses to the claims exist andthe Company intends tovigorously defend this action.

 

**4.****                                      STOCKHOLDERS’EQUITY**

 

**Warrants**- As an inducement to the Company’s February 2005 private offering ofcommon stock, the Company also issued 2,778,950 warrants to purchase stock at$1.00 per share to the investors. Unexercised warrants expired on August 31, 2006. In addition,purchase warrants for up to 808,462 shares of common stock at an exercise priceof $1.00 per share (which amount and exercise price reflect anti-dilutionadjustments since the date of issuance) were issued to the placement agent insuch offering. These warrants will expire September 1, 2010.

 

The following is asummary of stock warrants outstanding at September 30, 2008 and December 31,2007.

 
| ** **                                 | ** ** | ** **   | ** ** | ** **         | ** ** | **Value if** | ** ** |
|--------------------------------------------|------------|--------------|------------|--------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **Warrants** | ** ** | **Exercise Price** | ** ** | **Exercised**     | ** ** |
| Beginning balance (December 31, 2007) |       | 808,462      |       | 1.00               |       | $                 | 808,462    |   |
| Exercised                                  |       | (34,782      | )          | 1.00               |       | (34,782           | )          |
| Ending balance (September 30, 2008)   |       | 773,680      |       | 1.00               |       | $                 | 773,680    |   |

 

In accordance withStatement of Financial Accounting Standards (SFAS) No. 123 “Accounting forStock-Based Compensation,” and SFAS No. 148 “Accounting for Stock-Based Compensation— Transition and Disclosure”, the Company accounts for the stock warrants usingthe 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 the warrants as of December 31, 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, 2007,1,645,000 stock options were granted to officers and employees of theCompany.  An additional 72,500 stockoptions were granted to employees of the Company on February 20, 2008.

 

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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 $430,472, of which $75,820 and $0 has been expensed in the Statement ofOperations as of September 30, 2008 and 2007, respectively.

 

On July 23,2008, the Company entered into an Independent Consulting Agreement whichprovided for the issuance of options to purchase 175,000 shares of the Company’scommon stock with an exercise price equal to the fair market value of a shareof the Company’s common stock on each July 31 during the term of theConsulting Agreement.  The ConsultingAgreement will be effective until July 31, 2011 unless earlier terminatedby either party.

 

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       |   | 3 Years |   |
| Expected dividends  |   | —  |   |

 

Based on theassumptions noted above, the fair market value of the options issued was valuedat approximately $63,000 over the term of the agreement, of which $0 and $0 hasbeen expensed in the Statement of Operations as of September 30, 2008 and2007, respectively

 

**Sharesissued in connection with Asset Purchase Agreement –** In January 2008,the Company 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 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 September 30, 2008, the Companyhas paid $300,000 toward the anticipated purchase price.  The remaining balance due of $100,000 underagreement has been accrued as of September 30, 2008.

 

The consideration had been allocated to assets and liabilities based internal assessments with $280,000 initially allocated to goodwill.

 

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**6.****                                     ****SERIES A CONVERTIBLE PREFERRED STOCK, INVESTORWARRANTS AND PLACEMENT WARRANTS**

 

TheCompany entered into a Securities Purchase Agreement (“Purchase Agreement”) on March 7,2008 to sell shares of its Series A Convertible Preferred Stock (“Series APreferred”) and warrants (“Investor Warrants”) to purchase shares of its commonstock, and to conditionally sell shares of the Company’s common stock, to threeinvestors. The investors have agreed to purchase an aggregate of 15,000 sharesof Series A Preferred and Investor Warrants to purchase up to 3,750,000shares of common stock, and to conditionally purchase 100,000 shares of commonstock. The aggregate purchase price for the Series A Preferred andInvestor Warrants is $15,000,000 and the aggregate purchase price for thecommon stock is $500,000.

 

Aninitial closing under the Purchase Agreement was held on March 7, 2008 inwhich an aggregate of 10,975 shares of Series A Preferred and InvestorWarrants to purchase up to 2,743,706 shares of Common Stock were issued for anaggregate purchase price of $10,975,000. After the payment of investor expensesof $60,000 and the $658,500 cash portion of the placement agent fee describedbelow, the Company received net proceeds of $10,256,500.

 

Asecond closing occurred on April 4, 2008, in which an aggregate of 4,025shares of Series A Preferred and Investor Warrants to purchase up to1,006,250 shares of Common Stock were issued for a total price of$4,025,000.  The Company received netproceeds of $3,743,250, which is net of fees paid to the placement agent andinvestor expenses of $281,750.  TheCompany agreed with the investors in the Series A Preferred that theconditional sale of the 100,000 shares of Common Stock would not beconsummated.

 

Inconnection with sale of the Series A Preferred and Investor Warrants underthe Securities Purchase Agreement described above, the Company’s placementagent for the transaction is entitled to a cash fee equal to 6.0% of the grossproceeds and warrants to purchase that number of shares of common stock equalto 6.0% of the number of shares of common stock issued in the financing. Forthe initial closing above, the placement agent received a cash payment of$658,500 (6.0% of $10,975,000) and warrants to purchase 493,872 shares ofCommon Stock (6.0% of the sum of (i) 5,487,500, the initial number ofshares of Common Stock into which the Series A Preferred issued in the March 7,2008 closing may be converted and (ii) 2,743,706, the initial number ofshares of common stock that may be purchased under the Investor Warrants issuedin the March 7, 2008 closing). At the April 4, 2008 closing, theplacement agent received an additional cash payment of $281,750 (7.0% of$4,025,000) and warrants to purchase up to 181,128 shares of Common Stock (6.0%of the sum of (1) 2,012,500, the initial number of shares of Common Stockinto which the Series A Preferred issued in the April 4, 2008 closingmay be converted and (2) 1,006,294, the initial number of shares of commonstock that may be purchased under the Investor Warrants issued in the April 4,2008 closing).

 

Series AConvertible Preferred Stock

 

Theprovisions for the Series A Preferred are as follows:

 

*Dividendson Series A Preferred*

 

The shares of Series A Preferred accrue acumulative dividend at a rate of 9% per annum of the Conversion Amount, asdefined below. Dividends on the Series A Preferred shall be cumulative,shall accrue, whether or not declared, and be payable quarterly in cash or, atthe Company’s option, payable in common stock at 10%.  As of September 30, 2008, the Companyhas recorded $800,252 in dividends, of which $401,252 has been paid and$399,000 has been accrued as of September 30, 2008.

