UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C.  20549


FORM 10-Q
  QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT
OF 1934
  For
the Quarter Ended September 30, 2009
  Commission
File Number 001-33888
  
  American
Defense Systems, Inc.
 (Exact
Name of Registrant as Specified in Its Charter)
  Delaware
              
              83-0357690(State
      or Other Jurisdiction of Incorporation or
                Organization)
              
              (I.R.S.
      Employer Identification No.)
  230
Duffy Avenue
 Hicksville,
NY 11801
 (516)
390-5300
 (Address
including zip code, and telephone number, including area code, of principal
executive
 offices)
  Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days.  Yes x  No o
  Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).  Yes o  No o
  Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definition of “accelerated filer,” “large accelerated filer”
and smaller reporting company” in Rule 12b-2 of the Exchange Act. 
(Check one):
  Large
      Accelerated Filer  o
              
              Accelerated
      Filer  oNon-Accelerated
      Filer  o
              
              Smaller
      Reporting Company  x
  Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act).  Yes o  No x
  As of
November 19, 2009, 45,531,457 shares of common stock, par value $0.001 per
share, of the registrant were outstanding.
  
  TABLE OF
CONTENTS
  PART I
      — FINANCIAL INFORMATIONItem
1.
                                                  Condensed Financial
      Statements
                                                  3Consolidated Balance
      Sheets as of December 31, 2008 and September 30, 2009
      (unaudited)
                                                  3Consolidated
      Statements of Operations for the three and nine months ended
      September 30, 2008 and 2009 (unaudited)
                                                  4Consolidated
      Statements of Cash Flows for the nine months ended September 30, 2008
      and 2009 (unaudited)
                                                  5Notes to Consolidated
      Financial Statements
                                                  6Item
2.
                                                  Management’s Discussion and
      Analysis of Financial Condition and Results of
      Operations
                                                  40Item
3.
                                                  Quantitative and Qualitative
      Disclosure About Market Risk
                                                  51Item
4.
                                                  Controls and
      Procedures
                                                  51PART II
      — OTHER INFORMATIONItem
      1.
                                                  Legal
      Proceedings
                                                  52Item
      1A.
                                                  Risk
      Factors
                                                  53Item 2.
                                                  Unregistered Sales of Equity
      Securities and Use of Proceeds
                                                  65Item
      3.
                                                  Defaults Upon Senior
      Securities
                                                  65Item
      4.
                                                  Submission of Matters to a
      Vote of Security Holders
                                                  65Item
      5.
                                                  Other
      Information
                                                  65Item
      6.
                                                  Exhibits
                                                  66SIGNATURES
                                                  66
  2
  PART
I
  Item 1.    Condensed Consolidated Financial
Statements
  American
Defense Systems, Inc. and Subsidiaries
 Condensed
Consolidated Balance Sheets
  
 September
      30,
                                  
                                  
                                  December
      31,2009
                                  
                                  
                                  2008Unaudited
                                  
                                  
                                  RestatedAssets:Current Assets:Cash
                                  
                                  $
                                  107,381
                                  
                                  
                                  $
                                  374,457Accounts
      receivable, net
                                  
                                  
                                  5,948,023
                                  
                                  
                                  
                                  4,981,150Accounts
      receivable-factoring
                                  
                                  
                                  256,888
                                  
                                  
                                  
                                  -Inventory
                                  
                                  
                                  480,288
                                  
                                  
                                  
                                  621,048Prepaid
      expenses and other current assets
                                  
                                  
                                  1,995,302
                                  
                                  
                                  
                                  2,088,801Costs
      in excess of billings on uncompleted contracts
                                  
                                  
                                  10,198,639
                                  
                                  
                                  
                                  7,143,089Deposits
                                  
                                  
                                  309,685
                                  
                                  
                                  
                                  437,496Assets
      of discontinued operations
                                  
                                  
                                  -
                                  
                                  
                                  
                                  736,613TOTAL
      CURRENT ASSETS
                                  
                                  
                                  19,296,206
                                  
                                  
                                  
                                  16,382,654Property
      and equipment, net
                                  
                                  
                                  3,286,796
                                  
                                  
                                  
