Table of Contents

 

 

 

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

** **
| **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|----------------------------------------------------------------------------------------------------|
|                                                                                               |
| **For the  Quarter Ended March 31, 2009**                                                     |
| ** **                                                                                         |
| **Commission  File Number 001-33888**                                                              |

 

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**AmericanDefense Systems, Inc.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**230 Duffy Avenue**

**Hicksville, NY 11801****(516) 390-5300**

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

 

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

 

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

 

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o  No x

 

As of May 13, 2009, 39,760,952 shares of commonstock, par value $0.001 per share, of the registrant were outstanding.

 

 

 

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Table of Contents

 

TABLE OF CONTENTS

 
| **PART I  – FINANCIAL INFORMATION** |
|-----------------------------------------------|
|                                          |   |
| Item 1.                                       | Condensed Financial  Statements |
|                                          | Consolidated Balance Sheets as of  December 31, 2008 and March 31, 2009 (unaudited) |
|                                          | Consolidated Statements of  Operations for the three months ended March 31, 2008 and 2009  (unaudited) |
|                                          | Consolidated  Statements of Cash Flows for the three months ended March 31, 2008 and  2009 (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 1A.                                      | Risk Factors |
| 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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Table of Contents

 

**PART I**

 

**Item 1.    Consolidated Financial Statements**

 

AMERICAN DEFENSE SYSTEMS, INC. andSUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 
| ** **                                                                                                                                                                                                        | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                        | ** ** | **2009**           | ** ** | **2008**              | ** ** |
| ** **                                                                                                                                                                                                        | ** ** | **(Unaudited)**    | ** ** | **(Audited)**         | ** ** |
| ASSETS                                                                                                                                                                                                            |       |               |       |                  |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| CURRENT ASSETS                                                                                                                                                                                                    |       |               |       |                  |       |
| Cash                                                                                                                                                                                                              |       | $                  | 83,826     |                  | $          | 374,457 |   |
| Accounts receivable, net                                                                                                                                                                                          |       | 6,434,888          |       | 4,981,150             |       |
| Inventory                                                                                                                                                                                                         |       | 844,139            |       | 621,048               |       |
| Prepaid expenses and other current assets                                                                                                                                                                         |       | 3,539,842          |       | 3,144,601             |       |
| Costs in excess of billings on uncompleted contracts                                                                                                                                                              |       | 6,562,903          |       | 7,143,089             |       |
| Deposits                                                                                                                                                                                                          |       | 437,496            |       | 437,496               |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| TOTAL CURRENT ASSETS                                                                                                                                                                                              |       | 17,819,268         |       | 16,701,841            |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| PROPERTY and EQUIPMENT, net                                                                                                                                                                                       |       | 3,569,232          |       | 3,743,936             |       |
| DEFERRED FINANCING COSTS, net                                                                                                                                                                                     |       | 1,130,409          |       | 1,277,833             |       |
| NOTES RECEIVABLE                                                                                                                                                                                                  |       | 925,000            |       | 925,000               |       |
| GOODWILL                                                                                                                                                                                                          |       | 450,000            |       | 450,000               |       |
| ADVANCES for FUTURE ACQUISITIONS                                                                                                                                                                                  |       | 159,559            |       | 159,560               |       |
| DEFERRED TAX ASSET                                                                                                                                                                                                |       | 1,167,832          |       | 1,167,832             |       |
| ASSETS of DISCONTINUED OPERATIONS                                                                                                                                                                                 |       | —             |       | 736,613               |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| TOTAL ASSETS                                                                                                                                                                                                      |       | $                  | 25,221,300 |                  | $          | 25,162,615 |   |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                         |       |               |       |                  |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| CURRENT LIABILITIES                                                                                                                                                                                               |       |               |       |                  |       |
| Accounts payable                                                                                                                                                                                                  |       | $                  | 3,097,297  |                  | $          | 2,480,652 |   |
| Accrued payroll                                                                                                                                                                                                   |       | 409,852            |       | —                |       |
| Accrued expenses                                                                                                                                                                                                  |       | 386,447            |       | 755,615               |       |
| Line of credit                                                                                                                                                                                                    |       | 659,422            |       | 76,832                |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| TOTAL CURRENT LIABILITIES                                                                                                                                                                                         |       | 4,553,018          |       | 3,313,099             |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| LONG TERM LIABILITIES                                                                                                                                                                                             |       |               |       |                  |       |
| Preferred stock, $.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 |       | 11,809,196         |       | 10,981,577            |       |
| Investor warrant liability                                                                                                                                                                                        |       | 115,275            |       | 90,409                |       |
| Liabilities of discontinued operations                                                                                                                                                                            |       | —             |       | 736,613               |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| TOTAL LIABILITIES                                                                                                                                                                                                 |       | 16,477,489         |       | 15,121,698            |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| COMMITMENTS AND CONTINGENCIES                                                                                                                                                                                     |       |               |       |                  |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| SHAREHOLDERS’ EQUITY                                                                                                                                                                                         |       |               |       |                  |       |
| Common Stock, $.001 par value: 100,000,000 shares  authorized, 39,585,960 and 39,585,960 shares issued and outstanding as of  March 31, 2009 and December 31, 2008, respectively                        |       | 39,587             |       | 39,586                |       |
| Additional paid in capital                                                                                                                                                                                        |       | 9,534,616          |       | 9,534,616             |       |
| Retained earnings (accumulated deficit)                                                                                                                                                                           |       | (830,392           | )          | 466,715               |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                                                                                                   |       | 8,743,811          |       | 10,040,917            |       |
|                                                                                                                                                                                                              |       |               |       |                  |       |
| TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                                   |       | $                  | 25,221,300 |                  | $          | 25,162,615 |   |

 

The accompanying notes are an integral part ofthese consolidated financial statements

 

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AMERICAN DEFENSE SYSTEMS, INC. andSUBSIDIARIES

CONSOLIDATED STATEMENTS OFOPERATIONS

(Unaudited)

 
| ** **                                                                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                              | ** ** | **March 31,**     | ** ** |
| ** **                                                                                                              | ** ** | **2009**               | ** ** | **2008** | ** ** |
|                                                                                                                    |       |                   |       |   |   |
| CONTRACT REVENUES EARNED                                                                                                |       | $                      | 9,489,702  |   | $ | 8,734,909 |   |
|                                                                                                                    |       |                   |       |   |   |
| COST OF REVENUES EARNED                                                                                                 |       | 5,453,109              |       | 5,335,036 |   |
|                                                                                                                    |       |                   |       |   |   |
| GROSS PROFIT                                                                                                            |       | 4,036,593              |       | 3,399,873 |   |
|                                                                                                                    |       |                   |       |   |   |
| OPERATING EXPENSES                                                                                                      |       |                   |       |   |   |
| General and administrative expenses                                                                                     |       | 1,648,478              |       | 1,395,059 |   |
| General and administrative salaries                                                                                     |       | 1,073,037              |       | 1,136,596 |   |
| Marketing                                                                                                               |       | 733,794                |       | 632,307 |   |
| T2 expenses                                                                                                             |       | 113,602                |       | — |   |
| Research and development                                                                                                |       | 186,386                |       | 165,196 |   |
| Settlement of litigation                                                                                                |       | —                 |       | 57,377 |   |
| Depreciation                                                                                                            |       | 241,329                |       | 134,769 |   |
| Total operating expenses                                                                                                |       | 3,996,626              |       | 3,521,304 |   |
|                                                                                                                    |       |                   |       |   |   |
| INCOME (LOSS) FROM OPERATIONS                                                                                           |       | 39,967                 |       | (121,431 | ) |
|                                                                                                                    |       |                   |       |   |   |
| OTHER INCOME (EXPENSE)                                                                                                  |       |                   |       |   |   |
|                                                                                                                    |       |                   |       |   |   |
| Unrealized gain (loss) on adjustment of fair value  Series A convertible preferred stock classified as a liability |       | (694,454               | )          | (1,428,665 | ) |
| Unrealized gain (loss) on investor warrant liability                                                                    |       | 14,054                 |       | (107,589 | ) |
| Other income (expense)                                                                                                  |       | —                 |       | (9,046 | ) |
| Interest expense                                                                                                        |       | (290,320               | )          | (55,737 | ) |
| Interest income                                                                                                         |       | 8,646                  |       | 31,123 |   |
| Finance charge                                                                                                          |       | —                 |       | (4,536 | ) |
| Total other income (expense)                                                                                            |       | (962,074               | )          | (1,574,450 | ) |
|                                                                                                                    |       |                   |       |   |   |
| LOSS FROM CONTINUING OPERATIONS BEFORE INCOME TAXES                                                                     |       | (922,107               | )          | (1,695,881 | ) |
|                                                                                                                    |       |                   |       |   |   |
| INCOME TAX PROVISION (BENEFIT)                                                                                          |       | —                 |       | — |   |
|                                                                                                                    |       |                   |       |   |   |
| LOSS FROM CONTINUING OPERATIONS                                                                                         |       | (922,107               | )          | (1,695,881 | ) |
|                                                                                                                    |       |                   |       |   |   |
| LOSS FROM DISCONTINUED OPERATIONS, NET OF TAXES                                                                         |       |                   |       |   |   |
| Loss from operations of discontinued division                                                                           |       | —                 |       | (489 | ) |
| Loss from disposal of discontinued division                                                                             |       | —                 |       | — |   |
|                                                                                                                    |       | —                 |       | (489 | ) |
|                                                                                                                    |       |                   |       |   |   |
| NET LOSS                                                                                                                |       | (922,107               | )          | (1,696,370 | ) |
|                                                                                                                    |       |                   |       |   |   |
| PREFERRED STOCK DIVIDENDS ACCRUED                                                                                       |       | (375,000               | )          | — |   |
|                                                                                                                    |       |                   |       |   |   |
| NET LOSS ALLOCATED TO COMMON SHAREHOLDERS                                                                               |       | $                      | (1,297,107 | ) | $ | (1,696,370 | ) |
|                                                                                                                    |       |                   |       |   |   |
| Basic and Fully Diluted Net Loss Per Share                                                                              |       | $                      | (0.033     | ) | $ | (0.043 | ) |
|                                                                                                                    |       |                   |       |   |   |
| Weighted Average Shares Outstanding                                                                                     |       | 39,585,960             |       | 39,124,616 |   |
|                                                                                                                    |       |                   |       |   |   |
| EARNINGS PER SHARE - Basic                                                                                              |       |                   |       |   |   |
| Income from continuing operations                                                                                       |       | $                      | (0.02      | ) | $ | (0.04 | ) |
| (Loss) from discontinued operations                                                                                     |       | $                      | —     |   | $ | (0.00 | ) |
| Net income (loss)                                                                                                       |       | $                      | (0.03      | ) | $ | (0.04 | ) |

 

The accompanying notes are an integral part of theseconsolidated financial statements

 

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AMERICANDEFENSE SYSTEMS, INC.

ANDSUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(Unaudited)

 
| ** **                                                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                              | ** ** | **2009**                          | ** ** | **2008** | ** ** |
|                                                                                    |       |                              |       |   |   |
| Cash flows from operating activities:                                                   |       |                              |       |   |   |
| Net loss                                                                                |       | $                                 | (922,107   | ) | $ | (1,696,370 | ) |
|                                                                                    |       |                              |       |   |   |
| Adjustments to reconcile net loss to net cash used  in continuing operating activities: |       |                              |       |   |   |
| Change in fair value associated with preferred stock  and warrants                      |       | 680,400                           |       | 1,536,254 |   |
| Stock based compensation expense                                                        |       | 29,192                            |       | 33,685 |   |
| Amortization of deferred financing costs                                                |       | 147,424                           |       | — |   |
| Discount on Series A preferred stock                                               |       | 142,896                           |       | — |   |
| Depreciation and amortization                                                           |       | 241,329                           |       | 134,769 |   |
| Changes in operating assets and liabilities:                                            |       |                              |       |   |   |
| Accounts receivable                                                                     |       | (1,453,738                        | )          | 1,953,026 |   |
| Inventories                                                                             |       | (223,091                          | )          | (57,382 | ) |
| Deposits and other assets                                                               |       | —                            |       | 36,794 |   |
| Cost in excess of billing on uncompleted contracts                                      |       | 580,186                           |       | (3,685,895 | ) |
| Prepaid expenses and other assets                                                       |       | (395,240                          | )          | (618,395 | ) |
| Deferred tax assets                                                                     |       | —                            |       | — |   |
| Deferred financing costs                                                                |       | —                            |       | (658,500 | ) |
| Advances for future acquisitions                                                        |       | —                            |       | (20,000 | ) |
| Accounts payable and accrued expenses                                                   |       | 325,471                           |       | 1,090,986 |   |
| Accrued payroll                                                                         |       | 409,852                           |       | — |   |
| Accrued liabilities                                                                     |       | (369,168                          | )          | (425,550 | ) |
| Deferred tax liability                                                                  |       | —                            |       | — |   |
| Due to related party                                                                    |       | —                            |       | (91,993 | ) |
|                                                                                    |       |                              |       |   |   |
| Net cash used in operating activities                                                   |       | (806,594                          | )          | (2,468,571 | ) |
|                                                                                    |       |                              |       |   |   |
| Cash flows from continuing investing activities:                                        |       |                              |       |   |   |
| Purchase of equipment                                                                   |       | (66,625                           | )          | (368,238 | ) |
| Cash paid for acquisition in excess of cash received                                    |       | —                            |       | (100,000 | ) |
|                                                                                    |       |                              |       |   |   |
| Net cash used in investing activities                                                   |       | (66,625                           | )          | (468,238 | ) |
|                                                                                    |       |                              |       |   |   |
| Cash flows from continuing financing activities:                                        |       |                              |       |   |   |
| Proceeds from notes payable                                                             |       | —                            |       | 69,568 |   |
| Proceeds from line of credit                                                            |       | 582,950                           |       | — |   |
| Repayments of short term financing                                                      |       | —                            |       | (6,342 | ) |
| Proceeds from sale of Series A Convertible                                         |       |                              |       |   |   |
| Preferred Shares, net of capitalization costs of  $270,000                              |       | —                            |       | 11,303,500 |   |
|                                                                                    |       |                              |       |   |   |
| Net cash provided by financing activities                                               |       | 582,950                           |       | 11,366,726 |   |
|                                                                                    |       |                              |       |   |   |
| Discontinued operations                                                                 |       |                              |       |   |   |
| Cash used in operating activities                                                       |       | (362                              | )          | (235,145 | ) |
| Net cash used in discontinued operations                                                |       | (362                              | )          | (235,145 | ) |
|                                                                                    |       |                              |       |   |   |
| NET INCREASE (DECREASE) IN CASH                                                         |       | (290,631                          | )          | 8,194,772 |   |
|                                                                                    |       |                              |       |   |   |
| CASH AT BEGINNING OF YEAR                                                               |       | 374,457                           |       | 1,479,886 |   |
|                                                                                    |       |                              |       |   |   |
| CASH AT END OF PERIOD                                                                   |       | $                                 | 83,826     |   | $ | 9,674,658 |   |
|                                                                                    |       |                              |       |   |   |
| Supplemental disclosure of cash flow information:                                       |       |                              |       |   |   |
| Cash paid during the year for interest                                                  |       | $                                 | 9,730      |   | $ | 6,163 |   |
| Cash paid for taxes                                                                     |       | $                                 | —     |   | $ | — |   |
|                                                                                    |       |                              |       |   |   |
| Supplemental disclosure of non-cash financing  activities                               |       |                              |       |   |   |
| Stock options issued in lieu of cash for  compensation                                  |       | $                                 | 29,192     |   | $ | 33,685 |   |
| Dividends paid in cash                                                                  |       | $                                 | —     |   | $ | — |   |
| Fair value of placement agent warrants                                                  |       | $                                 | —     |   | $ | — |   |
|                                                                                    |       |                              |       |   |   |
| Assets and liabilities received in acquisition  American Anti-Ram, Inc.            |       |                              |       |   |   |
|                                                                                    |       |                              |       |   |   |
| Fixed assets                                                                            |       |                              |       | $ | 30,000 |   |
| Inventory                                                                               |       |                              |       | $ | 120,000 |   |
| Goodwill                                                                                |       |                              |       | $ | 280,000 |   |
| Accounts payable and accrued expense                                                    |       |                              |       | $ | (30,000 | ) |
| Notes payable                                                                           |       |                              |       | $ | — |   |
| Shares issuable in connection with acquisition                                          |       |                              |       | $ | (200,000 | ) |
| Cash paid in connection with acquisition                                                |       |                              |       | $ | (100,000 | ) |
| Amounts due to American Anti-Ram, Inc.                                             |       |                              |       | $ | (100,000 | ) |

 

The accompanying notes are an integral part of theseconsolidated financial statements

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

**Organization**

 

American Defense Systems, Inc. (the “Company” or “ADSI”) wasincorporated under the laws of the State of Delaware on December 6, 2002.