 

*LiquidationPreference*

 

In the event of the liquidation, dissolution orwinding up of the affairs of the Company, whether voluntary or involuntary (a “Liquidation”),the holders of shares of the Series A Preferred then outstanding shall beentitled to receive an amount per Series A Preferred equal to 110% of theConversion Amount.

 

*Voting Rights*

 

Holder’s of Series A Preferred are entitledto vote on an “as if” converted basis and vote with the common stockholders asrequired.  Voting rights are subject tothe maximum ownership percentage of 9.99%.

 

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*Holder’sRight to Convert*

 

At any time the holder of anysuch shares of Series A Preferred may, at such holder’s option, elect toconvert 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.

 

*Redemptionat Option of Holders*

 

Triggering Event – Upon theoccurrence of a Triggering Event, each Holder may, at such Holder’s option, subjectto the Limitation on Damages, require the Company to redeem all or a portion ofsuch Holder’s Series A Stock shares at a price per Preferred Share equalto the greater of (i) 110% of the Conversion Amount (or, in the case ofthe Triggering Events set forth in Sections 3(a)(v) and 3(a)(vi), 100% ofthe Conversion Amount) and (ii) the product of (A) the ConversionRate in effect at such time and (B) the Closing Sale Price of the Company’scommon stock on the trading day immediately preceding such Triggering Event(the “Triggering Event Redemption Price”).

 

Failure to Satisfy EquityCondition - 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 in case at a price equal to100% of the Conversion Amount.

 

*Redemption by Company*

 

Mandatory redemption – If any Series APreferred shares remain outstanding on the Maturity Date, which is December 31,2010, the Company shall redeem all such Series A Preferred shares on theMaturity Date for an amount in cash per Preferred Share equal to the ConversionAmount.

 

Optional redemption – At anytime on or after the (i) 2nd anniversary of the Public CompanyDate (the date on which the Company’s securities are initially registered underthe Exchange Act), (A) the median price of the Weighted Average Price ofthe Company’s common stock over any consecutive 30 Trading Day period isgreater than $3.00 per share, (B) the median trading volume for suchperiod is greater than 75,000 shares and (C) there shall not have been anyEquity Conditions Failure or (ii) 6-month anniversary of a QualifiedPublic Offering and there shall not have been any Equity Conditions Failure,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 Company accounted for thetransaction in accordance with SFAS 150 “Accounting for Certain FinancialInstrument with Characteristics of both 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 the issuer.The mandatory redemption provision incorporated into the Series APreferred causes the stock to fall within the scope of SFAS 150 since theCompany must redeem the stock by December 31, 2010 by transferring cash tothe Holders.

 

The proceeds from the issuanceof the Series A Preferred and accompanying common stock warrants, net ofdirect costs including the fair value of warrants issued to the placement agentin connection with the transaction, must be allocated to the instruments basedupon relative fair value upon issuance. In addition, under SFAS 150, paragraph 

 

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20, “mandatorily redeemableinstruments must be measured initially at fair value”. Therefore, after theinitial recording of the Series A Preferred based upon net proceedsreceived, the carrying value of the Series A Preferred must be adjusted tothe fair value at the date of issuance, with the difference recorded as a loss.The initial valuation of the Series A Preferred is as follows:

 
| **Security**            | ** ** | **Face Value** | ** ** | **Fair Value** | ** ** | **Allocation of  proceeds** | ** ** | **Proceeds in excess of  fair value** | ** ** |
|-------------------------|------------|---------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------------------------------|------------|
| Series A Preferred |       | $                   | 15,000,000 |                | $          | 12,444,850                       |       | $                                                         | 13,459,474 |   | $ | 1,014,624 |   |
| Warrants                |       | —              |       | 213,603             |       | 1,540,526                        |       | 1,326,923                                                 |       |
|                    |       |                |       |                |       |                             |       |                                                      |       |
|                    |       | $                   | 15,000,000 |                | $          | 12,658,453                       |       | $                                                         | 15,000,000 |   | $ | 2,341,547 |   |

 

The Series A Preferred hasbeen included as a noncurrent liability until December 31, 2009, at whichtime it will be included as a current liability.

 

For the three months ended September 30,2008, the Company has recorded a net gain on adjustment of fair value of their Series APreferred of $126,228. The total net gain on adjustment as of September 30,2008 is $1,176,494.

 

Investor Warrants

 

In connection with the closings under the PurchaseAgreement, Investor Warrants to purchase up to 3,750,000 shares of Common Stockat $2.40 per share were issued in addition to the 15,000 shares of Series APreferred.

 

The terms of the investor warrants provide thefollowing:

 

(a)                                 Exercise price of $2.40 per share. If notlisted on an eligible market on or before May 30, 2008, the exercise priceshall be reduced $.10 and shall be further decreased by $.04 on each 30thday thereafter until such listing occurs, subject to a maximum of $.24.

(b)                                The investor warrants are immediately exercisable upon issuance throughthe date that is 36 months after the Public Company date.

(c)                                 A cashless exercise is available at theoption of the Holders as of the Public Company date.

(d)                                In the event of a Fundamental Transaction, the Holders may request thatthe Company repurchase the Warrant from the Holders by paying a cash amountequal to the Black-Scholes Value of the remaining unexercised portion on thedate of the Fundamental Transaction. Fundamental Transactions are definedwithin the terms of the Investor Warrant Agreement.

(e)                                 The Company, at its option, has the right torequire that the Holder exercise all or a portion of their Investor Warrantsunder terms that are defined within the Investor Warrant Agreement.

 

The Investor Warrants were accounted for as follows:

 

**(a)****        **The warrants meet the criteria under SFAS 133“Accounting for Derivative Instruments and Hedging Activities”. Under SFAS 133,the warrants are recorded at fair value upon the date of issuance, with changesin the value fair value recognized as a gain or loss as they occur. At theinitial date of issuance, the Company recorded a derivative liability of$1,142,503, which represents the fair value of the Investor Warrants and a losson Investor Warrants of $146,510. Upon the second closing, the Company recordeda derivative liability of an additional $398,023 and a loss on InvestorWarrants of $51,836. This liability was subsequently adjusted to fair value asof September 30, 2008 and a corresponding fair value adjustment of$1,302,722 reduced the derivative liability. The total net gain on InvestorWarrants as of September 30, 2008 was $1,365,844.