 

On May 1, 2003, the stockholder of A. J. Piscitelli &Associates, Inc. (“AJP”) exchanged all of his issued and outstandingshares for shares of American Defense Systems, Inc. The exchange wasaccounted for as a recapitalization of the Company, wherein the stockholderretained all the outstanding stock of American Defense Systems, Inc. Atthe time of the acquisition American Defense Systems, Inc. wassubstantially inactive.

 

On November 15, 2007, the Company entered into an Asset PurchaseAgreement with Tactical Applications Group (“TAG”), a North Carolina based soleproprietorship, and its owner.   TAG hasa retail establishment located in Jacksonville, North Carolina that suppliestactical equipment to military and security personnel.  As discussed more fully in Note 7, theoperations of TAG were discontinued on January 2, 2009.

 

In January 2008, American Physical Security Group, LLC (“APSG”)was established as a wholly owned subsidiary of the Company for the purposes ofacquiring the assets of American Anti-Ram, Inc., a manufacturer of crashtested vehicle barricades. This acquisition represents a new product line forthe Company.  APSG is located in NorthCarolina.

 

**Interim Review Reporting**

 

The accompanying interim unaudited condensed financial statements havebeen prepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q and Article 8of Regulation 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 three month period ended March 31,2009 are not necessarily indicative of the results that may be expected for theyear ending December 31, 2009. For further information, refer to thefinancial statements and footnotes thereto included in the Company’s Form 10-Kannual report filed on April 15, 2009.

 

**Nature of Business**

 

The Company designs and supplies transparent and opaque armor solutionsfor both military and commercial applications. Its primary customers are UnitedStates government agencies and general contractors who have contracts withgovernmental entities. These products, sold under Vista trademarks, are used intransport and fighting vehicles, construction equipment, sea craft and variousfixed structures which require ballistic and blast attenuation.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

The Company also provides engineering and consulting services, developsand installs detention and security hardware, entry control and monitoringsystems, intrusion detection systems, and security glass. The Company alsosupplies vehicle anti-ram barriers.  Itsprimary customer for these services and products are the detention and securityindustry.

 

**Principles of Consolidation**

 

The consolidated financial statements include the accounts of AmericanDefense Systems, Inc. and its wholly-owned subsidiaries, A.J Piscitelli &Associates, Inc. and American Physical Security Group, LLC. The accountsof TAG have been presented as discontinued operations as discussed more fullyin Note 7.  All significant intercompanyaccounts and transactions have been eliminated in consolidation.

 

**Terms and Definitions**

 
| ADSI        | American Defense Systems, Inc. (the  “Company”)  |
|-------------|-----------------------------------------------------------------|
| AJP         | A.J. Piscitelli & Associates, Inc.,  a subsidiary |
| APB         | Accounting Principles Board                                     |
| ARB         | Accounting Review Board                                         |
| APSG        | American Physical Security Group, LLC, a  subsidiary            |
| EITF        | Emerging Issues Task Force                                      |
| FASB        | Financial Accounting Standards Board                            |
| FIN         | FASB Interpretation Number                                      |
| FSP         | FASB Staff Position                                             |
| GAAP        | Generally Accepted Accounting Principles                        |
| PCAOB       | Public Companies Accounting Oversight  Board                    |
| SAB         | Staff Accounting Bulletin                                       |
| SEC         | Securities Exchange Commission                                  |
| SFAS or FAS | Statement of Financial Accounting  Standards                    |
| TAG         | Tactical Applications Group, a subsidiary                       |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**Use of Estimates**

 

The preparation of financial statements and related disclosures inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the amountsreported in the consolidated financial statements and accompanying notes.Estimates are used for revenue recognition, income taxes and accruedliabilities among others. Actual results could differ materially from thoseestimates.

 

Significant estimates for all periods presented include cost in excessof billings, liabilities associated with the Series A Preferred Stock andInvestor Warrants and valuation of deferred tax assets.

 

**Revenue and CostRecognition**

 

The Company recognizesrevenue in accordance with the provisions of SAB 104, “Revenue Recognition”,which states that revenue is realized and earned when all of the followingcriteria are met:

 

(a) persuasiveevidence of the arrangement exists,

(b) deliveryhas occurred or services have been rendered,

(c) theseller’s price to the buyer is fixed and determinable and

(d) collectibilityis reasonably assured.

 

Under this provision,revenue is recognized upon satisfactory completion of specified inspection,wherein by contract, customer acceptance and delivery occurs and title passesto the customer.

 

Contract Revenue

 

*Cost in Excess of Billing*

All costs associated with uncompleted customer purchase orders undercontract are recorded on the balance sheet as a current asset called “Costs inExcess of Billings on Uncompleted Contracts.” Such costs include direct material, direct labor, and project-relatedoverhead.  Upon completion of purchaseorder, costs are then reclassified from the balance sheet to the statement ofoperations as costs of revenue.  A customerpurchase order is considered complete when a satisfactory inspection hasoccurred, resulting in customer acceptance and delivery.

 

*Billing in Excess of Cost*

All billings associated with uncompleted purchase orders under contractare recorded on the balance sheet as a current liability called “Billings inExcess of Costs on Uncompleted Contracts.” Upon completion of the purchase order, all such billings arereclassified from the balance sheet to the statement of operations asrevenues.  Due to the structure of theCompany’s contracts, billing is not done until the purchase order is complete,therefore there are no amounts recorded as liabilities as of March 31,2009 or December 31, 2008.  Contractretentions are included in accounts receivable.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

Retail Revenue

The Company recognizesrevenue 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 for the three months ended March 31, 2009 or 2008.  As a result of the discontinuing of TAGoperations, the Company will not generate retail revenue in the future. Asdiscussed in Note 7, revenue generated for the three months ended March 31,2009 and 2008 from TAG retail operations was $0 and $685,211, respectively.

 

**Cash and Cash Equivalents**

 

The Company considers all highly liquid investments with maturities ofthree months or less at the time of purchase to be cash equivalents.

 

**Concentrations**

 

Cash and cash equivalents are maintained in financial institutions.Deposits held with banks may exceed the amount of insurance provided on suchdeposits. Generally, these deposits may be redeemed upon demand and thereforebear minimal risk.

 

The Company received certain of its components from sole suppliers.Additionally, the Company relies on a limited number of contract manufacturersand suppliers to provide manufacturing services for its products. The inabilityof any contract manufacturer or supplier to fulfill supply requirements of theCompany could materially impact future operating results.

 

For the three months ended March 31, 2009 and 2008, the Companyderived 90% and 97% of its revenues from various U.S. government entities.

 

**Inventories**

 

Inventories are stated at the lower of cost or market, with cost determinedusing the first-in, first-out method.

 

**Equipment**

 

Equipment is stated at cost less accumulated depreciation. Depreciationis provided using a straight-line method over an estimated useful life of threeto five years. Expenditures for repairs and maintenance are charged to expenseas incurred.

 

**Long-Lived Assets**

 

The Company reviews long-lived assets and certain identifiable assetsrelated to those assets for impairment whenever circumstances and situationschange, such that there is an indication that the carrying amounts may not berecoverable. If the undiscounted cash flows of the long-lived assets are lessthan the carrying amount, their carrying amounts are reduced to fair value, andan impairment loss is recognized.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**Goodwill and Indefinite-Lived Intangible Assets**

 

In accordance with SFAS 142, “Goodwill andOther Intangible Assets,” goodwill, represents the excess of the purchase price over the fair value of netassets, including the amount assigned to identifiable intangible assets. TheCompany accounts for business combinations using the purchase method ofaccounting and accordingly, the assets and liabilities of the acquired entitiesare recorded at their estimated fair values at the acquisition date. Theprimary driver that generates goodwill is the value of synergies between theacquired entities and the company, which does not qualify as an identifiableintangible asset.  The Company does not amortize thegoodwill balance.

 

The Company assesses goodwill andindefinite-lived intangible assets for impairment annually during the fourthquarter, or more frequently if events and circumstances indicate impairment mayhave occurred. If the carrying value of a reporting unit’s goodwill exceeds itsimplied fair value, the Company records an impairment loss equal to the difference.SFAS 142 also requires that the fair value of indefinite-lived purchasedintangible assets be estimated and compared to the carrying value. The Companyrecognizes an impairment loss when the estimated fair value of theindefinite-lived purchased intangible assets is less than the carrying value.

 

**Advertising Costs**

 

The Company expenses all advertising costs asincurred.

 

**Earnings per Share**

 

Basic earnings (loss) per share is computed using the weighted-averagenumber of common shares outstanding during the period. Diluted net income pershare is computed using the weighted-average number of common shares anddilutive potential common shares outstanding during the period. Diluted netloss per share is computed using the weighted-average number of common sharesand excludes dilutive potential common shares outstanding, as their effect isanti-dilutive. Dilutive potential common shares would primarily consist ofemployee stock options and restricted common stock.

 

**Fair Value of Financial Instruments**

 

Fair value of certain of the Company’s financial instruments includingcash and cash equivalents, accounts receivable, accrued compensation, and otheraccrued liabilities approximate cost because of their short maturities.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**IncomeTaxes**

 

The Companyaccounts for income taxes according to SFAS 109 “Accounting for Income Taxes”which requires an asset and liability approach to financial accounting forincome taxes. Deferred income tax assets and liabilities are computed annuallyfor the difference between the financial statement and tax bases of assets andliabilities that will result in taxable or deductible amounts in the future,based on enacted tax laws and rates applicable to the periods in which thedifferences 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 Corporation adopted the provisions of FIN 48, “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement 109,”effective January 1, 2007. FIN 48 prescribes a recognition threshold and ameasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Benefits fromtax positions should be recognized in the financial statements only when it ismore likely than not that the tax position will be sustained upon examinationby the appropriate taxing authority that would have full knowledge of allrelevant information. A tax position that meets the more-likely-than-notrecognition threshold is measured at the largest amount of benefit that 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.

 

The Company files income tax returns in the U.S. federal jurisdictionand various states. The Company has not been subject to U.S. federal income taxexaminations by tax authorities nor state authorities since its inception in2000.

 

**Recentaccounting pronouncements**

 

*Business Combinations*

In December, 2007, the FASB issued SFAS 141 (revised 2007), “BusinessCombinations” (hereinafter “SFAS No. 141 (revised 2007)”). This statementestablishes principles and requirements for how an acquirer a) recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed and any noncontrolling interest in the acquiree, b)recognizes and measures the goodwill acquired in the business combination or again from a bargain purchase and c) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. The scope of SFAS 141 (revised 2007) isbroader than the scope of SFAS 141, which it replaces. The effective date ofSFAS 141 (revised 2007) is for all acquisitions in which the acquisition dateis on or after the beginning of the first annual reporting period beginning onor after 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

December 15, 2008. The adoption of this statement did not have amaterial effect on the Company’s consolidated financial condition or results ofoperations.

 

*Noncontrolling Interests in Consolidated Financial Statements — anamendment of ARB 51*

In December, 2007, the FASB issued SFAS 160, “Noncontrolling Interestsin Consolidated Financial Statements — an amendment of ARB No. 51.” Thisstatement establishes accounting and reporting standards that require a) theownership interests in subsidiaries held by parties other than the parent beclearly identified, labeled and presented in the consolidated statement offinancial position with equity, but separate from the parent’s equity, b) theamount of consolidated net income attributable to the parent and to thenoncontrolling interest be clearly identified and presented on the face of theconsolidated statement of income, c) changes in a parent’s ownership interestwhile the parent retains its controlling financial interest in its subsidiarybe accounted for consistently, d) when a subsidiary is deconsolidated, anyretained noncontrolling  equityinvestment in the former subsidiary be initially measured at fair value and e)entities provide sufficient disclosures that clearly identify and distinguishbetween the interests of the parent and the interests of the noncontrollingowners. The effective date of this standard is for fiscal years and interimperiods beginning on or after December 15, 2008. Since the Company has nosuch arrangements as of March 31, 2009, the adoption of this statement didnot affect the Company’s consolidated financial condition or results ofoperations.

 

*Disclosure about Derivative Instruments and Hedging Activities*

In March 2008, the FASB issued SFAS 161, “Disclosure about Derivative Instruments and Hedging Activities,” an amendment of FASB Statement No. 133,(SFAS 161). This statement requires that objectives for using derivativeinstruments be disclosed in terms of underlying risk and accountingdesignation. The Company is required to adopt SFAS 161 on January 1, 2009.The Company currently does not have such instruments and does not anticipatethat its adoption of SFAS 161 will have a potential impact of SFAS 161 on theCompany’s consolidated financial statements.

 

*Determination of the Useful Life of Intangible Assets*

In April 2008, the FASB issued FSP FAS 142-3, “Determination ofthe Useful Life of Intangible Assets,”, which amends the factors that should beconsidered in developing renewal or extension assumptions used to determine theuseful life of intangible assets  under FASB 142 “Goodwill and OtherIntangible Assets.”  The intent of this FSP is to improve the consistencybetween the useful life of a recognized intangible asset under SFAS 142 and theperiod of the expected cash flows used to measure the fair value of the assetunder SFAS 141 (revised 2007) “Business Combinations” and other U.S. generallyaccepted accounting principles.    The Company has consideredFSP FAS 142-3 in determining its useful life of intangible assets and hasconcluded  that the useful lives areconsistent.  As a result, the Company hasdetermined that there was no impact of FSP FAS 142-3 on its consolidatedfinancial statements.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

*The Hierarchy of Generally Accepted AccountingPrinciples*

In May 2008, the FASB issued SFAS 162, “TheHierarchy of Generally Accepted Accounting Principles.”  SFAS 162 identifies the sources of accountingprinciples and the framework for selecting the principles used in thepreparation of financial statements.  TheCompany has adopted SFAS 162 as of January 1, 2009.

 

*Accounting for Convertible Debt InstrumentsThat May Be Settled in Cash upon Conversion (Including Partial CashSettlement)*

In May 2008, the FASB issued FSP APB 14-1, “Accounting forConvertible Debt Instruments That May Be Settled in Cash upon Conversion(Including Partial Cash Settlement).” The FSP clarifies the accounting forconvertible debt instruments that may be settled in cash (including partial cashsettlement) upon conversion.  The FSPrequires issuers to account separately for the liability and equity componentsof certain convertible debt instruments in a manner that reflects the issuer’snonconvertible debt (unsecured debt) borrowing rate when interest cost isrecognized.  The FSP requires bifurcationof a component of the debt, classification of that component in equity and theaccretion of the resulting discount on the debt to be recognized as part of interestexpense in our consolidated statement of operations.  The FSP requires retrospective application tothe terms of instruments as they existed for all periods presented.  The Company has adopted this FSP as of January 1,2009, however does not anticipate that there will be an impact on its consolidatedfinancial statements since no such debt instruments exist.

 

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

In June 2008, the FASB ratified EITF 07-5, “Determining Whether anInstrument (or an Embedded Feature) Is Indexed to an Entity’s Own Stock.”  EITF 07-5 provides that an entity should usea two step approach to evaluate whether an equity-linked financial instrument(or embedded feature) is indexed to its own stock, including evaluating theinstrument’s contingent exercise and settlement provisions.  It also clarifies on the impact of foreigncurrency denominated strike prices and market-based employee stock optionvaluation instruments on the evaluation. EITF 07-5 is effective for fiscal years beginning after December 15,2008.  The Company currently has Series APreferred Stock that is indexed to their own stock as discussed further in Note7.  The Company is currently assessingthe impact of EITF 07-5 related to its Series A Preferred Stock andrelated Investor Warrant liability, however it does not appear that there willbe a material impact on its consolidated financial position and results ofoperations as of March 31, 2009.

 

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

In June 2008, the FASB issued FSP EITF 03-6-1, “DeterminingWhether Instruments Granted in Share-Based Payment Transactions AreParticipating 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 currently has no such securities and does not anticipate that

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

its adoption of FSP EITF 03-6-1 will have a material impact uponits consolidated financial statements.

 

*Determining the Fair Value of a FinancialAsset When the Market for That Asset is Not Active*

In October 2008, the FASB issued FSP FAS157-3, “Determining the Fair Value of a Financial Asset When the Market forThat Asset is Not Active.”  This FSPclarifies the application of SFAS 157, “Fair Value Measurements,” in a marketthat is not active.  The FSP alsoprovides examples for determining the fair value of a financial asset when themarket for that financial asset is not active. FSP FAS 157-3 was effective upon issuance, including prior periods forwhich financial statements have not been issued.  The impact of adoption was notmaterial to the Company’s consolidated financial condition or results ofoperations as the Company currently has no such financial assets.

 

*Equity Method Investment AccountingConsiderations*

In November 2008, the FASB issued EITF08-6, “Equity Method Investment Accounting Considerations.”  EITF 08-6 clarifies accounting for certaintransactions and impairment considerations involving the equity method.  Transactions and impairment dealt with areinitial measurement, decrease in investment value, and change in level ofownership or degree of influence.  EITF08-6 is effective on a prospective basis for fiscal years beginning on or afterDecember 15, 2008.  The Company’sadoption of EITF 08-6 as of January 1, 2009 had no impact on itsconsolidated financial position and results of operations.

 

*Accounting for Defensive Intangible Assets*

In November 2008, the FASB issued EITF08-7, “Accounting for Defensive Intangible Assets.”  EITF 08-7 clarifies how to account fordefensive intangible assets subsequent to initial measurement.  EITF 08-7 applies to all defensive intangibleassets except for intangible assets that are used in research and developmentactivities.  EITF 08-7 is effective forintangible assets acquired on or after the beginning of the first annualreporting period beginning on or after December 15, 2008.  The Company is currently assessing the impactof EITF 08-7 on its consolidated financial position and results of operations.

 

*Accounting for an Instrument (or an EmbeddedFeature) with a Settlement Amount That is Based on the Stock of an Entity’sConsolidated Subsidiary*

In November 2008, the FASB issued EITF08-8, “Accounting for an Instrument(or an Embedded Feature) with a Settlement Amount That is Based on the Stock ofan Entity’s Consolidated Subsidiary.” EITF 08-8 clarifies whether a financial instrument for which the payoffto the counterparty is based, in whole or in part, on the stock of an entity’sconsolidated subsidiary is indexed to the reporting entity’s own stock.  EITF 08-8 also clarifies whether or not stockshould be precluded from qualifying for the scope exception of SFAS 133, “Accountingfor Derivative Instruments and Hedging Activities,” or from being within thescope of EITF 00-19, “Accounting for Derivative Financial Instruments Indexedto, and Potentially Settled in, a Company’s Own Stock.”  EITF 08-8 is effective for fiscal yearsbeginning on or after December 15, 2008, and interim periods within thosefiscal years.  There was no effect to theCompany’s consolidated financial statements upon its adoption EITF 08-8 as of January 1,2009 as it has no such instruments.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

*Disclosures by Public Entities (Enterprises)about Transfers of Financial Assets and Interests in Variable Interest Entities*

In December 2008, the FASB issued FSPFAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) aboutTransfers of Financial Assets and Interests in Variable Interest Entities.”  This FSP amends SFAS 140, “Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities,”to require public entities to provide additional disclosures about transfers offinancials assets.  FSP FAS 140-4 alsoamends FIN 46(R)-8, “Consolidation of Variable Interest Entities,” to requirepublic enterprises, including sponsors that have a variable interest entity, toprovide additional disclosures about their involvement with a variable interestentity.  FSP FAS 140-4 also requirescertain additional disclosures, in regards to variable interest entities, toprovide greater transparency to financial statement users.  FSP FAS 140-4 is effective for the firstreporting period (interim or annual) ending after December 15, 2008, withearly application encouraged.  There wasno effect to the Company’s consolidated financial statements upon its adoptionFSP FAS 140-4 as of January 1, 2009 as it has no such transfers.

 

*Employers’ Disclosures about PostretirementBenefit Plan Assets*

In December 2008, the FASB issued FSPFAS 132(R)-1, “Employers’ Disclosuresabout Postretirement Benefit Plan Assets.” This FSP amends SFAS 132(R), “Employers’ Disclosures about Pensions andOther Postretirement Benefits,” to provide guidance on an employer’sdisclosures about plan assets of a defined benefit pension or otherpostretirement plan.  FSP FAS No. 132(R)-1also includes a technical amendment to SFAS 132(R) that requires anonpublic entity to disclose net periodic benefit cost for each annual periodfor which a statement of income is presented. The required disclosures about plan assets are effective for fiscalyears ending after December 15, 2008. The technical amendment was effective upon issuance of FSP FAS132(R)-1.  The impact of adoptionwas not material to the Company’s consolidated financial condition or resultsof operations.

 

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

 

Costs in Excess of Billings and Billing in Excess of Costs

The cost in excess of billings on uncompleted contracts reflects theaccumulated costs incurred on contracts in production but not completed.  Upon completion, inspection and acceptance bythe customer, the contract is invoiced and the accumulated costs are charged tostatement of operations as costs of revenues. During the production cycle of the contract, should any progressbillings occur or any interim cash payments or advances be received, suchbillings and/or receipts on uncompleted contracts are accumulated as billingsin excess of costs. The Company fully expects to collect net costs incurred inexcess of billing and periodically evaluates each contract for potentialdisputes related to contract overruns and uncollectable amounts.  There was no bad debt expense recorded forthe three months ended March 31, 2009 and 2008.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

Net costs incurred in excess of billing consisted of the following as ofMarch 31, 2009 and December 31, 2008

 
| ** **                                                        | ** ** | **2009** | ** ** | **2008** | ** ** |
|-------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                              |       |     |       |     |       |
| Cost in excess of billings on uncompleted contracts               |       | $        | 6,562,903  |     | $          | 7,143,089 |   |
| Billings and/or receipts on uncompleted contracts                 |       | —   |       | —   |       |
| Net costs incurred in excess of billing on  uncompleted contracts |       | $        | 6,562,903  |     | $          | 7,143,089 |   |

 

Accounts Receivable

The Company records accounts receivable related to its long-termcontracts, based on billings or on amounts due under the contractualterms.  Accounts receivable consistprimarily of receivables from completed contracts and progress billings onuncompleted contracts.  Allowance fordoubtful accounts is based upon a review of outstanding receivables, historicalcollection information, and existing economic conditions. Any amountsconsidered recoverable under the customer’s surety bonds are treated ascontingent gains and recognized only when received.

 

Accounts receivable throughout the year may decrease based on paymentsreceived, credits for change orders, or back charges incurred. At March 31,2009 and December 31, 2008, the Company had $6,434,888 and $4,981,150,respectively, of accounts receivable, of which the Company considers all to befully collectible.  There was no bad debtexpense recorded for the three months ended March 31, 2009 or 2008.

 

**3.****                  ****PROPERTYAND EQUIPMENT**

 

Property and equipment at March 31, 2009 and December 31,2008 consisted of the following:

 
| ** **                                      | ** ** | **2009**  | ** ** | **2008**  | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|
| Leasehold improvements                          |       | $         | 1,749,367  |      | $          | 1,749,367 |   |
| General equipment                               |       | 732,745   |       | 666,120   |       |
| Light vehicles and trailers                     |       | 221,247   |       | 221,247   |       |
| T2 Demonstration range and firearms             |       | 744,454   |       | 744,454   |       |
| Office equipment                                |       | 855,294   |       | 855,294   |       |
| Furniture and fixtures                          |       | 163,658   |       | 163,658   |       |
| Aircraft                                        |       | 868,750   |       | 868,750   |       |
|                                            |       | 5,335,515 |       | 5,268,890 |       |
| Less: accumulated depreciation and amortization |       | 1,766,283 |       | 1,524,954 |       |
|                                            |       | $         | 3,569,232  |      | $          | 3,743,936 |   |

 

For the three months ended March 31, 2009 and 2008, the Companyrecorded $241,329 and $134,769 in depreciation and amortization expense,respectively.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

The Company maintains its firearms under the custodianship of an individualin accordance with New York State law. The firearms are used for testing anddemonstrating the effectiveness of the Company’s bullet resistant and blastmitigation products.

 

**4.****                  ****COMMITMENTSAND CONTINGENCIES**

 

**Legal Proceedings**

 

SouthernCalifornia Gold Products d/b/a Gypsy Rack

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. The amendedcomplaint seeks to enjoin the defendants from misappropriating, disclosing, orusing our confidential information and trade secrets, and recall and surrenderall products and trade secrets wrongfully misappropriated or converted by thedefendants. It also seeks compensatory damages in an amount to be establishedat trial together with prejudgment and post judgment interest, exemplarydamages, disgorgement, restitution with interest, attorney’s fees and the costsof suit.  Defendants filed an answer tothe amended complaint on April 16, 2008. Shortly after the filing of the amended answer, defendants made a motionfor summary judgment on, among others, the grounds of collateral estoppel andres judicata. We filed opposition to the motion. The defendants motion and asubsequent application for an immediate interlocutory appeal were denied. Amediation settlement conference was held on October 31, 2008, which wasunsuccessful. The discovery process is continuing and trial is currently setfor August 25, 2009.

 

Breachof Contract

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.

 

Breach of Contract

 

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. TheCompany believes the allegations to be without merit and intend to 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

vigorouslydefend against the action. On March 7, 2008, a second action was commencedagainst 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, the Company served a motionto dismiss the complaint, which is fully submitted to the Court and on or aboutSeptember 26, 2008, the Court dismissed several claims.  The remaining claims include breach ofcontract claims and claims seeking the lifting of the transfer restrictions onstock. On October 13, 2008, the Company’s former General Counsel filed anamended complaint as to the remaining claims. On November 5, 2008, the Company filed an answer to the complaintand filed counterclaims for fraud. The parties are to commence documentarydiscovery, which will be followed by depositions. No amounts have been accruedfor damages as the Company believes meritorious defenses to the claims exist.  The Company intends to vigorously defend thisaction. No further significant actions have occurred and the matter is stillpending resolution at March 31, 2009.

 

**Financing**

 

As of March 31, 2009 and 2008, the Company had access to $12million dollars of financing, respectively, with TD Bank, f/k/a Commerce Bankas follows:

 

$12 Million Line of Credit — This line of credit allows the Company toborrow up to $12 Million dollars, limited to 80 – 85% of the total accountsreceivable.  Under the line of credit, the Company is chargedinterest at 1.75% over the libor rate.  The line of credit repaymentterms are due upon demand.  The balances as of March 31, 2009and 2008 were $659,422 and $76,832, respectively.

 

**5.****                  ****STOCKHOLDERS’EQUITY**

 

**Warrants**

 

As part of the February 2005 private offering, the Company issuedpurchase warrants for up to 808,462 shares of common stock at the purchaseprice of $1.00 per share to the placement agent which will expire September 1,2010. The original warrants issued in connection with the offering expired on August 31,2006.

 

Thefollowing is a summary of stock warrants outstanding at March 31, 2009.

 
| ** **           | ** ** | ** **   | ** ** | ** **         | ** ** | **Value if**  | ** ** |
|----------------------|------------|--------------|------------|--------------------|------------|---------------|------------|
| ** **           | ** ** | **Warrants** | ** ** | **Exercise Price** | ** ** | **Exercised** | ** ** |
| Beginning balance    |       | 773,680      |       | 1.00               |       | $             | 773,680    |   |
| Exercised            |       | —       |       | 1.00               |       | —        |       |
| Forfeited or expired |       | —       |       | 1.00               |       | —        |       |
| Ending balance       |       | 773,680      |       | 1.00               |       | $             | 773,680    |   |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Stock Option Plan**

 

Thefollowing is a summary of stock options outstanding as of March 31, 2009;

 
| Beginning balance — December 31, 2008 |   | 1,995,000 |   |
|-------------------------------------------------|--------|-----------|--------|
| Options issued                                  |   | 200,000   |   |
| Exercised                                       |   | —    |   |
| Forfeited or expired                            |   | —    |   |
| Ending balance — March 31, 2009       |   | 2,195,000 |   |

 

On January 12, 2009, we issued options to purchase an aggregate of100,000 shares of our common stock to our consultants for servicesrendered.  The exercise price for eachoption is $2.00 per share and each option vested immediately upon the issuance.

 

TheBlack-Scholes method option pricing model was used to estimate fair value as ofthe date of grant using the following assumptions:

 
| Risk-Free           |   | 2.99    | %      |
|---------------------|--------|---------|--------|
| Expected volatility |   | 45.00   | %      |
| Forfeiture rate     |   | 10.00   | %      |
| Expected life       |   | 5 Years |   |
| Expected dividends  |   | —  |   |

 

Based on the assumptions noted above, the fair market value of theoptions issued was valued at $13,183 as of March 31, 2009.

 

**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.

 

*Accounting for the Series APreferred*

 

TheCompany accounted for the transaction in accordance with SFAS 150 “Accountingfor Certain Financial Instrument with Characteristics of both Liabilities andEquity.”  SFAS 150 provides guidance onhow financial instruments should be classified and measured whencharacteristics of both liabilities and equity exist and requires that anentity classify a financial instrument that is within its scope as a liabilitybecause the financial instrument embodies an 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

obligationof the issuer.  The mandatory redemptionprovision incorporated into the Series A Preferred causes the stock tofall within the scope of SFAS 150 since the Company must redeem the stock by December 31,2010 by transferring cash to the Holders.

 

Theproceeds from the issuance of the Series A Preferred and accompanyingcommon stock warrants, net of direct costs including the fair value of warrantsissued to placement agent in connection with the transaction, must be allocatedto the instruments based upon relative fair value upon issuance.  In addition, under SFAS 150, paragraph 20, “mandatorilyredeemable instruments must be measured initially at fair value.”   Therefore, after the initial recording ofthe Series A Stock based upon net proceeds received, the carrying value ofthe Series A Preferred must be adjusted to the fair value at the date ofissuance, with the difference recorded as a loss.

 

Thevaluation of the Series A Preferred at March 31, 2009 is as follows:

 
| **Security**       | ** ** | **Face Value** | ** **       | **Fair Value** | ** ** | **Allocation of   proceeds** | ** ** | **Proceeds in excess   of fair value** | ** ** |
|--------------------|------------|----------------|------------------|----------------|------------|------------------------------|------------|----------------------------------------|------------|
| Series A      |       | $              | 15,000,000       |           | $          | 11,809,196                   |       | $                                      | 13,459,474 |   | $ | 1,650,278 |   |
| Preferred Warrants |       | —         |             | 115,275        |       | 1,540,526                    |       | 1,425,251                              |       |
|               |       |           |             |           |       |                         |       |                                   |       |
|               |       | $              |  15,000,000 |           | $          | 11,924,471                   |       | $                                      | 15,000,000 |   | $ | 3,075,529 |   |

 

OnApril 14, 2009, the Company received a Notice of Triggering EventRedemption purportedly pursuant to a redemption option provided under theCertificate of Designation, as more fully discussed in Note 10.  The Company continues to reflect the Series APreferred Stock and Investor Warrant liability as long term liabilities.  The Company is precluded from satisfying sucha demand, due to its lack of sufficient surplus as such term is defined underDelaware law to effect the redemption demand, and restrictions under ourrevolving line of credit would nevertheless prohibit any such redemption.