 

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(b)        The warrants meet the criteria under EITF 01-6 “The Meaning of Indexedto a Company’s Own Stock”, which provides guidance as to whether a contract isindexed to a Company’s own stock. However, since the warrants do not meet thecriteria for reporting as an equity instruments under EITF 00-19 “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”, the fair value of the Investor Warrants is included as anoncurrent liability.

 

In valuing the Investor Warrantsassociated with the Series A Preferred Stock the Company used theBlack-Scholes option pricing model with the following range of assumptions:

 
| ** **          | ** ** | **March 7, 2008** | ** ** | **April 4, 2008** | ** ** |
|---------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Expected Life       |       | 3.10 Years                  |       | 2.78 Years                  |       |
| Risk-Free Rate      |       | 2.13%                       |       | 2.85%                       |       |
| Expected Volatility |       | 40%                         |       | 40%                         |       |
| Dividend Rate       |       | 0%                          |       | 0%                          |       |

 

The resulting values per warrantfor the March 7, 2008 and the April 4, 2008 issuances were $.47 and$.07, respectively. The resulting fair value associated with the 3,750,000Investor Warrants as of September 30, 2008 was $213,603.

 

Placement Agent Warrants

 

The placement agent with respect to the sale of the Series APreferred and Investor Warrants was entitled to receive warrants (PlacementAgent Warrants) to purchase a total of 6% of the number of common stock issuedin the financing or 675,000 shares. The Placement Agent Warrants were accountedfor as a transaction cost associated with the issuance of the Series APreferred. The Placement Agent Warrants were recorded at fair value at the dateof issuance. Under EITF 00-19 “Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock”, the Companysatisfies the criteria for classification of the Placement Agent Warrants asequity. The Company has recorded the corresponding amount recorded as aDeferred Financing Cost. Since the Series A Preferred and InvestorWarrants are classified as liabilities, the carrying value of the PlacementAgent Warrants has been recorded as an other asset and is amortized asadditional financing costs over the term of the Series A Preferred usingthe interest method. At the date of each issuance, the Company recorded$1,033,433 and $418,559 in deferred financing costs and amortized $292,631 asinterest expense as of September 30, 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:

 
| ** **          | ** ** | **March 7, 2008** | ** ** | **April 4, 2008** | ** ** |
|---------------------|------------|-----------------------------|------------|-----------------------------|------------|
| Expected Life       |       | 4 Years                     |       | 4 Years                     |       |
| Risk-Free Rate      |       | 2.45%                       |       | 2.31%                       |       |
| Expected Volatility |       | 45%                         |       | 45%                         |       |
| Dividend Rate       |       | 0%                          |       | 0%                          |       |

 

The resulting value per warrantfor both issuances was approximately $.76. The fair value associated with the675,000 Placement Agent Warrants was $511,742.

 

**7.             COMMITMENTSAND CONTINGENCIES**

 

On May 23, 2008, the Company agreed to seek stockholder approval priorto the issuance of more than an aggregate of 7,858,358 shares of common stockupon the conversion of, and as stock dividends on, the Series A Preferred Stockand upon the exercise of the Investor Warrants.   If stockholder approval is not obtained, theCompany may be in a position whereby the Equity Conditions are not met.  In such event, the Company will continue tobe required to pay dividends on the Series A Preferred Stock in cash ratherthan having the option to pay in common stock or cash, will be unable to causethe redemption of the Series A Preferred Stock at the Company’s discretion(subject to condition) and the Series A Holders may be able to exercise theirright to cause the Company to redeem the shares of Series A Preferred Stock.  The requirement to pay substantial amountsfor cash dividends or upon an unscheduled redemption could adversely affect theCompany’s financial position.

 

**8.****           ****SUBSEQUENT EVENTS**

 

During October 2008, the Company has granted 100,000 stock optionsto officers of the Company.

 

**Item 2.****  ****Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*The following discussion and analysis of our financial condition andresults of operations should be read in conjunction with our consolidatedfinancial statements and related notes that appear elsewhere in this report andin our registration statement on Form 10 (SEC No. 0-53092) filed withthe SEC on April 22, 2008.*

 

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*Except for statements of historical fact, certain information describedin this report contains “forward-looking statements” that involve substantialrisks and uncertainties. You can identify these statements by forward-lookingwords such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,”“may,” “should,” “will,” “would” or similar words. The statements that containthese or similar words should be read carefully because these statementsdiscuss our future expectations, contain projections of our future results ofoperations 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,  describesuch risks, uncertainties and events that may cause our actual results andachievements, whether expressed or implied, to differ materially from theexpectations we describe in our forward-looking statements. The occurrence ofany of the events described as risk factors could have a material adverseeffect on our business, results of operations and financial position.*

 

**Overview**

 

We are aprovider of customized transparent and opaque armor solutions for tactical andnon-tactical transport vehicles and construction equipment used by themilitary. We focus primarily on research and development, design andengineering, fabrication and providing component integration. Our armorsolutions are used in retrofit applications for equipment already in service,and we work with original equipment manufacturers to provide armor solutionsfor new equipment purchased by the military.

 

We also sellphysical security products consisting primarily of vehicle anti-ram barrierssuch as bollards, steel gates and steel wedges that deploy out of the ground. In addition, we sell tactical products such as body armor, nylonholsters, vests and packs, weapons, ammunition, weapons parts and accessoriesthrough a retail outlet.

 

In May 2008,we launched our new live-fire interactive T2 Tactical Training System and havebegun active marketing of the system.  T2 provides law enforcementofficers, SWAT team members, tactical specialists and military operators withthe opportunity to hone their firearms and combat skills, with their ownweapons and ammunition, in conjunction with realistic video scenarios broadcaston a large screen, incorporating environmental factors such as heat, cold,sound and light effects.  In addition to installation fees for T2 systems,we anticipate additional revenue opportunities for service and support of T2facilities once installed.

 

Ourtechnical expertise is in the development of lightweight composite ballistic,blast and bullet mitigating materials used to fortify and enhance capabilitiesof existing and in-service equipment and structures. We serve primarily thedefense market and our sale are highly concentrated within the U.S. government.Our customers include various branches of the U.S. military through the U.S. Departmentof Defense (or DoD) and to a much lesser extent other government, lawenforcement and correctional agencies as well as private sector customers.

 

We haveexperienced significant growth, with revenues of $4.8 million, $25.3 millionand $36.5 million in 2005, 2006 and 2007, respectively, and $32 million for thenine months ended September 30, 2008. The principal factor contributing toour recent growth has been increased demand by the U.S. military forlightweight ballistic and blast resistant transparent and opaque armor thatprotects soldiers, sailors and marines.