 

Forthe three months ended March 31, 2009 and 2008, the Company has recorded anet loss on adjustment of fair value of their Series A Preferred of$694,454 and $1,428,665, respectively.

 

Investor Warrants

 

Inconnection with the closings under the Purchase Agreement, Investor Warrants topurchase up to 3,750,000 shares of Common Stock at $2.40 per share were issuedin addition to the 15,000 shares of Series A Preferred.

 

Placement Agent Warrants

 

Inconnection with the sale of the Series A Preferred and Investor Warrants,the placement agent was entitled to receive warrants (Placement Agent Warrants)to purchase a total of 6% of the number of common stock issued in the financingor 675,000 shares.  The Placement AgentWarrants were accounted for as a transaction cost associated with the issuanceof the Series A Preferred.  ThePlacement Agent Warrants recorded at fair value at the date of issuance.  Under 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

EITF00-19 “Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock”, the Company satisfies the criteria forclassification of the Placement Agent Warrants as equity.  The fair value associated with the 675,000Placement Agent Warrants was $511,742.

 

DeferredFinancing Costs

 

Deferredfinancing costs include the corresponding amount associated with the PlacementAgent Warrants as indicated above, along with all other costs associated withobtaining the Series A Preferred financing.  Since the Series A Preferred andInvestor Warrants are classified as liabilities, the carrying value of thePlacement Agent Warrants has been recorded as Other Assets on the balance sheetand is amortized as additional financing costs over the term of the Series APreferred using the interest method.  Deferred financing costs included thefollowing:

 
| Placement agent costs                         |   | $        | 900,000   |   |
|-----------------------------------------------|--------|----------|-----------|--------|
| Investor expenses                             |   | 60,000   |      |
| Legal and other related costs                 |   | 233,350  |      |
| Fair market value of placement agent warrants |   | 511,742  |      |
| Less: amortization                            |   | (576,691 | )         |
| Deferred financing costs, net                 |   | $        | 1,130,409 |   |

 

**7.****                  ****DISCONTINUED OPERATIONS**

 

OnJanuary 2, 2009, the Company entered into an agreement with the priorowners of TAG to sell the assets and liabilities back to TAG.  TAG was accounted for as a discontinuedoperation under GAAP, which requires the income statement and cash flowinformation be reformatted to separate the divested business from the Company’scontinuing operations.

 

Thefollowing amounts represent TAG’s operations and have been segregated fromcontinuing operations and reported as discontinued operations as of March 31,2009 and March 31, 2008.

 
| ** **               | ** ** | **2009** | ** ** | **2008** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|
| Contract revenues earned |       | $        | —     |     | $          | 685,210 |   |
| Cost of revenues earned  |       | —   |       | 131,642  |       |
| Gross Profit             |       | —   |       | 553,568  |       |
| Operating expenses       |       | —   |       | 554,057  |       |
| Other expenses           |       | —   |       | —   |       |
| Net Loss                 |       | $        | —     |     | $          | (489 | ) |

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

Thefollowing is a summary of assets and liabilities of TAG discontinued operationsas of March 31, 2009 and December 31, 2008.

 
| ** **                  | ** ** | **2009** | ** ** | **2008** | ** ** |
|-----------------------------|------------|----------|------------|----------|------------|
| Assets                      |       |     |       |     |       |
| Cash                        |       | $        | —     |     | $          | 75,103 |   |
| Inventory                   |       | —   |       | 591,688  |       |
| Prepaid expenses            |       | —   |       | 174      |       |
| Property and equipment, net |       | —   |       | 69,648   |       |
| Total Assets                |       | $        | —     |     | $          | 736,613 |   |
|                        |       |     |       |     |       |
| Liabilities                 |       |     |       |     |       |
| Accounts payable            |       | $        | —     |     | $          | 700,287 |   |
| Short term notes            |       | —   |       | 36,326   |       |
| Total Liabilities           |       | $        | —     |     | $          | 736,613 |   |

 

Inaccordance with the terms of the agreement, the original owners of TAG agreedto repay $1,000,000 of the original $2,000,000 in consideration as follows:

 
| 2009  |   | $         | 75,000  |   |
|-------|--------|-----------|---------|--------|
| 2010  |   | $         | 100,000 |   |
| 2011  |   | $         | 175,000 |   |
| 2012  |   | $         | 275,000 |   |
| 2013  |   | $         | 375,000 |   |
| Total |   | 1,000,000 |    |

 

The Company has included the entire amount as notes receivable on itsbalance sheet, of which $75,000 is included within other current assets and$925,000 is recorded as a long term notes receivable.  The original owners of TAG havecollateralized the note receivable with their personal residence and the250,000 shares issued to them on the date of acquisition.  These shares are being held by the Company inescrow since January 2009 and will be returned upon final payment towardthe note receivable.

 

**8.****                  ****SUBSEQUENTEVENT**

 

Series A Preferred Stock

TheCompany, West Coast Opportunity Fund, LLC (“WCOF”), Centaur ValuePartners, LP (“Centaur Value”) and United Centaur Master Fund (“UnitedCentaur”, and together with Centaur Value, “Centaur”) entered into aSecurities Purchase Agreement, dated March 7, 2008 (the “Purchase Agreement”),pursuant to which WCOF and Centaur purchased an aggregate of 15,000 sharesof the Company’s Series A Convertible Preferred Stock (the “Series APreferred”) and warrants to acquire an aggregate of 3,750,000 shares of theCompany’s common stock (the “Warrants”) for an aggregate purchase priceof $15,000,000.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

TheCompany, WCOF and Centaur entered into a Consent and Agreement of Series AConvertible Preferred Stockholders, dated May 23, 2008 (the “ConsentAgreement”), in which the parties agreed that the Company would not bepermitted to issue shares of common stock as dividends on, or upon conversionof, the Series A Preferred or upon the exercise of the Warrants in excessof a specified number of shares without the approval of the Company’sstockholders.  In the Consent Agreement, the Company covenanted, for thefiscal year ending December 31, 2008  (A) to achieve (i) Revenues(as that term is defined in the Consent Agreement) equal to or exceeding$50,000,000 and (ii) Consolidated EBITDA (as that term is defined in theConsent Agreement) equal to or exceeding $13,500,000, and (B) to publiclydisclose and disseminate, and to certify to WCOF and Centaur, its operatingresults for such period, no later than February 15, 2009 (collectively,the “Financial Covenants”).

 

TheCompany did not meet the Revenue and Consolidated EBITDA targets set forth inthe Consent Agreement and was not in a position to disclose or certify itsoperating results by February 15, 2009.

 

Underthe Consent Agreement, the breach of the Financial Covenants are each deemed a “TriggeringEvent” under Section 3(a)(vii) of the Company’s Certificate ofDesignations, Preferences and Rights of the Series A Convertible PreferredStock (the “Certificate of Designations”), giving the holders of the Series APreferred the right to require the Company to redeem all or a portion of suchholder’s Series A Preferred shares at a price per share as calculatedpursuant to Section 3(b)(i) of the Certificate of Designations. The Company had negotiated the key terms of a resolution to the foregoing withWCOF and Centaur, and, to that end entered into a Term Sheet with each of WCOFand Centaur dated February 13, 2009 (the “WCOF Term Sheet” and the “CentaurTerm Sheet”, respectively, and, collectively, the “Term Sheets”).

 

Inorder to allow the parties to negotiate definitive agreements relating to theforegoing and to consummate the same, WCOF and Centaur had agreed, subject tothe terms and conditions set forth in the letters of forbearance entered intoby the Company and each of WCOF and Centaur on February 13, 2009 toforbear from exercising their rights and remedies, including without limitationthe right to cause the redemption of the Series A Preferred shares as aresult of breaches of the Consent Agreement described above, until the earlierof (a) the date on which any Triggering Event (as defined in theCertificate of Designations), other than a breach of the Financial Covenants,shall occur or exist and (b) February 27, 2009.

 

The Forbearance Period expired effective February 27, 2009.  The Company received a notice of TriggeringEvent redemption purportedly pursuant to a redemption option provided under theCertificate of Designation (or Notice of Triggering Event Redemption) on April 14,2009 from a Series A Preferred Stockholder that holds approximately 94% ofsuch preferred stock.  The Series APreferred Stockholder has demanded that the Company immediately redeem 14,025shares of the Series A Preferred, which constitutes all of the shares of Series APreferred held by such Series A Preferred Stockholder, at an aggregateprice of $15,427,500.  The Series APreferred Stockholder has also demanded payment of $470,317 as dividends theyassert have accrued from January 1, 2009 through April 13, 2009, ontheir Series A Preferred at the cash dividend rate of 12%, as well as$70,000.00 in legal fees and expenses incurred in connection 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

with the negotiations relating to the breach of the Financial Covenantspursuant to the forbearance letter dated February 13, 2009.  Due to restrictions on the payment ofdividends under our revolving line of credit with TD Bank, the Company has notpaid dividends on the Series A Preferred for 2009.

 

The Company currently does not have sufficient surplus as such term isdefined under Delaware law to effect the redemption sought by the Series APreferred Stockholder, and restrictions under the Company’s revolving line ofcredit would nevertheless prohibit any such redemption.  The Company continues to value the Series APreferred Stock and Investor Warrants at its fair value as of March 31,2009 of $11,924,471.

 

TD Bank

 

On April 1, 2009, the Company received a Notice of Default from TDBank (Lender), resulting from the violation of financial covenants.  TheLender has stated that they are not presently taking action to enforce itsrights and remedies under the Loan Documents; however they are not waivingtheir rights under any existing or future defaults or events of default.  TheLender will continue to make advances under the Revolving Credit, but it has noobligation to do so and may refuse an advance request in its sole discretionwithout notice.

 

TheCompany and Lender have entered into a Forbearance Agreement and Amendment toLoan Agreement on April 27, 2009 pursuant to which the Lender will forbearfrom exercising its default-related rights and remedies with respect to theSpecified Defaults, including without limitation acceleration and foreclosure,and continue to provide Advances and other financial accommodations under theLoan Agreement, until the earlier to occur of the termination of theForbearance Period as a result of any Forbearance Default (as such term isdefined in the Forbearance Agreement) and June 15, 2009 (the “ForbearancePeriod”). Notwithstanding the foregoing, the lender will have no obligation tomake any advance if, after giving effect thereto, the aggregate principalamount of the Advances plus outstanding letters of audit issued by the lenderfor the account of any Borrower would exceed $2,000,000 prior to May 15,2009 and $1,000,000 as of May 15, 2009 and thereafter. Under theForbearance Agreement, the Company has agreed, among other things, (i) notto make any Restricted Payment (as such term is defined in the Loan Agreement),other than a stock dividend payable in common stock of the Company and approvedby the Lender in its sole discretion, (ii) to use their best efforts toobtain a Refinancing, (iii) to provide certain monthly financialinformation as set forth in the Forbearance Agreement and (iv) to pay theAdvances, the Term Loan (as such term is defined in the Loan Agreement) and allother Obligations in full by June 15, 2009. The failure by the Borrower tocomply with any of the foregoing shall constitute a Forbearance Default underthe Forbearance Agreement, which can result in termination of the ForbearanceAgreement.

 

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**Item 2.    Management’s Discussion and Analysis ofFinancial 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 annual report on Form 10-K (SEC No. 001-33888) filed with theSecurities and Exchange Commission (or SEC) on April 15, 2009.*

 

*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,” in ourannual report on Form 10-K filed with the SEC on April 15, 2009, aswell as other cautionary language in such Form 10-K, describe suchrisks, 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 a provider ofcustomized transparent and opaque armor solutions for tactical and non-tacticaltransport vehicles and construction equipment used by the military.

 

        We also provide physicalsecurity products for architectural hardening and perimeter defense, such asbullet and blast resistant transparent armor, walls and doors, as well asvehicle anti-ram barriers such as bollards, steel gates and steel wedges thatdeploy out of the ground.

 

        In 2008, we launched ournew live-fire interactive T2 Tactical Training System and have begun activemarketing of the system. T2 provides law enforcement officers, SWAT teammembers, tactical specialists and military operators with the opportunity tohone their firearms and combat skills, with their own weapons and ammunition,in conjunction with realistic video scenarios broadcast on a large screen,incorporating environmental factors such as heat, cold,

 

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sound and light effects. In addition toinstallation fees for T2 systems, we anticipate additional revenueopportunities for service and support of T2 facilities once installed, andexpect to offer training in the T2 as part of our American Institute forDefense and Tactical Studies.

 

        Alsoin 2008, in conjunction with the T2, we began offering courses and seminarsthrough our tactical training institute, the American Institute for Defense andTactical Studies. Course offerings include training in the fields ofCounterterrorism, Fundamentalist Islam and Middle Eastern Mindset, DignitaryProtection, IED Terrorist Tradecraft, Emergency Tactical Medicine, PostSuicide-Bombing Command and Incident Response, Forensics and Hand-to-HandCombat.

 

        Wefocus primarily on research and development, design and engineering,fabrication and providing component integration. Our armor solutions are usedin retrofit applications for equipment already in service, and we work withoriginal equipment manufacturers to provide armor solutions for new equipmentpurchased by the military. Similarly, our architectural hardening and otherphysical security products are incorporated in new construction, but are more oftendeployed in existing structures and facilities ranging from secure commercialbuildings to military bases and other facilities.

 

        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 sales are highly concentrated within the U.S.government. Our customers include various branches of the U.S. military throughthe U.S. Department of Defense (or DoD) and to a much lesser extent other U.S.government, law enforcement and correctional agencies as well as private sectorcustomers.

 

        Ourrecent historical revenues have been generated primarily from two largecontracts and a series of purchase orders from a single customer.** **To continueexpanding our business, we are seeking to broaden our customer base and todiversify our product and service offerings. Our strategy to increase ourrevenue, grow our company and increase stockholder value involves the followingkey elements:

 

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

·                  formstrategic partnerships with original equipment manufacturers (OEMs);

·                  developstrategic alliances;

·                  capitalizeon increased homeland security requirements and non-military platforms;

·                  increasemarketing efforts relating to our new tactical training products and services;and

·                  focuson an advanced research and development program to capitalize on increaseddemand for new armor materials.

 

        Weare pursuing each of these growth strategies simultaneously, and expect one ormore of them to result in additional revenue opportunities within the next12 months.

 

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**Sources of Revenues**

 

        Wederive our revenues by fulfilling orders under master contracts awarded bybranches of the United States military, law enforcement and correctionsagencies and private companies involved in the defense market and othercustomer purchase orders. Under these contracts and purchase orders, we providecustomized transparent and opaque armor products for transport and constructionvehicles used by the military, group protection kits and spare parts. We alsoderive revenues from sales of our physical security products.

 

        Our contractbacklog as of March 31, 2009 and March 31, 2008 was $60.0 million and$35 million, respectively, and ofour $60 million of contract backlog as of March 31, 2009, we estimatethat $45.0 million will be filled in 2009. Accordingly, in order to maintainour current revenue levels and to generate revenue growth, we will need to winmore contracts with the U.S. government and other commercial entities, achievesignificant penetration into critical infrastructure and public safetyprotection markets, and successfully further develop our relationships with OEM’sand strategic partners. Notwithstanding the possible significant troopreductions in Afghanistan and Iraq, we expect that demand in those countriesfor armored military construction vehicles will continue in order to repairsignificant war damage and for nation-building purposes. In addition, we areexploring interest in armored construction equipment in other countries withmine-infested regions.

 

        Wecontinue to aggressively bid on projects and are in preliminary talks with anumber of international firms to pursue long-term government and commercialcontracts, including with respect to Homeland Security. While no assurances canbe given that we will obtain a sufficient number of contracts or that anycontracts we do obtain will be of significant value or duration, we areconfident that we will continue to have the opportunity to bid and wincontracts as we have in 2007 and 2008.

 

**Cost of Revenues and OperatingExpenses**

 

*        Costof Revenues.*    Costof revenues consists of parts, direct labor and overhead expense incurred forthe fulfillment of orders under contract. These costs are charged to expenseupon completion and acceptance of an order. Costs of revenue also includes thecosts of protyping and engineering, which are expensed upon completion of anorder as well. These costs are included as costs of revenue because they areincurred to modify products based upon government specifications and arereimbursable costs within the contract. These costs for the production of goodsunder contract are expensed when they are complete. We allocate overheadexpenses such as employee benefits, computer supplies, depreciation forcomputer equipment and office supplies based on personnel assigned to the job.As a result, indirect overhead expenses are included in cost of revenues andeach operating expense category.

 

*        Salesand Marketing.*    Expensesrelated to sales and marketing consist primarily of compensation for our salesand marketing personnel, sales commissions and incentives, trade shows andrelated travel.

 

        Asour revenues increase, we plan to continue to invest heavily in sales andmarketing by increasing the number of direct sales personnel in order to addnew customers and increase sales to our existing customers. We also plan toexpand our marketing activities in order to build brand 

 

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awareness and generate additional leads for ourgrowing sales personnel. We expect that in 2009, sales and marketing expenseswill remain at the same or a slightly higher level in absolute dollars but willdecrease as a percentage of revenues.

 

*        Researchand Development.*    Researchand development expenses are incurred as we perform ongoing evaluations ofmaterials and processes for existing products, as well as the development ofnew products and processes. Such expenses typically include compensation andemployee benefits of engineering and testing personnel, materials, travel andcosts associated with design and required testing procedures associated withour product line. We expect that in 2009, research and development expenseswill 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.

 

*        Generaland Administrative.*    Generaland administrative expenses consist of compensation and related expenses forexecutive, finance, accounting, administrative, legal, professional fees, othercorporate expenses and allocated overhead. We expect that in 2009, general andadministrative expenses will remain at the same or a slightly higher level inabsolute dollars but decrease as a percentage of revenues.

 

**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.

 

        Webelieve that of our significant accounting policies, which are described inNote 1 to the consolidated financial statements, the following accountingpolicies involve a greater degree of judgment and complexity. Accordingly,these are the policies we believe are the most critical to aid in fullyunderstanding and evaluating our consolidated financial condition and resultsof operations.

 

*        Revenueand Cost Recognition.*    Werecognize revenue in accordance with the provisions of the Securities andExchange Commission (SEC) Staff Accounting Board (SAB) No. 104, “*Revenue Recognition”*, which states thatrevenue is realized and earned when all of the following criteria are met: (a) persuasiveevidence of the arrangement exists, (b) delivery has occurred or serviceshave been rendered, (c) the seller’s price to the buyer is fixed anddeterminable and (d) collectability is reasonably assured. Under thisprovision, revenue is recognized upon delivery and acceptance of the order.

 

        Werecognize revenue and report profits from purchases orders filled under mastercontracts under the completed contract method. Purchase orders received undermaster contracts may extend for periods in excess of one year. Contract costsare accumulated as deferred assets and 

 

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billings and/or cash received are charged to adeferred revenue account during the periods of construction. However, norevenues, costs or profits are recognized in operations until the period uponcompletion of the order. An order is considered complete when all costs, exceptinsignificant items, have been incurred and, the installation or product isoperating according to specification or the shipment has been accepted by thecustomer. Provisions for estimated contract losses are made in the period thatsuch losses are determined. As of March 31, 2009, there were no suchprovisions made.

 

        Allcosts associated with uncompleted purchase orders under contract are recordedon the balance 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.

 

        Allbillings associated with uncompleted purchase orders under contract arerecorded on the balance sheet as a deferred liability called “Billings inExcess of Costs on Uncompleted Contracts”. Upon completion of a purchase order,all such associated billings would be reclassified from the balance sheet tothe statement of operations as revenues. Due to the structure of our contracts,billing is not done until the purchase order is complete, therefore there areno amounts recorded as deferred liabilities as of March 31, 2009.

 

*        Stock-BasedCompensation.*    Stockbased compensation consists of stock or options issued to employees, directorsand contractors for services rendered. We accounted for the stock issued usingthe estimated current market price per share at the date of issuance. Such costwas recorded as compensation in our statement of operations at the date ofissuance.

 

        InDecember 2007, we adopted our 2007 Incentive Compensation Plan pursuant towhich we have issued and intend to issue stock-based compensation from time totime, in the form of stock, stock options and other equity based awards. Ourpolicy for accounting for such compensation in the form of stock options is asfollows:

 

        Wehave adopted 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.

 

        Becausewe have 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 

 

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assumptions can affect the estimated fair valueof options 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 $29,192 and $33,685 in stock compensation expense as of March 31,2009 and March 31, 2008, respectively.

 

**Series A ConvertiblePreferred Stock, Investor Warrants and Placement Agent Warrants**

 

*        Series APreferred Stock.*    Weaccounted 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 wemust redeem the stock by December 31, 2010 by transferring cash to theholders of the Series A Preferred.

 

        Theproceeds from the issuance of the Series A Preferred and accompanyingcommon stock warrants, net of direct costs including the fair value of warrantsissued to the Placement Agent in connection with the transaction, must beallocated to the instruments based upon relative fair value upon issuance. Inaddition, under SFAS 150, paragraph 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 gainor loss. On March 7, 2007, the date of initial issuance, we recorded aderivative liability of $9,832,497. On April 4, the date of the second issuance,we recorded a derivative liability of $3,626,977.  These liabilities were subsequently adjustedto fair value as of March 31, 2009, which resulted in a net loss of$694,454. As of March 31, 2009, the Series A Preferred liability was$11,809,196.

 

*        InvestorWarrants.*    Thewarrants issued with the Series A Preferred (or Investor Warrants) meetthe criteria under SFAS 133 “Accounting for Derivative Instruments andHedging Activities”. Under SFAS 133, the warrants are recorded at fairvalue upon the date of issuance, with changes in the value fair valuerecognized as a gain or loss as they occur. On March 7, 2007, the date ofinitial issuance, we recorded a derivative liability of $1,142,503. On April 4,2008, the date of the second issuance, we recorded a derivative liability of$398,023.  As of December 31, 2008,the Investor Warrant liability was $115,275. These liabilities were subsequently adjusted to fair value as of March 31,2009, which resulted in a net gain of $14,054. The Investor Warrants meet the criteria under EITF 01-6 “TheMeaning of Indexed to a Company’s Own Stock”, which provides guidance as towhether a contract is indexed to a company’s own stock. However, since thewarrants do not meet the criteria for reporting as an 

 

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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.

 

*        PlacementAgent Warrants.*    Thewarrants issued to the Placement Agent with respect to the sale of the Series APreferred and Investor Warrants (or Placement Agent Warrants) were accountedfor as a transaction cost associated with the issuance of the Series APreferred. The Placement Agent Warrants are recorded at fair value at the dateof issuance. Under EITF 00-19 “Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, wesatisfy the criteria for classification of the Placement Agent Warrants asequity. We have recorded the corresponding amount recorded as a DeferredFinancing Cost. Since the Series A Preferred and Investor Warrants areclassified as liabilities, the carrying value of the Placement Agent Warrantshas been recorded as an other asset and is amortized as additional financingcosts over the term of the Series A Preferred using the interest method.At the date of each issuance, we recorded $1,033,433 and $418,559 in deferredfinancing costs and amortized $147,424 as interest expense as of March 31,2009.

 

***Comparison of the Three Months EndedMarch 31, 2009 and 2008***

 

*Revenues.*  Revenuesfrom continuing operations for the three months ended March 31, 2009 wasapproximately $9.4 million, an increase of approximately $700,000, or 8%, overrevenues of approximately $8.7 million in the comparable period in 2008. This increase was due primarily to increased order fulfillment under our MarineCorp Contract No. M67854-07-D-5023 during the first quarter of 2009 versusthe same quarter in 2008, including orders that had been expected in the fourthquarter of 2008 that were delayed into the first quarter of 2009.  Therevenue increase also was due to additional sales generated from our physicalsecurity product business for the three months ended March 31, 2009 ofapproximately $963,000, an increase of approximately $800,000 or 490% overrevenues of approximately $163,000 for the three months ended March 31,2008.

 

Revenues from discontinued operations fromthe tactical application retail outlet for the three months ended March 31,2008 was approximately $685,000.  Therewere no revenues generated from discontinued operations during the three monthsended March 31, 2009.

 

*Cost ofRevenues.* Cost of revenues for the three months ended March 31,2009 was approximately $5.4 million, an increase of approximately $100,000, or2%, over cost of revenue of $5.3 million in the comparable period in2008.  This increase was related to our increased production costs underthe Marine Corp. sales contract mentioned above.  The costs of revenuealso increased due to additional costs of sales from our physical securityproduct business, which had just commenced during the first quarter of March 31,2008.

 

Cost of revenues from discontinued operationsfrom the tactical application retail outlet for the three months ended March 31,2008 was approximately $131,000.  Therewere no costs of revenues generated from discontinued operations for the threemonths ended March 31, 2009.

 

*Grossprofit margin*.   The gross profit margin for the threemonths ended March 31, 2009 and March 31, 2008 were approximately $4 millionand $3.4 million, respectively.  The 

 

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gross profit margin percentage was 42.5% and 39% for the three monthsended March 31, 2009 and March 31, 2008, respectively. The increasein gross profit margin percentage from continuing operations from 2008 to 2009resulted primarily from a reduction in overall costs incurred during the threemonths ended March 31, 2009 that were associated with production on theMarine Corp. sales contract.

 

*Sales andMarketing Expenses.*  Sales and marketing expenses for thethree months ended March 31, 2009 and March 31, 2008 wereapproximately $733,000 and $632,000, respectively, representing an increase of$101,000, or 16%.  The increase was due primarily to an increase in tradeshow expenses and related expenses from marketing T2, along with our currentproduct line for the three months ended March 31, 2009.  We did not offer the T2 during the threemonths ended March 31, 2008 and, therefore, incurred no marketing expensefor its promotion.  There were no salesor marketing expenses for discontinued operations.

 

*Researchand Development Expenses.*  Research and development expensesfor the three months ended March 31, 2009 and March 31, 2008 wereapproximately $186,000 and $165,000, respectively.  The increase of$21,000 or 12% from 2008 to 2009 was the result of additional testing andimprovements of existing products and continued work on our products indevelopment.  There were no research anddevelopment expenses for discontinued operations.

 

*Generaland Administrative Expenses.*  General andadministrative expenses from continuing operations for the three months ended March 31,2009 and March 31, 2008 were approximately $1.65 million and $1.4 million,respectively.  The increase of approximately $250,000, or 17%, wasprimarily due to general increases in expenses, such as general and liabilityinsurance, rent and general supplies, which approximated $190,000.  Wealso incurred additional general and administrative expenses associated withthe facilities for our physical security product business of approximately$60,000.

 

General and administrative expensesassociated with discontinued operations was approximately $554,000 for thethree months ended March 31, 2008. There were no such expenses incurred during the three months ended March 31,2009.

 

*Generaland Administrative Salaries Expense.*  General andadministrative salaries expense for the three months ended March 31, 2009and March 31, 2008 were approximately $1.07 million and $1.13 million,respectively.  The net decrease of $60,000, or 5% was due to the decreasein salary expense at the Hicksville facility and the reduction of salaryexpense associated with the tactical application retail outlet that wasdiscontinued in 2008.  As of March 31, 2009, there were 39 employeesthat were classified as general and administrative personnel, versus 41employees as of March 31, 2008.

 

*Depreciationexpense.*  Depreciation expense was approximately$241,000 and $135,000 for the three months ended March 31, 2009 and March 31,2008, respectively.  The increase of 

 

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$107,000, or 79%, was the result of our higher property and equipmentbalance as of March 31, 2009 versus March 31, 2008.  This increase was the result of additionalleasehold improvements and equipment associated with the expansion of ourfacility during 2008, property and equipment purchased 2008 for our physicalsecurity product business, and T2 equipment. This higher capital balance as of March 31, 2009 resulted in higherdepreciation expense.

 

*Other (income) and expense.*  As aresult of our agreement to sell our Series A Convertible Preferred Stockand warrants to purchase common stock, we incurred losses which occurred uponthe valuation of the stock.  Such valuation took into account thefeatures, rights and obligations of the convertible preferred stock, whichultimately resulted in a higher 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 loss on such securities.  Weexperienced a loss on adjustment of fair value with respect to our Series AConvertible Preferred Stock of $694,000 and $1.4 million for the three monthsended March 31, 2009 and 2008, respectively.  We also recognized income of approximately$14,000 and a loss on the related investor warrants of $107,000 as of March 31,2009 and 2008, respectively.  In addition, we incurred interest expenseassociated with the amortization of the deferred financing costs and discounton the Series A Preferred Stock of $290,320 and $54,752 for the threemonths ended March 31, 2009 and 2008.

 

**Liquidity and Capital Resources**

 

The primary sources of our liquidity during the quarter ended March 31,2009 have come from operations and to a lesser extent under our bank creditfacility.  As of March 31, 2009, ourprincipal sources of liquidity were net accounts receivable of approximately$6.4 million and costs in excess of billings of approximately $6.6 million andborrowings under our revolving credit facility with TD Bank of approximately$591,000.

 

As of March 31, 2008, our principal sources of liquidity were cashand cash equivalents totaling approximately $9.8 million, net accountsreceivable of approximately $4.8 million and costs in excess of billings ofapproximately $8.7 million.  The primary sources of our liquidity duringthe three months ended March 31, 2008 came from operations and theproceeds from the sale of our Series A Convertible Preferred Stock.

 

On March 7, 2008, we entered into an agreement to sell shares ofour Series A Convertible Preferred Stock and warrants to purchase ourcommon stock, and to conditionally sell shares of our common stock, to threeinvestors. The aggregate purchase price of the preferred stock and warrants is$15.0 million and the aggregate purchase price of the common stock is$0.5 million.  An initial closing on the sale of the preferred stockand warrants was held on March 7, 2008 in which we received gross proceedsof $10,975,000. A subsequent closing took place on April 4, 2008 in whichwe received gross proceeds of $4,025,000.

 

  On April 14,2009, we received a Notice of Triggering Event Redemption purportedly pursuantto a redemption option provided under the Series A Convertible PreferredStock Certificate of Designations from the holder of approximately 94% of our Series AConvertible Preferred Stock, resulting from the breach of certain financialcovenants and the purported 

 

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occurrenceof a Triggering Event (as defined under the Series A Convertible PreferredStock Certification of Designations) resulting from such breach. The Series APreferred Stockholder has demanded that we immediately redeem14,025 shares of our Series A Convertible Preferred Stock, whichconstitutes all of the shares of such preferred stock held by the stockholder,at an aggregate price of $15,427,500.00. The Series A PreferredStockholder has also demanded that we pay $470,317.81 as dividends it assertshave accrued from January 1, 2009 through April 13, 2009, on itspreferred stock at the cash dividend rate of 12%, as well as $70,000.00 inlegal fees and expenses the stockholder states that it has incurred inconnection with the negotiations relating to the breach of the financialcovenants pursuant to the forbearance letter dated February 13, 2009. Dueto restrictions on the payment of dividends under our revolving line of creditwith TD Bank, we have not paid dividends on the Series A Preferredfor 2009.  We continue to negotiate withthe holders of our Series A Convertible Preferred Stock to resolve theforegoing matters.