 

Our recenthistorical revenues have been generated primarily from three large contracts.To continue expanding our business, we are seeking to broaden our customer baseand to diversify our product and service offerings. Our strategy to increaseour revenue, grow our company and increase stockholder value involves thefollowing key elements:

 

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

 

·form strategic partnerships with original equipment manufacturers (OEMs);

 

·develop strategic alliances;

 

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·capitalize on increased homeland security requirements and non-militaryplatforms; and

 

·focus on an advanced research and development program to capitalize onincreased demand for new armor materials.

 

We arepursuing each of these growth strategies simultaneously, and expect one or moreof them to result in additional revenue opportunities within the next 12 months.Please see “Business—Our Growth Strategy” in our Form 10 filed April 22,2008 for additional information.

 

**Sources of Revenues**

 

We deriveour revenues by fulfilling orders under master contracts awarded by branches ofthe United States military, law enforcement and corrections agencies andprivate companies involved in the defense market. Under these contracts, weprovide customized transparent and opaque armor products for transport andconstruction vehicles used by the military, group protection kits and spareparts.  We also derive revenues from sales of our physical securityproducts and retail sales of our tactical products.

 

Our contractbacklog as of September 30, 2008 and 2007 was $55 million and $42 million,respectively.  Of our $55 million contract backlog at September 30,2008, we estimate that $10 million, $35 million and $10 million will be filledduring 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 critical infrastructureand public safety protection markets, and successfully further develop ourrelationships with OEM’s and strategic partners. Notwithstanding the possiblesignificant troop reductions in Afghanistan and Iraq, we expect that demand inthose countries for armored military construction vehicles will continue inorder to repair significant war damage and for nation-building purposes. Inaddition, we are exploring interest in armored construction equipment in othercountries with mine-infested regions.

 

We continueto aggressively 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. While no assurances can be giventhat we will obtain a sufficient number of contracts or that any contracts wedo obtain will be of significant value or duration, we are confident that wewill continue to have the opportunity to bid and win contracts as we have in2006 and 2007. 

 

We currently have a contract with JCB ConstructionEquipment (JCB) to provide our armored crew protection kits, or CPKs.  JCB has announced plans to produceapproximately 800 high-mobility engineer excavators, or HMEEs, for the U.S.Army.  Although we have not received anyCPK purchase orders under our contract with JCB for their planned HMEE sales tothe U.S. Army, we expect to receive over $10 million of such orders during atwo year period beginning in early 2009. However, there can be no assurance that we will obtain a sufficientnumber of CPK orders under our JCB contract, if any at all, to generate theanticipated more than $10 million in revenue or that such orders will be placedduring the expected two year period. Accordingly, our revenues under the JCB contract could be significantlyless than $10 million and may not be realized during such two year period.

 

**Cost of Revenues and Operating Expenses**

 

*Cost of Revenues.* Cost of revenues consists ofparts, direct labor and overhead expense incurred for the fulfillment of ordersunder contract. These costs are charged to expense upon completion andacceptance of an order. Costs of revenue also includes the costs of protypingand engineering, which are expensed upon completion of an order as well. Thesecosts are included as costs of revenue because they are incurred to modifyproducts based upon government specifications and are reimbursable costs withinthe 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.

 

*Sales and Marketing.* Expenses related to sales and marketing consist primarilyof compensation for our sales and marketing personnel, sales commissions andincentives, trade shows and related travel.

 

As ourrevenues increase, we plan to continue to invest heavily in sales and marketingby increasing the number of direct sales personnel in order to add newcustomers and increase sales to our existing customers. We also plan to expandour marketing activities in order to build brand awareness and generateadditional leads for our growing sales personnel.

 

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*Research and Development.* Research and development expenses are incurred as weperform ongoing evaluations of materials and processes for existing products,as well as the development of new products and processes. Such expensestypically include compensation and employee benefits of engineering and testingpersonnel, materials, travel and costs associated with design and requiredtesting procedures associated with our product line. We expect that in theremainder of 2008, research and development expenses will increase **[**in absolute dollars as we upgrade and extend our serviceofferings and develop new protections products, but will remain relativelyconsistent or decrease slightly as a percentage of revenues. Research anddevelopment costs are charged to expense as incurred.

 

*General and Administrative.* General and administrative expenses consist of executive,finance, accounting, administrative, legal, professional fees, other corporateexpenses and allocated overhead. We expect that in the remainder of 2008,general and administrative expenses will remain consistent in absolute dollars.General and administrative salaries expense consist of compensation and relatedexpenses for executive, finance, accounting and administrative salaries andrelated payroll taxes. We expect that in the remainder of 2008, general andadministrative salaries expense will remain consistent or decrease slightly inabsolute dollars.

 

**Critical Accounting Policies**

 

Ourconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States. The preparation of theseconsolidated financial statements requires us to make estimates and assumptionsthat affect the reported amounts of assets, liabilities, revenues, costs andexpenses and related disclosures. On an ongoing basis, we evaluate ourestimates and assumptions. Our actual results may differ from these estimatesunder different assumptions or conditions.

 

We believethat of our significant accounting policies, which are described in Note 1 tothe consolidated financial statements, the following accounting policiesinvolve a greater degree of judgment and complexity. Accordingly, these are thepolicies we believe are the most critical to aid in fully understanding andevaluating our consolidated financial condition and results of operations.

 

*Revenue and Cost Recognition.* We recognize revenue in accordance with the provisions ofthe Securities 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 and, the installation or product is operatingaccording to specification or the shipment has been accepted by the customer.Provisions for estimated contract losses are made in the period that suchlosses are determined. As of September 30, 2008 and December 31,2007, there were no such provisions made.

 

All costsassociated with uncompleted purchase orders under contract are recorded on thebalance sheet as a deferred asset called “Costs in Excess of Billings onUncompleted Contracts.” Upon completion of a purchase order, such associatedcosts are then reclassified from the balance sheet to the statement ofoperations as costs of revenue.

 

All billingsassociated with uncompleted purchase orders under contract are recorded on thebalance sheet 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 September 30, 2008 or December 31,2007.

 

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*Stock-Based Compensation.* Stock based compensation consists of stock issued toemployees, directors and contractors for services rendered. We accounted forthe stock issued using the estimated current market price per share at the dateof issuance. Such cost was recorded as compensation in our statement ofoperations at the date of issuance.