 

In May 2007, we entered into a loanagreement with Commerce Bank, N.A. (now known as TD Bank) pursuant to which wehave access to a revolving credit facility up to a maximum of $12.0 milliondepending upon the periodic balance of our qualified accounts receivable.  As of March 31, 2009 and 2008, $591,000and $0, respectively, was outstanding under the revolving credit facility.  As part of the same loan facility, weborrowed approximately $68,000 under a term loan due July 1, 2010, whichis payable in equal monthly installments. As of March 31, 2009 and March 31, 2008, approximately $68,000and $120,000 was outstanding under the term loan, respectively.  The credit facility is secured by all of ourassets, and bears interest at a variable rate equal to LIBOR plus a margin ofbetween 1.75% and 2.45%.

 

 On April 1, 2009, we received a Notice of Default from ourprimary lender, TD Bank, resulting from the violation of certain financialcovenants. The bank has stated that it is not presently taking action toenforce its rights and remedies under our existing revolving line of creditwith the bank, however they are not waiving their rights under any exiting orfuture defaults or events of default. The bank has indicated that it willcontinue to make advances under the credit line, but it has no obligation to doso and may refuse an advance request in its sole discretion without notice. Inthe event the bank does refuse to make one or more advances, we mayunexpectedly be unable to meet our working capital obligations which could harmour reputation and our business. The bank has demanded that we provideunaudited consolidated financial statements and a cash flow forecast within20 days after each month end. We currently are evaluating alternativefinancing sources.

 

Subsequently, on April 27, 2009, we entered into a ForbearanceAgreement and Amendment to Loan Agreement with the bank, pursuant to which thebank has agreed to forbear from exercising its default-related rights andremedies with respect to the defaults specified in the Notice of Default, includingwithout limitation acceleration and foreclosure, and continue to provideadvances and other financial accommodations under the Loan Agreement until June 15,2009 (or Forbearance Period) unless such Forbearance Period is earlierterminated as a result of any Forbearance Default (as such term is defined inthe Forbearance Agreement). Notwithstanding the foregoing, the bank will have no obligation to makeany advance if, after giving effect thereto, the aggregate principal amount ofthe Advances plus outstanding letters of audit issued by the lender for theaccount of our company and subsidiaries would exceed $2,000,000 prior to May 15,2009 and $1,000,000 as of May 15, 2009 and thereafter.  Under the 

 

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ForbearanceAgreement, we have agreed, among other things, (i) not to make anyRestricted Payment (as such term is defined in the Loan Agreement), other thana stock dividend payable in our common stock and approved by the Lender in itssole discretion, (ii) to use their best efforts to obtain a refinancing, (iii) toprovide certain monthly financial information as set forth in the ForbearanceAgreement and (iv) to pay the Advances, the Term Loan (as such term isdefined in the Loan Agreement) and all other obligations in full by June 15,2009.  Our failure to comply with any of the foregoing shall constitute aForbearance Default under the Forbearance Agreement, which can result intermination of the Forbearance Agreement.

 

We believe that our current cash, cash equivalents, net accountsreceivable and costs in excess of billings together with our expected cashflows from operations will be sufficient to meet our anticipated cashrequirements for working capital and capital expenditures for at least the next12 months, subject to the matters concerning TD Bank and the Series Aredemptions.

 

*Cash Flowsfrom Operating Activities.*Net cash used in operatingactivities was approximately $1.16 million for the three months ended March 31,2009 compared to net cash used in operating activities of approximately $2.6million for the three months ended March 31, 2008.  Net cash used in operating activities in 2009consisted primarily of changes in our operating assets and liabilities ofapproximately $2.3 million, including changes in accounts receivable, cost inexcess of billing, prepaid expense, accounts payable and accruedliabilities.  The changes in accounts receivable and costs in excess ofbilling of $(1.4) million and $580,000, respectively, reflects the increases inprojects in process as of March 31, 2009. Our prepaid expenses and other current assets increased approximately$653,000 due to amounts paid in advance in connection prepayment of legalexpense and marketing expenses.  Net cashused in operating activities for the three months ended March 31, 2008consisted primarily of changes in operating assets and liabilities ofapproximately $2.4 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 invoiced to customers.  In addition,the changes in accounts payable and accrued liabilities reflect the relatedincrease in expenses incurred, with no funds paid out.

 

As of March 31, 2009, we had netoperating loss carryforwards of approximately $4.6 million available toreduce future taxable income. In the future, we may utilize our net operatingloss carryforwards and would begin making cash tax payments at that time. Inaddition, the limitations on utilizing net operating loss carryforwards andother minimum taxes may also increase our overall tax obligations. We expectthat if we generate taxable income and/or we are not allowed to use netoperating loss carryforwards, our cash generated from operations will beadequate to meet our income tax obligations.

 

*Net CashUsed In Investing**Activities.* Net cash used in investing activities for the three months ended March 31,2009 and 2008 was approximately $66,000 and $468,000, respectively.  Netcash used in investing activities during these periods consisted primarily ofcash paid for the acquisition of equipment and leasehold improvements and cashpaid out for the acquisition of assets in excess of cash received.

 

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*Net CashProvided by Financing**Activities.* Net cash provided by financing for the three months ended March 31, 2009and 2008 was approximately $583,000 and $11 million, respectively. Net cashprovided by financing activities during 2009 consisted of proceeds from theline of credit of approximately $583,000. Net cash provided by financing activities during 2008 consistedprimarily of proceeds of $10.9 million received from the sale of the Series APreferred Stock and approximately $70,000 received from the term loan, offsetby repayments of short term financing of approximately $6,300.

 

**Item 4.    Controls and Procedure**

 

**Evaluationof Disclosure Controls and Procedures**

 

        Ourmanagement carried out an evaluation required by Rule 13a-15 under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”), under thesupervision and with the participation of our President and Chief ExecutiveOfficer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness ofour disclosure controls and procedures as defined in Rule 13a-15 and15d-15 under the Exchange Act (“Disclosure Controls”). Based on the evaluation,our CEO and CFO concluded that, subject to the limitations noted herein, as of March 31,2009, our Disclosure Controls are effective in timely alerting them to materialinformation required to be included in our reports filed with the SEC.

 

**Changes in Internal Controls**

 

        Therewere no changes in our internal controls over financial reporting during thequarter ended March 31, 2009 that have materially affected, or arereasonably likely to affect, our internal control over financial reporting.

 

**PART II**

 

**Item 1.  Legal Proceedings**

 

On July 10,2007, we filed a lawsuit against a former subcontractor, Southern CaliforniaGold Products 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, CaseNumber 07-CV-02779. On February 21, 2008, pursuant to the court’sorder, we filed an amended complaint. The amended complaint names only SouthernCalifornia Gold Products and James McAvoy as defendants and asserts six countsas follows: misappropriation of trade secrets and confidential information;breach of contract; unfair competition; conversion; violation of the LanhamAct; and interference with prospective economic advantage. The amendedcomplaint seeks to enjoin the defendants from misappropriating, disclosing, orusing our confidential information and trade secrets, and recall and surrenderall products and trade secrets wrongfully misappropriated or converted by thedefendants. It also seeks compensatory damages in an amount to be establishedat trial together with prejudgment and post judgment interest, exemplary damages,disgorgement,

 

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restitution with interest, attorney’s fees andthe costs of suit. Defendants filed an answer to the amended complaint on April 16,2008. Shortly after the filing of the amended answer, defendants made a motionfor summary judgment on, among others, the grounds of collateral estoppel andres judicata. We filed opposition to the motion. The defendants motion and asubsequent application for an immediate interlocutory appeal were denied. Amediation settlement conference was held on October 31, 2008, which wasunsuccessful. The discovery process is continuing and oral arguments on motionfor summary judgment are scheduled for May 18, 2009.   Trial is currently set for August 25,2009.

 

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

 

On March 4,2008, Thomas Cusack, our former General Counsel, commenced an action with theUnited States Department of Labor, Occupational Safety and Health and SafetyAdministration, alleging retaliation in contravention of the Sarbanes-OxleyAct. Mr. Cusack seeks damages in excess of $3,000,000. On April 2,2008, we filed a response to the charges. We believe the allegations to bewithout merit and intend to vigorously defend against the action. On March 7,2008, Mr. Cusack also commenced a second action against us for breach ofcontract and related issues arising from his termination of employment in NewYork State Supreme Court, Nassau County. On May 7, 2008, we served amotion to dismiss the complaint, and on or about September 26, 2008, theCourt dismissed several claims (tortious interference with a contract, tortiousinterference with economic opportunity, fraudulent inducement to enter into acontract and breach of good faith and fair dealing). The remaining claims are Mr. Cusack’sbreach of contract claims and claims seeking the lifting of the transferrestrictions on his stock. On October 13, 2008, Mr. Cusack filed anamended complaint as to the remaining claims, and on November 5, 2008, wefiled an answer to the complaint and filed counterclaims against Mr. Cusackfor fraud.  The parties have commenced documentary discovery, whichwill be followed by depositions. Meritorious defenses to the claims exist andwe intend to vigorously defend this action.

 

**Item 1A.  Risk Factors**

 

Our business,industry and common stock are subject to numerous risks and uncertainties. Thediscussion below sets forth all of such risks and uncertainties that arematerial. Any of the following risks, if realized, could materially andadversely affect our revenues, operating results, profitability, financialcondition, prospects for future growth and overall business, as well as thevalue of our common stock.

 

**Risks Relating to Our Company**

 

***We depend onthe U.S. Government for a substantial amount of our sales and our growth in thelast few years has been attributable in large part to U.S. wartime spending insupport of troop deployments in Iraq and Afghanistan. If such troop levels arereduced significantly, our***

 

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***business maybe harmed; and if we do not continue to experience demand for our productswithin the U.S. Government, our business may fail.***

 

        Weserve primarily the defense market and our sales are highly concentrated withinthe U.S. government. Customers for our products include the U.S. Department ofDefense, including the U.S. Marine Corps and TACOM, and the U.S. Department ofHomeland Security. Government tax revenues and budgetary constraints, whichfluctuate from time to time, can affect budgetary allocations for thesecustomers. Many government agencies have in the past experienced budgetdeficits that have led to decreased spending in defense, law enforcement andother military and security areas. Our results of operations may be subject tosubstantial period-to-period fluctuations because of these and other factorsaffecting military, law enforcement and other governmental spending.

 

        U.S.defense spending historically has been cyclical. Defense budgets have receivedtheir strongest support when perceived threats to national security raise thelevel of concern over the country’s safety, such as in Iraq and Afghanistan. Asthese threats subside, spending on the military tends to decrease. Accordingly,while U.S. Department of Defense funding has grown rapidly over the past fewyears, there is no assurance that this trend will continue. Rising budgetdeficits, the cost of the war on terror and increasing costs for domesticprograms continue to put pressure on all areas of discretionary spending, andthe new administration has signaled that this pressure will most likely impactthe defense budget. A decrease in U.S. government defense spending, includingas a result of planned significant U.S. troop level reductions in Iraq or Afghanistan,or changes in spending allocation could result in our government contractsbeing reduced, delayed or terminated. Reductions in our government contracts,unless offset by other military and commercial opportunities, could adverselyaffect our ability to sustain and grow our future sales and earnings within theU.S. Department of Defense.

 

***Our revenuesin 2008 and the first three months of 2009 have been concentrated in a smallnumber of contracts obtained through the U.S. Department of Defense and theloss of, or reduction in estimated revenue under, any of these contracts, orthe inability to contract further with the U.S. Department of Defense couldsignificantly reduce our revenues and harm our business.***

 

        During2008 and the first three months of 2009, two contracts with the U.S. Departmentof Defense represented approximately 75% of our revenue. While we believe wehave satisfied and continue to satisfy the terms of these contracts, there canbe no assurance that we will continue to receive orders under such contracts.Our government customers generally have the right to cancel any contract, orongoing or planned orders under any contract, at any time. If any of these twocontracts were canceled, there are significant reductions in expected ordersunder any of the contracts, or we were unable to contract further with the U.S.Department of Defense, our revenues could significantly decrease and ourbusiness could be severely harmed.

 

***We arecurrently in breach of certain financial covenants relating to our Series AConvertible Preferred Stock, and the holder of approximately 94% of our Series AConvertible Preferred Stock has exercised its right to cause us to redeem suchshares of stock, which right purportedly has been triggered because of suchbreach. If we are required to redeem such***

 

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***Series AConvertible Preferred Stock, we will need to secure additional financing. If weare unable to obtain such financing or the cost of obtaining such financing isprohibitive, our business would be significantly harmed.***

 

        Inconnection with our application to list shares of our common stock on theAmerican Stock Exchange (now known as the NYSE Amex), we entered into a consentagreement with the holders of our Series A Convertible Preferred Stock. Wedid not meet the financial performance targets set forth in the consentagreement, which was filed as an exhibit to our Current Report on Form 8-Kfiled with the SEC on March 27, 2008. Our breach purportedly gives theholders of the Series A Convertible Preferred Stock the right to requireus to redeem all or a portion of their shares of such stock. We have filedCurrent Reports on Form 8-K with the SEC on February 17, 2009 and March 4,2009 regarding the foregoing. On April 14, 2009, we received a notice fromthe holder of approximately 94% of our Series A Convertible PreferredStock that it is exercising such redemption right. The Series AConvertible Preferred Stockholder has also demanded that we pay them 12%dividends they assert accrued from January 1, 2009 to April 13, 2009,on its Series A Convertible Preferred Stock, in cash, as well as certainof their legal fees in connection with related matters. We currently do nothave sufficient surplus as such term is defined under Delaware law to effectthe redemption sought by the stockholder described above, and restrictionsunder our revolving line of credit with our primary lender would neverthelessprohibit any such redemption. Although we continue to negotiate with our Series APreferred Stockholders to resolve the foregoing, if we are required to redeemsuch Series A Convertible Preferred Stock, we will need to secureadditional financing. If we are unable to obtain such financing or the cost ofobtaining such financing were prohibitive, our business would be significantlyharmed. See “Item 2.  Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Liquidity and Capital Resources” for additional information.

 

***We arerequired to comply with complex procurement laws and regulations, and the costof compliance with these laws and regulations, and penalties and sanctions forany non-compliance could adversely affect our business.***

 

        Weare required to comply with laws and regulations relating to the administrationand performance of U.S. government contracts, which affect how we do businesswith our customers and impose added costs on our business. Among the moresignificant laws and regulations affecting our business are the following:

 

· The FederalAcquisition Regulations: Along with agency regulations supplemental to theFederal Acquisition Regulations, comprehensively regulate the formation,administration and performance of federal government contracts;

 

· The Truth inNegotiations Act: Requires certification and disclosure of all cost and pricingdata in connection with contract negotiations;

 

· The Cost AccountingStandards and Cost Principles: Imposes accounting requirements that govern ourright to reimbursement under certain cost-based federal government contracts;and

 

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· Laws, regulationsand executive orders restricting the use and dissemination of informationclassified for national security purposes and the export of certain productsand technical data. We engage in international work falling under thejurisdiction of U.S. export control laws. Failure to comply with these controlregimes can lead to severe penalties, both civil and criminal, and can includedebarment from contracting with the U.S. government.

 

        Ourcontracting agency customers periodically review our performance under andcompliance with the terms of our federal government contracts. We alsoroutinely perform internal reviews. As a result of these reviews, we may learnthat we are not in compliance with all of the terms of our contracts. If agovernment review or investigation uncovers improper or illegal activities, wemay be subject to civil or criminal penalties or administrative sanctions,including

 

· Termination ofcontracts;

 

· Forfeiture ofprofits;

 

· Cost associated withtriggering of price reduction clauses;

 

· Suspension ofpayments;

 

· Fines; and

 

· Suspension ordebarment from doing business with federal government agencies.