 

In December 2007,we adopted our 2007 Incentive Compensation Plan pursuant to which we haveissued and intend to issue stock-based compensation from time to time, in theform of stock, stock options and other equity based awards. Our policy foraccounting for such compensation in the form of stock options is as follows:

 

We haveadopted the provisions 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 wehave only recently become a public entity, we will have a limited tradinghistory. The expected term of an award is based on the “simplified” methodallowed by SAB No. 107, whereby the expected term is equal to the midpointbetween the vesting date and the end of the contractual term of the award. Therisk-free interest rate will be based on the rate on U.S. Treasury zero couponissues with maturities consistent with the estimated expected term of theawards. We have not paid and do not anticipate paying a dividend on our commonstock in the foreseeable future and accordingly, use an expected dividend yieldof zero. Changes in these assumptions can affect the estimated fair value ofoptions granted and the related compensation expense which may significantlyimpact our results of operations in future periods.

 

Stock-basedcompensation expense recognized will be based on the estimated portion of theawards that are expected to vest. We will apply estimated forfeiture ratesbased on analyses of historical data, including termination patterns and otherfactors.

 

Werecognized $75,280 and $6,800 in stock compensation expense as of September 30,2008 and December 31, 2007, respectively.

 

**Series A Convertible Preferred Stock, Investor Warrants andPlacement Agent Warrants**

 

*Series A Preferred Stock*. We accounted for our Series A Convertible Preferred Stock (or Series APreferred) in accordance with SFAS 150 “Accounting for Certain FinancialInstrument with Characteristics of both 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 redemption provision incorporated into the Series APreferred causes the stock to fall 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 proceedsfrom the issuance of the Series A Preferred and accompanying common stockwarrants, net of direct costs including the fair value of warrants issued tothe Placement Agent in connection with the transaction, must be allocated tothe instruments based upon relative fair value upon issuance.  Inaddition, under SFAS 150, paragraph 20, “mandatorily redeemable instrumentsmust be measured initially at fair value”.   Therefore, after theinitial recording of the Series A Preferred based upon net proceedsreceived, the carrying value of the Series A Preferred must be adjusted tothe fair value at the date of issuance, with the difference recorded as a gainor loss. On March 7, 2007, the date of initial issuance, we recorded a derivativeliability of $9,832,497. On April 4, the date of the second issuance, werecorded a derivative liability of $3,626,977. These liabilities weresubsequently adjusted to fair value as of September 30, 2008, which resulted ina net gain of $1,302,722. As of September 30, 2008, the Series A Preferredliability was $12,444,850.

 

*Investor Warrants.*  The warrants issued with the Series A Preferred(or Investor Warrants) meet the criteria under SFAS 133 “Accounting forDerivative Instruments and Hedging Activities”.  Under SFAS 133, thewarrants are recorded at fair value upon the date of issuance, with changes inthe value fair value recognized as a gain or loss as they occur.  On March 7,2007, the date of initial issuance, we recorded a derivative liability of$1,142,503.  On April 4, 2008, the date of the second issuance, werecorded a derivative liability of $398,023.  These liabilities were

 

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subsequently adjusted to fairvalue as of September 30, 2008, which resulted in a net gain of $1,365,844. As of September 30, 2008, the Investor Warrant liability was $213,603.

 

The InvestorWarrants meet the criteria under EITF 01-6 “The Meaning of Indexed to a Company’sOwn Stock”, which provides guidance as to whether a contract is indexed to acompany’s own stock.    However, since the warrants do not meetthe criteria for reporting as an equity instruments under EITF 00-19 “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”, the fair value of the Investor Warrants is included as anoncurrent liability.

 

*Placement Agent Warrants.*  The warrants issued to the Placement Agent withrespect to the sale of the Series A Preferred and Investor Warrants (orPlacement Agent Warrants) were accounted for as a transaction cost associatedwith the issuance of the Series A Preferred.  The Placement AgentWarrants are recorded at fair value at the date of issuance.  Under EITF00-19 “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”, we satisfy the criteria forclassification of the Placement Agent Warrants as equity.   We haverecorded the corresponding amount recorded as a Deferred Financing Cost. Since the Series A Preferred and Investor Warrants are classified asliabilities, the carrying value of the Placement Agent Warrants has beenrecorded as an other asset and is amortized as additional financing costs overthe term of the Series A Preferred using the interest method.  At thedate of each issuance, we recorded $1,033,433 and $418,559 in deferredfinancing costs and amortized $288,098 as interest expense as of September 30,2008.

 

***Comparison of the Three Months Ended September 30, 2008 versus September 30,2007***

 

*Revenues.*  Revenues for the three months ended September 30,2008 were approximately $13.5 million, an increase of approximately $5.9million, or 79%, over revenues of approximately $7.5 million in the comparableperiod in 2007.  This increase was due primarily to higher volume ofcontracts completed under the Marine Corp. sole source contract (no.M6785407D5023) of approximately $4.0 million. In addition, the Companygenerated revenues of approximately $1 million in billings for its FieldService Representatives (FSRS) under the Marine Corp. contract and Tacom Multicontract (no. W56HZV05-D-0382) . The Company also generated approximately$500,000 under the JCB Hemi contract and an additional $400,000 from its retailapplication outlet and physical security product business. The Company did notgenerate revenue from these sources during the three months ended September 30,2007.

 

*Cost ofRevenues.* Costof revenues for the three months ended September 30, 2008 and September 30,2007 were approximately $9.1 million and $4.6 million, respectively.   As a percentage of revenue, the cost ofrevenue was 67% for the three months ended September 30, 2008 versus 61%for the three months ended September 30, 2007. This increase was dueprimarily to additional costs of sales included from the tactical applicationretail outlet and physical security product business, both of which were not inexistence in 2007. In addition, the increase was related to increasedproduction costs under the Marine Corp. sales contract mentioned above.

 

*Grossprofit margin*.  The gross profit margin for the three months ended September 30, 2008 and September 30,2007 was approximately $4.4 million and $2.9 million, respectively.  Thegross profit margin percentage was 33% and 39% for the three months ended September 30,2008 and September 30, 2007, respectively.  The decrease in the grossprofit margin percentage was due to higher production costs associated with theMarine Corp. sales contract and lower gross profit margins associated with ourtactical application retail outlet and physical security product business.  The decrease in gross profit margins was alsothe result of  the Company completed workunder its Navy Seabees contract (no. N6247307C4055) whereby the costs wereconsiderably higher than anticipated, which resulted in a very low gross margin.During the nine months ended September 30, 2007, the Company had receivedprice adjustments which resulted in additional revenue with no additional cost.No such price adjustments were given to the Company for the nine months ended September 30,2008.

 

*Sales andMarketing Expenses.*  Salesand marketing expenses for the three months ended September 30, 2008 and September 30,2007 were approximately $688,000 and $381,000, respectively, representing anincrease of $307,000, or 81%.  During 2008, the Company expanded its salesand marketing department from 7 employees as of September 30, 2007 to 15employees as of September 30, 2008. This increase in personnel resulted inapproximately $300,000 in additional salaries and employee benefit expense.

 

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*Researchand Development Expenses.*  Research and development expenses for the three monthsended September 30, 2008 and September 30, 2007 were approximately$170,000 and $183,000, respectively.  The decrease of $13,000 or 7% from2007 to 2008 was the result result of additional expenses incurred as of September 30,2007 for product testing and research that were not incurred as of September 30,2008.

 

*Generaland Administrative Expenses.*  General and administrative expenses for the three monthsended September 30, 2008 and September 30, 2007 were approximately$2.0 million and $1.0 million, respectively.  The increase of $1.0million, or 100%, was due to increases in general and liability insurance, rentand general supplies, which approximated $200,000.  We also incurredadditional general and administrative expenses associated with the facilitiesfor our tactical application retail outlet and our physical security productbusiness of approximately $100,000.  We also incurred expenses associatedwith the Company’s public status, including board of director fees andincreased accounting and legal fees of approximately $300,000.  In addition, the Company incurred expensesassociated with Safe Harbor Matching contributions that were required to bepaid  under its profit sharing plan andconsulting fees of approximately $250,000. The Company also incurred additional travel expenses associated withroad shows and potential acquisitions of approximately $150,000 that were notincurred in the prior year.  While theCompany will continue to incur such travel expenses in the future, they areexpected to be reduced due to less planned road shows and additional costsaving measures implemented currently.

 

 *Generaland Administrative Salaries Expense .*  General andadministrative salaries expense for the three months ended September 30,2008 and September 30, 2007 were approximately $967,000 and $886,000,respectively.  The increase of $81,000, or 9%, was primarily due to theincrease in personnel associated with our expansion and our acquisition of ourtactical application retail outlet and our physical security productbusiness.  As of September 30, 2008,there were 41 employees that were classified as general and administrativepersonnel, versus 27 employees as of September 30, 2007.

 

*Depreciationexpense.* Depreciation expense was approximately $266,000 and $103,000 for the threemonths ended September 30, 2008 and September 30, 2007,respectively.  The increase of $163,000, or 158%, was the result of ourincreased capital expenditures during 2008. We experienced an increase of approximately $140,000 in depreciationexpense associated with the expansion of the building  located in Hicksville and an increase ofapproximately $23,000 related to  theacquisition of property and equipment for our tactical application retailoutlet and our physical security product business.  No such property or equipment was acquiredduring the three months ended September 30, 2007.

 

*Other income and (expense).*  We experienced a gain on adjustment offair value with respect to our Series A Convertible Preferred Stock, whichwas classified as a liability, of approximately $126,000 and a gain on the relatedinvestor warrants of approximately $52,000 for the three months ended September 30,2008.  These securities were not outstanding during the three months endedSeptember 30, 2007 and accordingly there was no such gain or lossrecorded.   As a result of our agreement to sell our Series AConvertible Preferred Stock and warrants to purchase common stock, we incurredgains which occurred upon the valuation of the stock.  Such valuation tookinto account the features, rights and obligations of the convertible preferredstock, which ultimately resulted in a lower fair value than the proceedsreceived.   Since the Series A Convertible Preferred Stock andrelated Investor Warrants are required to be recorded at fair value, werecorded a gain on such securities.   Interest expense for the three months ended September 30, 2008 and September 30,2007 was $(273,000) versus $(44,000). The increase of $229,000 or 520% for the three months ended September 30,2008 was the result of interest expense associated with the amortization of thedeferred financing costs and related discounts on the Series A preferredstock of approximately $270,000.

 

***Comparison of the nine Months Ended September 30,2008 versus September 30, 2007***

 

*Revenues.*  Revenues for the nine months ended September 30,2008 was approximately $32 million, an increase of approximately $8 million, or33%, over revenues of approximately $24.1 million in the comparable period in2007.  This increase was due primarily to a higher volume of orderscompleted under the Marine Corp. contract for the nine months ended 2008 versus2007.   The Company also generatedapproximately $3.5 million from its JCB Hemi contract during 2008.   In addition, the Company recordedapproximately $1 million dollars in 

 

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sales relating to the tactical application retail outlet and physicalsecurity product business for the nine months ended September 30,2008.  No such revenue was recorded forthe nine months ended September 30, 2007.

 

*Cost ofRevenues.* Costof revenues for the nine months ended September 30, 2008 and September 30,2007 was approximately $20.9 million and $14.2 million, respectively.  This resulted in an increase of approximately$6.7 million or 47%.  This increase wasdue to additional costs of revenue associated with the tactical applicationretail outlet and physical security product business, both of which were not inexistence in 2007.  In addition, theincrease was related to our increased production costs under the Marine Corp.sales contract mentioned above.  Cost of sales for the nine months ended September 30,2007 also included costs related to orders filled for spare parts, which have amuch lower cost.

 

*Grossprofit margin*.  The gross profit margin for the nine months ended September 30, 2008 and September 30,2007 was approximately $11.2 million and $9.9 million, respectively.  Thegross profit margin percentage was 35% and 41% for the nine months ended September 30,2008 and September 30, 2007, respectively.  The decrease in grossprofit 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    Gross profitmargin for the nine months ended September 30, 2007 also include salesrelated to orders filled for spare parts, which have higher gross profitmargins.

 

*Sales and Marketing Expenses.*  Salesand marketing expenses for the nine months ended September 30, 2008 and September 30,2007 were approximately $2 million and $1.7 million, respectively, representingan increase of $300,000, or 18%.  The Company has increased its sales andmarketing department from 7 employees as of September 30, 2007 to 15employees as of September 30, 2008.  This increase in personnel resulted in approximately $300,000 inadditional salaries and employee benefits expense for the nine months ended September 30,2008.

 

*Researchand Development Expenses.*  Research and development expenses for the nine months endedSeptember 30, 2008 and September 30, 2007 were approximately $540,000and $419,000, respectively.  The increase of $121,000 or 29% from 2007 to2008 was the result of additional testing and improvements of existingproducts, such as helmets and vests.