 

        Ifwe fail to comply with these laws and regulations, we may also suffer harm toour reputation, which could impair our ability to win awards of contracts inthe future or receive renewals of existing contracts. If we are subject tocivil and criminal penalties and administrative sanctions or suffer harm to ourreputation, our current business, future prospects, financial condition, oroperating results could be materially harmed. In addition, we are subject toindustrial security regulations of the U.S. Department of Defense and otherfederal agencies that are designed to safeguard against unauthorized release oraccess to classified information by foreign nationals.

 

***Governmentcontracts are usually awarded through a competitive bidding process thatentails risks not present in the acquisition of commercial contracts.***

 

        Asignificant portion of our contracts and task orders with the U.S. governmentis awarded through a competitive bidding process. We expect that much of thebusiness we seek in the foreseeable future will continue to be awarded throughcompetitive bidding. Budgetary pressures and changes in the procurement processhave caused many government customers to increasingly purchase goods andservices through indefinite delivery/indefinite quantity, or IDIQ contracts,General Services Administration, or GSA schedule contracts and othergovernment-wide acquisition contracts, or GWACs. These contracts, some of whichare awarded to multiple

 

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contractors, have increased competition andpricing pressure, requiring us to make sustained post-award efforts to realizerevenue under each such contract. Competitive bidding presents a number ofrisks, including without limitation:

 

· the need to bid onprograms in advance of the completion of their design, which may result inunforeseen technological difficulties and cost overruns;

 

· the substantial costand managerial time and effort that we may spend to prepare bids and proposals forcontracts that may not be awarded to us;

 

· the need to estimateaccurately the resources and cost structure that will be required to serviceany contract we award; and

 

· the expense anddelay that may arise if our or our partners’ competitors protest or challengecontract awards made to us or our partners pursuant to competitive bidding, andthe risk that any such protest or challenge could result in the resubmission ofbids on modified specifications, or in the termination, reduction ormodification of the awarded contract.

 

        Ifwe are unable to consistently win new contract awards over any extended period,our business and prospects will be adversely affected, and that could cause ouractual results to be adversely affected. In addition, upon the expiration of acontract, if the customer requires further services of the type provided by thecontract, there is frequently a competitive rebidding process. There can be noassurance that we will win any particular bid, or that we will be able to replacebusiness lost upon expiration or completion of a contract, and the terminationor non-renewal of any of our significant contracts would cause our actualresults to be adversely affected.

 

***The U.S.government may reform its procurement or other practices in a manner adverse tous.***

 

        Becausewe derive a significant portion of our revenues from contracts with the U.S.government or its agencies, we believe that the success and development of ourbusiness will depend on our continued successful participation in federalcontracting programs. The current administration has signed a Memorandum forthe Heads of Executive Departments and Agencies on Government Contracting,which orders significant changes to government contracting, including thereview of existing federal contracts to eliminate waste and the issuance ofgovernment-wide guidance to implement reforms aimed at cutting wastefulspending and fraud. The federal procurement reform called for in the Memorandumrequires the heads of several federal agencies to develop and issue guidance onreview of existing government contracts and authorizes that any contractsidentified as wasteful or otherwise inefficient be modified or cancelled. Ifany of our contracts were to be modified or cancelled, our actual results couldbe adversely affected and we can give no assurance that we would be able toprocure new U.S. Government contracts to offset the revenues lost as a resultof any modification or cancellation of our contracts. In addition, there may besubstantial costs or management time required to respond to government reviewof any of our current contracts, which could delay or otherwise adverselyaffect our ability to compete for or perform contracts. Further, if the orderedreform of the U.S. Government’s procurement practices involves the adoption ofnew cost-accounting

 

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standards or the requirement that competitorssubmit bids or perform work through teaming arrangements, that could be costlyto satisfy or could impair our ability to obtain new contracts. The reform mayalso involve the adoption of new contracting methods to GSA or othergovernment-wide contracts, or new standards for contract awards intended toachieve certain socio-economic or other policy objectives, such as establishingnew set-aside programs for small or minority-owned businesses. In addition, theU.S. government may face restrictions from other new legislation orregulations, as well as pressure from government employees and their unions, onthe nature and amount of services the U.S. government may obtain from privatecontractors. These changes could impair our ability to obtain new contracts.Any new contracting methods could be costly or administratively difficult forus to implement and, as a result, could harm our operating results.

 

***Ourcontracts with the U.S. government and its agencies are subject to audits andcost adjustments.***

 

        U.S.government agencies, including the Defense Contract Audit Agency, or the DCAA,routinely audit and investigate government contracts and government contractors’incurred costs, administrative processes and systems. Certain of theseagencies, including the DCAA, review our performance on contracts, pricingpractices, cost structure and compliance with applicable laws, regulations andstandards. They also review the adequacy of our internal control systems andpolicies, including our purchase, property, estimation, compensation andmanagement information systems. Any costs found to be improperly allocated to aspecific contract will not be reimbursed, and any such costs already reimbursedmust be refunded. Moreover, if any of the administrative processes and systemsare found not to comply with requirements, we may be subjected to increasedgovernment scrutiny and approval that could delay or otherwise adversely affectour ability to compete for or perform contracts. Therefore, an unfavorableoutcome of an audit by the DCAA or another government agency could cause actualresults to be adversely affected and differ materially from those anticipated.If a government investigation uncovers improper or illegal activities, we maybe subject to civil and criminal penalties and administrative sanctions,including termination of contracts, forfeitures of profits, suspension ofpayments, fines and suspension or debarment from doing business with the U.S.government. In addition, we could suffer serious reputational harm ifallegations of impropriety were made against us. Each of these events couldcause our actual results to be adversely affected.

 

***A portion ofour business depends upon obtaining and maintaining required securityclearances, and our failure to do so could result in termination of certain ofour contracts or cause us to be unable to bid or re-bid on certain contracts.***

 

        Obtainingand maintaining personal security clearances (or PCLs) for employees involves alengthy process, and it can be difficult to identify, recruit and retainemployees who already hold security clearances. If our employees are unable toobtain or retain security clearances, or if such employees who hold securityclearances terminate their employment with us, the customer whose work requirescleared employees could terminate the contract or decide not to exerciseavailable options, or to not renew it. To the extent we are not able to engageemployees with the required security clearances for a particular contract, wemay not be able to bid on or win new contracts, or effectively re-bid onexpiring contracts, which could adversely affect our business.

 

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        Afacility security clearance (or FCL) is an administrative determination by theDefense Security Service (DSS), a U.S. Department of Defense component, that aparticular contractor facility has the requisite level of security, procedures,and safeguards to handle classified information requirements for access toclassified information. Our ability to obtain and maintain facility securityclearances has a direct impact on our ability to compete for and perform U.S.government contracts, the performance of which requires access to classifiedinformation. Our ability to so obtain or maintain any facility securityclearance level could result in the termination, non-renewal or our inabilityto obtain certain U.S. government contracts, which would reduce our revenuesand harm our business.

 

***We may notrealize the full amount of revenues reflected in our backlog, which could harmour operations and significantly reduce our future revenues.***

 

        Therecan be no assurances that our backlog estimates will result in actual revenuesin any particular fiscal period because our customers may modify or terminateprojects and contracts and may decide not to exercise contract options. Wedefine backlog as the future revenue we expect to receive from our contracts.We include potential orders expected to be awarded under IDIQ contracts. Ourrevenue estimates for a particular contract are based, to a large extent, onthe amount of revenue we have recently recognized on that contract, our experiencein utilizing capacity on similar types of contracts, and our professionaljudgment. Our revenue estimate for a contract included in backlog can be lowerthan the revenue that would result from our customers utilizing all remainingcontract capacity. Our backlog includes estimates of revenues the receipt ofwhich require future government appropriation, option exercise by our clientsand/or is subject to contract modification or termination. At March 31,2009, our backlog was approximately $60 million, of which $45 million isestimated to be realized in 2009. These estimates are based on our experienceunder such contracts and similar contracts, and we believe such estimates to bereasonable. However, we believe that the receipt of revenues reflected in ourbacklog estimate for the following twelve months will generally be more certainthan our backlog estimate for periods thereafter. If we do not realize asubstantial amount of our backlog, our operations could be harmed and ourfuture revenues could be significantly reduced.

 

***We havebreached certain financial covenants under our revolving line of credit with TDBank and the partial or complete loss of such revolving line may impact ourability to timely meet our working capital requirements.***

 

        OnApril 1, 2009, we received a Notice of Default from our primary lender, TDBank, resulting from the violation of certain financial covenants under theLoan Agreement, dated May 2, 2007, as amended, and as assumed by one ofour subsidiaries. The bank has stated that it is not presently taking action toenforce its rights and remedies under our existing revolving line of creditwith the bank, however they are not waiving their rights under any exiting orfuture defaults or events of default. The bank has indicated that it willcontinue to make advances under the Loan Agreement, but it has no obligation todo so and may refuse an advance request in its sole discretion without notice.

 

        Subsequently,on April 27, 2009, we entered into a Forbearance Agreement and Amendmentto Loan Agreement with the bank, pursuant to which the bank has agreed toforbear

 

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from exercising its default-related rights and remedies with respect tothe defaults specified in the Notice of Default, including without limitationacceleration and foreclosure, and continue to provide advances and otherfinancial accommodations under the Loan Agreement until June 15, 2009 (orForbearance Period) unless such Forbearance Period is earlier terminated as aresult of any Forbearance Default (as such term is defined in the ForbearanceAgreement).  Notwithstanding theforegoing, the bank will have no obligation to make any advance if, aftergiving effect thereto, the aggregate principal amount of the Advances plusoutstanding letters of audit issued by the lender for the account of ourcompany and subsidiaries would exceed $2,000,000 prior to May 15, 2009 and$1,000,000 as of May 15, 2009 and thereafter.  Under the ForbearanceAgreement, we have agreed, among other things, (i) not to make anyRestricted Payment (as such term is defined in the Loan Agreement), other thana stock dividend payable in our common stock and approved by the Lender in itssole discretion, (ii) to use their best efforts to obtain a refinancing, (iii) toprovide certain monthly financial information as set forth in the ForbearanceAgreement and (iv) to pay the Advances, the Term Loan (as such term isdefined in the Loan Agreement) and all other obligations in full by June 15,2009.  Our failure to comply with any of the foregoing shall constitute aForbearance Default under the Forbearance Agreement, which can result intermination of the Forbearance Agreement. The Forbearance Agreement has been filed as an exhibit to the Form 8-Kfiled with the SEC on May 1, 2009.

 

        Inthe event we violate any covenants in the Loan Agreement or fail to comply withadditional covenants set forth in the Forbearance Agreement during theForbearance Period, the bank can refuse to make one or more advances andterminate the Forbearance Agreement, and we may unexpectedly be unable to meetour working capital obligations which could harm our reputation and ourbusiness.

 

***U.S.government contracts often contain provisions that are typically not found incommercial contracts and that are unfavorable to us, which could adverselyaffect our business.***

 

        U.S.government contracts contain provisions and are subject to laws and regulationsthat give the U.S. government rights and remedies not typically found incommercial contracts, including without limitation, allowing the U.S.government to:

 

· terminate existingcontracts for convenience, as well as for default;

 

· establishlimitations on future services that can be offered to prospective customersbased on conflict of interest regulations;

 

· reduce or modifycontracts or subcontracts;

 

· cancel multi-yearcontracts and related orders if funds for contract performance for anysubsequent year become unavailable;

 

· decline to exercisean option to renew a multi-year contract;

 

· claim intellectualproperty rights in products provided by us; and

 

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· suspend or bar usfrom doing business with the federal government or with a governmental agency.

 

***Theownership, control or influence of our company by foreigners could result inthe termination, non-renewal or our inability to obtain certain U.S. governmentcontracts, which would reduce our revenues and harm our business.***

 

        Weare subject to industrial security regulations of the U.S. Department ofDefense and other federal agencies that are designed to safeguard againstunauthorized access by foreigners and others to classified and other sensitiveinformation. If we were to come under foreign ownership, control or influence,our clearances could be revoked and our U.S. government customers couldterminate, or decide not to renew, our contracts, and such a situation couldalso impair our ability to obtain new contracts and subcontracts. Any suchactions would reduce our revenues and harm our business.

 

***We depend onour suppliers and three, in particular, currently provide us with approximately55% to 65% of our supply needs. If we can not obtain certain components for ourproducts or we lost our key supplier, we might have to develop alternativedesigns that could increase our costs or delay our operations.***

 

        Wedepend upon a number of suppliers for components of our products. Of thesesuppliers, Action Group supplies approximately 35% and Standard Bent Glass andRed Dot each supply between 10% and 15% of our overall supply needs. Moreover,Action Group supplies all of our steel pieces and hardware, Standard Bent Glasssupplies all of our glass requirements and Red Dot supplies all of our vehicleair conditioning and heating equipment for our CPKs. There is an inherent riskthat certain components of our products will be unavailable for prompt deliveryor, in some cases, discontinued. We have only limited control over anythird-party manufacturer as to quality controls, timeliness of production,deliveries and various other factors. Should the availability of certaincomponents be compromised through the loss of, or impairment of therelationship with, any of our three key suppliers or otherwise, it could forceus to develop alternative designs using other components, which could add tothe cost of goods sold and compromise delivery commitments. If we are unable toobtain components in a timely manner, at an acceptable cost, or at all, we mayneed to select new suppliers, redesign or reconstruct processes we use to buildour transparent and opaque armored products. We may not be able to manufactureone or more of our products for a period of time, which could materiallyadversely affect our business, results from operations and financial condition.

 

***If we failto keep pace with the ever-changing market of security-related defenseproducts, our revenues and financial condition will be negatively affected.***

 

        Thesecurity-related defense product market is rapidly changing, with evolvingindustry standards. Our future success will depend in part upon our ability tointroduce new products, designs, technologies and features to meet changingcustomer requirements and emerging industry standards; however, there can be noassurance that we will successfully introduce new products or features to ourexisting products or develop new products that will achieve market acceptance.Any delay or failure of these products to achieve market acceptance wouldadversely

 

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affect our business. In addition, there can beno assurance that products or technologies developed by others will not renderour products or technologies non-competitive or obsolete. Should we fail tokeep pace with the ever-changing nature of the security-related defense productmarket, our revenues and financial condition will be negatively affected.

 

        Webelieve that, in order to remain competitive in the future, we will need tocontinue to invest significant financial resources to develop new and adapt ormodify our existing offerings and technologies, including through internalresearch and development, acquisitions and joint ventures or other teamingarrangements. These expenditures could divert our attention and resources fromother projects, and we cannot be sure that these expenditures will ultimatelylead to the timely development of new offerings and technologies. Due to thedesign complexity of our products, we may in the future experience delays incompleting the development and introduction of new products. Any delays couldresult in increased costs of development or deflect resources from otherprojects. In addition, there can be no assurance that the market for ourofferings will develop or continue to expand as we currently anticipate. Thefailure of our technology to gain market acceptance could significantly reduceour revenues and harm our business. Furthermore, we cannot be sure that ourcompetitors will not develop competing technologies which gain marketacceptance in advance of our products.

 

***We may besubject to personal liability claims for our products and if our insurance isnot sufficient to cover such claims, our expenses may increase substantially.***

 

        Ourproducts are used in applications where the failure to use our productsproperly or their malfunction could result in bodily injury or death. We may besubject to personal liability claims and our insurance may not be adequate tocover such claims. As a result, a significant lawsuit could adversely affectour business. We may be exposed to liability for personal injury or propertydamage claims relating to the use of the products. Any future claim against usfor personal injury or property damage could materially adversely affect thebusiness, financial condition, and results of operations and result in negativepublicity. We currently maintain insurance for this type of liability as wellas seek SAFETY Act certification for our products where we deem appropriate.However, even if we do purchase insurance, we may experience legal claimsoutside of our insurance coverage, or in excess of our insurance coverage, orthat insurance will not cover. Even if we are not found liable, the costs ofdefending a lawsuit can be high.

 

***We aresubject to substantial competition and we must continue research anddevelopment to remain competitive.***

 

        Weare subject to significant competition that could harm our ability to winbusiness and increase the price pressure on our products. We face strongcompetition from a wide variety of firms, including large, multinational,defense and aerospace firms. Most of our competitors have considerably greaterfinancial, marketing and technological resources than we do, which may make itdifficult to win new contracts and we may not be able to compete successfully.Certain competitors operate larger facilities and have longer operatinghistories and presence in key markets, greater name recognition, largercustomer bases and significantly greater financial, sales and marketing,manufacturing, distribution, technical and other resources. As a result, these

 

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competitors may be able to adapt more quicklyto new or emerging technologies and changes in customer requirements. They mayalso be able to devote greater resources to the promotion and sale of theirproducts. Moreover, we may not have sufficient resources to undertake thecontinuing research and development necessary to remain competitive.

 

***We mustcomply with environmental regulations or we may have to pay expensive penaltiesor clean up costs.***

 

        Weare subject to federal, state, local and foreign laws, and regulationsregarding protection of the environment, including air, water, and soil. Ourmanufacturing business involves the use, handling, storage, discharge anddisposal of, hazardous or toxic substances or wastes to manufacture ourproducts. We must comply with certain requirements for the use, management,handling, and disposal of these materials. If we are found responsible for anyhazardous contamination, we may have to pay expensive fines or penalties orperform costly clean-up. Even if we are charged, and later found notresponsible, for such contamination or clean up, the cost of defending thecharges could be high. Authorities may also force us to suspend production,alter our manufacturing processes, or stop operations if we do not comply withthese laws and regulations.

 

***We may notbe able to adequately safeguard our intellectual property rights and tradesecrets from unauthorized use, and we may become subject to claims that weinfringe on others’ intellectual property rights.***

 

        Werely on a combination of patents, trade secrets, trademarks, and otherintellectual property laws, nondisclosure agreements and other protectivemeasures to preserve our proprietary rights to our products and productionprocesses. We currently have a number of U.S. pending patent applications.

 

        These measures afford only limited protection and may not precludecompetitors from developing products or processes similar or superior to ours.Moreover, the laws of certain foreign countries do not protect intellectualproperty rights to the same extent as the laws of the United States.

 

        Althoughwe implement protective measures and intend to defend our proprietary rights,these efforts may not be successful. From time to time, we may litigate withinthe United States or abroad to enforce our licensed patents, to protect ourtrade secrets and know-how or to determine the enforceability, scope and validityof our proprietary rights and the proprietary rights of others. Enforcing ordefending our proprietary rights could be expensive, require management’sattention and might not bring us timely or effective relief.

 

        Furthermore,third parties may assert that our products or processes infringe their patentrights. Our patents, if granted, may be challenged, invalidated orcircumvented. Although there are no pending or threatened intellectual propertylawsuits against us, we may face litigation or infringement claims in thefuture. Infringement claims could result in substantial costs and diversion ofour resources even if we ultimately prevail. A third party claiminginfringement may also obtain an injunction or other equitable relief, whichcould effectively block the distribution 

 

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or sale of allegedly infringing products.Although we may seek licenses from third parties covering intellectual propertythat we are allegedly infringing, we may not be able to obtain any suchlicenses on acceptable terms, if at all.

 

***We depend onmanagement and other key personnel and we may not be able to execute ourbusiness plan without their services.***

 

        Oursuccess and our business strategy depend in large part on our ability toattract and retain key management and operating personnel. Such individuals arein high demand and are often subject to competing employment offers. We dependto a large extent on the abilities and continued participation of our executiveofficers and other key employees. We presently maintain “key man” insurance onAnthony Piscitelli, our President and Chief Executive Officer. We believe that,as our activities increase and change in character, additional experiencedpersonnel will be required to implement our business plan. Competition for suchpersonnel is intense and we may not be able to hire them when required, or havethe ability to attract and retain them.

 

***We depend onthe use of our operating facilities, which currently are nearing capacity. Tothe extent our growth strategy is successful, our operations could requireadditional space by the end of 2009 which, if not obtained on a cost-effectivebasis, could adversely affect our results of operations and financialconditions.***

 

        Oursuccess depends on the use of current operating facilities. However, the use ofour facilities is quickly becoming maximized. To the extent our growth strategyis successful, we may require the acquisition or lease of additional propertyby the end of 2009 in order to effectively increase operating capabilities.Obtaining additional space may result in the investment of substantial time andcapital and may not prove cost-effective, which could harm our results ofoperations and financial condition.

 

***We maypartner with foreign entities, and domestic entities with foreign contacts,which may affect our business plans.***

 

        Werecognize that there may be opportunities for increased product sales in boththe domestic and global defense markets. We have recently initiated plans tostrategically team with foreign entities as well as domestic entities withforeign business contacts in order to better compete for both domestic andforeign military contracts. In order to implement these plans, we may incursubstantial costs which may include additional research and development,prototyping, hiring personnel with specialized skills, implementing andmaintaining technology control plans, technical data export licenses,production, product integration, marketing, warehousing, finance charges,licensing, tariffs, transportation and other costs. In the event that workingwith foreign entities and/or domestic entities with foreign business contactsproves to be unsuccessful, this may ineffectively use our resources which mayaffect our profitability and the costs associated with such work may precludeus from pursuing alternative opportunities.

 

        Ifinternational sales grow, we may be exposed to certain unique and potentiallygreater risks than are presented in our domestic business. Internationalbusiness is sensitive to changes in 

 

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the in the budgets and priorities ofinternational customers, which may be driven by potentially volatile worldwideeconomic conditions, regional and local economic and political factors, as wellas U.S. foreign policy. International sales will also expose us to localgovernment laws, regulations and procurement regimes which may differ from U.S.Government regulation, including import-export control, exchange control,investment and repatriation of earnings, as well as to varying currency andother economic risks. International contracts may also require the use offoreign representatives and consultants or may require us to commit tofinancial support obligations, known as offsets, and provide for penalties ifwe fail to meet such requirements. As a result of these and other factors, wecould experience award and funding delays on international projects or couldincur losses on such projects, which could negatively impact our results of operationsand financial condition.

 

***We arepresently classified as a small business and the loss of our small businessstatus may adversely affect our ability to compete for government contracts.***

 

        Weare presently classified as a small business as determined by the SmallBusiness Administration based upon the North American Industry ClassificationSystems (NAICS) industry and product specific codes which are regulated in theUnited States by the Small Business Administration. While we do not presentlyderive a substantial portion of our business from contracts which are set-asidefor small businesses, we are able to bid on small business set-aside contractsas well as contracts which are open to non-small business entities. It is alsopossible that we may become more reliant upon small business set-asidecontracts. Our continuing growth may cause us to lose our designation as asmall business, and additionally, as the NAICS codes are periodically revised,it is possible that we may lose our status as a small business and may sustainan adverse impact on our current competitive advantage. The loss of smallbusiness status could adversely impact our ability to compete for governmentcontracts, maintain eligibility for special small business programs and limitour ability to partner with other business entities which are seeking to teamwith small business entities that may be required under a specific contract.

 

***We intend topursue international sales opportunities which may require export licenses andcontrols.***

 

        Inorder to pursue international sales opportunities, we have initiated a programto obtain product classifications, commodity jurisdictions, licenses,technology control plans, technical data export licenses and export relatedprograms. Due to our diverse products, it is possible that some products may besubject to classification under the United States State DepartmentInternational Traffic in Arms Regulations (ITAR). In the event that a productis classified as an ITAR-controlled item, we will be required to obtain an ITARexport license. While we believe that we will be able to obtain such licenses,the denial of required licenses and/or the delay in obtaining such licenses mayhave a significant adverse impact on our ability to sell productsinternationally. Alternatively, our products may be subject to classificationunder the United States Commerce Department’s Export Administration Regulations(EAR). We also anticipate that we may be required to comply with internationalregulations, tariffs and controls and we intend to work closely withexperienced freight forwarders and advisors. We anticipate that an 

 

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internal compliance program for internationalsales will require the commitment of significant resources and capital.

 

***We havemade, and expect to continue to make, strategic acquisitions and investments,and these activities involve risks and uncertainties.***

 

        Inpursuing our business strategies, we continually review, evaluate and considerpotential investments and acquisitions. In evaluating such transactions, we arerequired to make difficult judgments regarding the value of business opportunities,technologies and other assets, and the risks and cost of potential liabilities.Furthermore, acquisitions and investments involve certain other risks anduncertainties, including the difficulty in integrating newly-acquiredbusinesses, the challenges in achieving strategic objectives and other benefitsexpected from acquisitions or investments, the diversion of our attention andresources from our operations and other initiatives, the potential impairmentof acquired assets and the potential loss of key employees of the acquiredbusinesses.

 

***The outcomeof litigation in which we have been named as a defendant is unpredictable andan adverse decision in any such matter could have a material adverse effect onour financial position or results of operations.***

 

        Weare defendants in a number of litigation matters. These matters may divertfinancial and management resources that would otherwise be used to benefit ouroperations. Although we believe that we have meritorious defenses to the claimsmade in the litigation matters to which we have been named a party and intendto contest each lawsuit vigorously, no assurances can be given that the resultsof these matters will be favorable to us. An adverse resolution or outcome ofany of these lawsuits, claims, demands or investigations could have a negativeimpact on our financial condition, results of operations and liquidity.

 

***Unanticipatedchanges in our tax provisions or exposure to additional income tax liabilitiescould affect our profitability.***

 

        Weare subject to income taxes in the United States. In the ordinary course of ourbusiness, there are many transactions and calculations where the ultimate taxdetermination is uncertain. Furthermore, changes in domestic or foreign incometax laws and regulations, or their interpretation, could result in higher orlower income tax rates assessed or changes in the taxability of certain salesor the deductibility of certain expenses, thereby affecting our income taxexpense and profitability. Although we believe our tax estimates arereasonable, the final determination of tax audits could be materially differentfrom our historical income tax provisions and accruals. Additionally, changesin the geographic mix of our sales could also impact our tax liabilities andaffect our income tax expense and profitability.

 

**Risks Relating to Our CommonStock**

 

***If we failto maintain an effective system of internal controls over financial reporting,we may not be able to report accurately our financial results. This could havea material adverse effect on our share price.***

 

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        Effectiveinternal controls are necessary for us to provide accurate financial reports.We are beginning to evaluate how to document and test our internal controlprocedures to satisfy the requirements of Section 404 of the SarbanesOxley Act of 2002 and the related rules of the SEC, which require, amongother things, our management to assess annually the effectiveness of ourinternal control over financial reporting and our independent registered publicaccounting firm to issue a report on that assessment. During the course of thisdocumentation and testing, we may identify significant deficiencies or materialweaknesses that we may be unable to remediate before the deadline for thosereports.

 

        Therecan be no assurance that we will maintain adequate controls over our financialprocesses and reporting in the future or that those controls will be adequatein all cases to uncover inaccurate or misleading financial information thatcould be reported by members of management. If our controls failed to identifyany misreporting of financial information or our management or independentregistered public accounting firm were to conclude in their reports that ourinternal control over financial reporting was not effective, investors couldlose confidence in our reported financial information and the trading price ofour shares could drop significantly. In addition, we could be subject tosanctions or investigations by the stock exchange upon which our common stockmay be listed, the SEC or other regulatory authorities, which would requireadditional financial and management resources.

 

***Volatilityof our stock price could adversely affect stockholders.***

 

        Themarket price of our common stock could fluctuate significantly as a result of:

 

· quarterly variations in our operating results;

 

· cyclical nature of defense spending;

 

· interest rate changes;

 

· changes in the market’s expectations about our operating results;

 

· our operating results failing to meet the expectation of securities analystsor investors in a particular period;

 

· changes in financial estimates and recommendations by securities analystsconcerning our company or the defense industry in general;

 

· operating and stock price performance of other companies that investors deemcomparable to us;

 

· news reports relating to trends in our markets;

 

· changes in laws and regulations affecting our business;

 

· material announcements by us or our competitors;

 

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· sales of substantial amounts of common stock by our directors, executiveofficers or significant stockholders or the perception that such sales couldoccur; and

 

· general economic and political conditions such as recessions and acts ofwar or terrorism.

 

        Fluctuationsin the price of our common stock could contribute to the loss of all or part ofan investor’s investment in the company.

 

***We currentlydo not intend to pay dividends on our common stock and consequently your onlyopportunity to achieve a return on your investment is if the price of commonstock appreciates.***

 

        Wecurrently do not plan to declare dividends on our common stock in theforeseeable future. Any payment of cash dividends will depend upon ourfinancial condition, capital requirements, earnings and other factors deemedrelevant by our board of directors. Further, our credit facility restricts ourability to pay cash dividends. Agreements governing future indebtedness willlikely contain similar restrictions on our ability to pay cash dividends.Consequently, your only opportunity to achieve a return on your investment inour company will be if the market price of our common stock appreciates and yousell your common stock at a profit.

 

***Provisionsin our certificate of incorporation and bylaws or Delaware law mightdiscourage, delay or prevent a change of control of our company or changes inour management and, therefore, depress the trading price of our stock.***

 

        Ouramended and restated certificate of incorporation and bylaws contain provisionsthat could depress the trading price of our common stock by acting todiscourage, delay or prevent a change in control of our company or changes inour management that the stockholders of our company may deem advantageous.These provisions:

 

· establish a classified board of directors so that not all members of ourboard of directors are elected at one time;

 

· provide that directors may only be removed “for cause” and only with theapproval of 66 2/3 percent of our stockholders;

 

· provide that only our board of directors can fill vacancies on the boardof directors;

 

· require super-majority voting to amend our bylaws or specified provisionsin our certificate of incorporation;

 

· authorize the issuance of “blank check” preferred stock that our board ofdirectors could issue to increase the number of outstanding shares and todiscourage a takeover attempt;

 

· limit the ability of our stockholders to call special meetings ofstockholders;

 

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· prohibit stockholder action by written consent, which requires all stockholderactions to be taken at a meeting of our stockholders;

 

· provide that the board of directors is expressly authorized to adopt,amend, or repeal our bylaws, subject to the rights of our stockholders to dothe same by super-majority vote of stockholders; and

 

· establish advance notice requirements for nominations for election to ourboard of directors or for proposing matters that can be acted upon bystockholders at stockholder meetings.

 

        Inaddition, Section 203 of the Delaware General Corporation Law maydiscourage, delay or prevent a change in control of our company.

 

        Theseand other provisions contained in our amended and restated certificate ofincorporation and bylaws could delay or discourage transactions involving anactual or potential change in control of us or our management, includingtransactions in which our stockholders might otherwise receive a premium fortheir shares over then current prices, and may limit the ability ofstockholders to remove our current management or approve transactions that ourstockholders may deem to be in their best interests and, therefore, couldadversely affect the price of our common stock.

 

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

 

On January 12,2009, we issued options to purchase an aggregate of 100,000 shares of ourcommon stock to consultants for services rendered.  The exercise price for each option is $2.00per share and each option vested immediately upon the issuance.

 

The foregoing grants were exempt fromregistration under the Securities Act, pursuant to Section 4(2) and Rule 506promulgated thereunder as transactions with accredited investors by an issuernot involving a public offering.

 

**Item 3.****           ****DefaultsUpon Senior Securities**

 

               None.

 

**Item 4.****           ****Submissionof Matters to a Vote of Security Holders**

 

                None.

 

**Item 5.           OtherInformation**

 

   None.

 

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** **

**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**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                    | AMERICAN DEFENSE SYSTEMS,  INC. |
|-------------------------|---------------------------------|
|                    |                            |
|                    |                            |   |
| Date: May 15, 2009 | 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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