 

*Generaland Administrative Expenses.*  General and administrative expenses for the nine months endedSeptember 30, 2008 and September 30, 2007 were approximately $4.6million and $2.8 million, respectively.  The increase of $1,800,000, or64%, was due primarily to expansion expenses incurred during the nine monthsended September 30, 2008, mainly during the first three months of2008.  Due to our expansion, we alsoincurred increases in general and liability insurance, rent and generalsupplies, which approximated $800,000.  We also incurred additional generaland administrative expenses associated with the facilities for our tacticalapplication retail outlet and our physical security product business ofapproximately $600,000.  We also incurred significant legal, merger andacquisition, and accounting costs associated with the registration of our commonstock with the SEC under the Securities Exchange Act of 1934 and our assetacquisition during the first quarter of 2008, which were approximately$200,000.

 

 *Generaland Administrative Salaries Expense.*  General andadministrative salaries expense for the nine months ended September 30,2008 and September 30, 2007 were approximately $3.2 million and $2.2million, respectively.  The increase of $1,000,000 or 45% was due to theincrease in personnel associated with our expansion and our acquisition of ourtactical application retail outlet and our physical security productbusiness.  As of September 30, 2008,there were 41 employees that were classified as general and administrativepersonnel, versus 27 employees as of September 30, 2007.

 

*Depreciationexpense.* Depreciation expense was approximately $549,000 and $278,000 for the ninemonths ended September 30, 2008 and September 30, 2007,respectively.  The increase of $271,000, or 97%, was the result theexpansion of the building in Hicksville during 2008, which resulted in higherdepreciation expense of approximately $221,000.  For the nine months endedSeptember 30, 2008, we acquired additional property and equipmentassociated with our tactical application retail outlet and our physicalsecurity product business and, as a result, incurred higher depreciation costsof approximately $50,000.  No suchproperty or equipment was acquired as 

 

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of September 30, 2007.

 

*Other income and (expense).*  We experienced a gain on adjustment offair value with respect to our Series A Convertible Preferred Stock, whichwas classified as a liability, of approximately $1.3 million and a gain on therelated investor warrants of approximately $1.4 million for the nine monthsended September 30, 2008.  These securities were not outstanding asof September 30, 2007 and accordingly there was no such gain or lossrecorded for the nine months then ended.   As a result of ouragreement to sell our Series A Convertible Preferred Stock and warrants topurchase common stock, we incurred gains which occurred upon the valuation ofthe stock.  Such valuation took into account the features, rights andobligations of the convertible preferred stock, which ultimately resulted in alower fair value than the proceeds received.   Since the Series AConvertible Preferred Stock and related Investor Warrants are required to berecorded at fair value, we recorded a gain on such securities.    Interest expense for the nine months ended September 30,2008 and September 30, 2007 was $583,000 versus $47,000.  The increase of $536,000 or 114% for the ninemonths ended September 30, 2008 was the result of interest expenseassociated with the amortization of the deferred financing costs and relateddiscounts on the Series A preferred stock of approximately $(580,000).

 

**Liquidity and Capital Resources**

 

As September 30, 2008, our principal sources of liquidity werecash and cash equivalents totaling approximately $3.66 million, net accountsreceivable of approximately $8.5 million and costs in excess of billings ofapproximately $7.6 million.  The primary sources of our liquidity during2008 have come from operations and proceeds received from the sale of ourshares of Series A Convertible Preferred Stock to purchase our commonstock.

 

On March 7, 2008, we entered into an agreement to sell shares ofour Series A Convertible Preferred Stock and warrants to purchase our commonstock, and to conditionally sell shares of our common stock, to threeinvestors. The aggregate purchase price of the preferred stock and warrants was$15.0 million and the aggregate purchase price of the common stock was tobe $0.5 million.  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 second closing took place on April 4, 2008 inwhich we received gross proceeds of $4,025,000.

 

In May 2007, we entered into a loanagreement with Commerce Bank, N.A. pursuant to which we have access to a $12.0million revolving credit facility, and had access to a term loan of up to $3.0million through October 2007.  As of the end of September 30,2008, approximately $130,000 was outstanding under the term loan.   Therewere no other draws upon the term loan.  The credit facility is secured byall of our assets, and bears interest at a variable rate equal to LIBOR plus amargin of between 1.75% and 2.45%.  We have not yet drawn on any fundsavailable under the revolving credit facility. The Company and investors determined not to consummate the conditionalsale of the common stock.

 

As of September 30, 2007, our principalsources of liquidity were cash and cash equivalents totaling approximately$2.0 million, net accounts receivable of approximately $5.3 millionand costs in excess of billings of approximately $4.2 million.  Theprimary source of our liquidity and capital resources has come from operations.

 

We believe that our current cash, cash equivalents and short-terminvestments together with our expected cash flows from operations will besufficient to meet our anticipated cash requirements for working capital andcapital expenditures for at least the next 12 months.

 

It is possible, however, that implementationof our growth strategy could result in additional business requiring us toexpand our operations.  In particular, as a result of on-going discussionsto enter into relationships with original equipment manufacturers of tacticalwheeled vehicles and construction and material handling equipment, we expect toengage in additional vehicle prototype work during the third quarter of 2008that could lead to significant manufacturing opportunities for us commencing towardsthe end of 2008 and the first half of 2009.  If such prototype work isobtained and the manufacturing opportunities realized, we believe we would needadditional operating facilities, 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 

 

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alternatives to plan for this possibility.  There can be noassurances that any outside funding will be available to us or, if available,on reasonably acceptable terms.

 

*Cash Flowsfrom Operating Activities.*Net cash used in operating activities was approximately $(9.2) millionfor the nine months ended September 30, 2008 compared to netcash used in operating activities of approximately $(2.4) million as of September 30,2007.  Net cash used in operating activities in 2008 consisted primarilyof  changes in our operating assets and liabilities of approximately$(9.6) million, including changes in accounts receivable, cost in excess ofbilling, prepaid expense, accounts payable and accrued liabilities.  Thechanges in accounts receivable and costs in excess of billing of $(1.8) millionand $(2.6) million, respectively, reflects the increased payments received fromour customers and increases in projects in process as of September 30,2008.   Our prepaid expenses increased to approximately $(2.6)million due to amounts paid in advance in connection with our intent to enterthe public market and obtain outside financing.  In addition, the changesin accounts payable and accrued liabilities reflect the related increase inexpenses incurred, with no funds paid out. Net cash used in operating activities for the nine months ended September 30,2007 consisted primarily of changes in operating assets and liabilities ofapproximately $(5.0) million, including changes in accounts receivable, cost inexcess of billing, accounts payable and accrued liabilities.  Thesechanges in accounts receivable and cost in excess of billing resulted from theincrease in projects completed and invoices issued to customers.

 

As of September 30, 2008, we have no netoperating loss carryforwards available to reduce future taxable income.   We expect that if we generate taxable incomeand/or we are not allowed to use net operating loss carryforwards, our cashgenerated from operations will be adequate to meet our income tax obligations.

 

*Net CashUsed In Investing**Activities.*  Net cash used ininvesting activities for the nine months ended September 30, 2008 and 2007was approximately $(2.8) million and $(642,000), respectively.  Net cashused in investing activities during these periods consisted primarily of cashpaid for the acquisition of equipment, leasehold improvements  related to the expansion of the office andcash paid out for the acquisition of assets in excess of cash received.

 

*Net CashProvided by Financing**Activities.*  Net cashprovided by financing for the nine months ended September 30, 2008 and2007 was approximately $14.2 million and $120,000 respectively. Net cashprovided by financing activities during 2008 consisted primarily of proceeds of$13.9 million received from the sale of  Series A Preferred Stock,$203,000 received from the sale of the Company’s common stock and proceedsreceived from the exercise of warrants for common stock****andapproximately $65,000 received from the term loan, offset by repayments ofshort term financing of approximately $13,000.  Net cash used in financingactivities during 2007 consisted of proceeds from the sale of the Company’scommon stock of $260,000 and proceeds from short term financing of $141,000,which were offset by repayments of short term financing of approximately$20,000.

 

**Item 4.    Controls and Procedure**

 

**Evaluation of Disclosure Controls andProcedures**

 

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 September 30, 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 theEffectiveness of Internal Controls**

 

This quarterly report doesnot include a report of management’s assessment regarding internal controls overfinancial reporting or an attestation report of our registered independentpublic accounting firm due to a transition period established by rules ofthe Securities and Exchange Commission for newly formed public companies.

 

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**Limitations on the Effectiveness ofControls**

 

Our management, including ourCEO and CFO, does not expect that our Disclosure Controls and internal controlswill prevent all error and all fraud. A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. Further, the design of acontrol system must reflect the fact that there are resource constraints, andthe benefits of controls must be considered relative to their costs. Because ofthe inherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, with American Defense Systems have been detected. These inherentlimitations include the realities that judgments in decision-making can befaulty and that breakdowns can occur because of simple error or mistake.Additionally, controls can be circumvented by the individual acts of somepersons, by collusion of two or more people or by management override of thecontrols.

 

The design of any system ofcontrols also is based in part upon certain assumptions about the likelihood offuture events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions; over time, acontrol may become inadequate because of changes in conditions or the degree ofcompliance with the policies or procedures may deteriorate. Because of theinherent limitations in a cost-effective control system, misstatements due toerror or fraud may occur and may not be detected.

 

**PART II**

 

**Item 1.  Legal Proceedings**

 

On July 10, 2007, wefiled a lawsuit against a former subcontractor, Southern California GoldProducts d/b/a Gypsy Rack, the subcontractor’s President and owner, GlennHarris, and a designer, James McAvoy in the United States District Court,Eastern District of New York. Defendants moved to change venue to the CentralDistrict of California based upon insufficient contacts to the State of NewYork 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 filedan amended 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 seeksto enjoin 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.  Shortly after the filing of theamended answer, defendants made a motion for summary judgment on, among others,the grounds of collateral estoppel and res judicata. We filed opposition to themotion.  The defendants motion and a subsequent application for an immediateinterlocutory appeal were denied.  A mediation settlement conference washeld on October 31, 2008, which was unsuccessful.  Responses to interrogatories and documentproduction is due on or about November 17, 2008.

 

On December 6,2006,  Stephen Lassak, our former ChiefFinancial Officer commenced an action for breach of contract arising from histermination of employment, which was in the United States District Court,Eastern District of New York.  Theparties have reached a settlement in this matter and the case was dismissed on October 3,2008.

 

On February 29, 2008,Roy Elfers, a former employee commenced an action against us for breach ofcontract arising from his termination of employment in the Supreme Court of theState of New York, Nassau County. The Complaint seeks damages of approximately$87,000. We filed an answer to the complaint and will be commencingdiscovery.  Meritorious defenses to the claims exist and we intend tovigorously defend this action.

 

On March 4, 2008, ThomasCusack, our former General Counsel, commenced an action with the United StatesDepartment of Labor, Occupational Safety and Health and Safety Administration,alleging retaliation in contravention of the Sarbanes-Oxley Act. Mr. Cusackseeks damages in excess of $3,000,000. On April 2, 2008, we filed aresponse to the charges. We believe the allegations to be without merit andintend to vigorously defend 

 

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against the action. On March 7, 2008, Mr. Cusack also commenced a second actionagainst the Company for breach of contract and related issues arising from histermination of employment in New York State Supreme Court, Nassau County. On May 7,2008, we served a motion to dismiss the complaint, and in or about September 26,2008, the Court dismissed several claims (tortious interference with acontract, tortious interference with economic opportunity, fraudulentinducement to enter into a contract and breach of good faith and fairdealing).  The remaining claims are Mr. Cusack’sbreach of contract claims and claims seeking the lifting of the restriction ofhis stock.  On October 13, 2008, Mr. Cusackfiled an amended complaint as to the remaining claims, and on November 5,2008, we filed an answer to the complaint and filed counterclaims against Mr. Cusackfor fraud.  The parties are to commencedocumentary discovery, which will be followed by depositions.  Meritorious defenses to the claims exist andwe intend to vigorously defend this action.

 

**Item 2.  Unregistered Sales of Equity Securities and Use ofProceeds**

 

None.

 

 

**Item 3.                    Defaults Upon Senior Securities**

 

None.

 

 

**Item 4.                    Submission of Matters to a Vote of SecurityHolders**

 

None.

 

**Item 5.  Other Information**

 

None.

 

**Item 6.    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.* |

 

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*      Filed herewith.

 

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**SIGNATURES**

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
|                         | AMERICAN DEFENSE SYSTEMS, INC. |
|------------------------------|--------------------------------|
|                         |                           |   |
|                         |                           |   |
| Date: November 14, 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. |

 

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