                                  3,743,936Deferred
      Financing Costs, net
                                  
                                  
                                  2,131,603
                                  
                                  
                                  
                                  1,500,533Deferred
      Offering Costs
                                  
                                  
                                  222,000
                                  
                                  
                                  
                                  -Notes
      Receivable
                                  
                                  
                                  925,000
                                  
                                  
                                  
                                  925,000Intangible
      Assets
                                  
                                  
                                  606,000
                                  
                                  
                                  
                                  606,000Goodwill
                                  
                                  
                                  450,000
                                  
                                  
                                  
                                  450,000Deferred
      Tax Asset
                                  
                                  
                                  1,167,832
                                  
                                  
                                  
                                  1,167,832Other
      Assets
                                  
                                  
                                  159,559
                                  
                                  
                                  
                                  159,560TOTAL
      ASSETS
                                  
                                  $
                                  28,244,996
                                  
                                  
                                  $
                                  24,935,515LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      Liabilities:Accounts
      payable
                                  
                                  $
                                  9,209,076
                                  
                                  
                                  $
                                  2,480,652Accrued
      expenses
                                  
                                  
                                  385,620
                                  
                                  
                                  
                                  755,615Line
      of Credit
                                  
                                  
                                  -
                                  
                                  
                                  
                                  76,832Mandatory
      redeemable Series A Convertible Preferred Stock (cumulative), 15,000
      shares authorized issued and outstanding
                                  
                                  
                                  7,500,000
                                  
                                  
                                  
                                  10,981,577Warrant
      Liability
                                  
                                  
                                  86,762
                                  
                                  
                                  
                                  90,409Liabilities
      of Discontinued operations
                                  
                                  
                                  -
                                  
                                  
                                  
                                  736,613TOTAL
      CURRENT LIABILITIES
                                  
                                  
                                  17,181,458
                                  
                                  
                                  
                                  15,121,698Long
      Term Liabilites:Mandatory
      Redeemable Series A Convertible Preferred Stock, - Long
    Term
                                  
                                  
                                  5,360,813
                                  
                                  
                                  
                                  -Total
      Liabilities
                                  
                                  
                                  22,542,271
                                  
                                  
                                  
                                  15,121,698Shareholders' Equity:Common
      stock, $0.001 par value, 100,000,000 shares authorized, 45,531,457 and
      39,585,960 shares issued and outstanding as of September 30, 2009 and
      December 31, 2008, respectively
                                  
                                  
                                  45,532
                                  
                                  
                                  
                                  39,586Additional
      paid-in capital
                                  
                                  
                                  14,222,331
                                  
                                  
                                  
                                  11,096,031Accumulated
      deficit
                                  
                                  
                                  (8,565,138
                                  )
                                  
                                  
                                  (1,321,800
                                  )Total
      Shareholders' Equity
                                  
                                  
                                  5,702,725
                                  
                                  
                                  
                                  9,813,817TOTAL
      LIABILITIES AND SHAREHOULDERS' EQUITY
                                  
                                  $
                                  28,244,996
                                  
                                  
                                  $
                                  24,935,515
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.
 3
 
 AMERICAN
DEFENSE SYSTEMS, INC. and SUBSIDIARIES
 CONDENSED
CONSOLIDATED STATEMENTS OF
OPERATIONS
 (Unaudited)
  
 Three
      Months Ended
                                                                    
                                                                    
                                                                    Nine
      Months EndedSept
      30
                                                                    
                                                                    
                                                                    Sept
      302009
                                                                    
                                                                    
                                                                    2008 (Restated)
                                                                    
                                                                    
                                                                    2009
                                                                    
                                                                    
                                                                    2008 (Restated)CONTRACT
      REVENUES EARNED
                                                                    
                                                                    $
                                                                    12,643,488
                                                                    
                                                                    
                                                                    $
                                                                    13,308,862
                                                                    
                                                                    
                                                                    $
                                                                    36,166,765
                                                                    
                                                                    
                                                                    $
                                                                    31,268,223COST
      OF REVENUES EARNED
                                                                    
                                                                    
                                                                    9,999,606
                                                                    
                                                                    
                                                                    
                                                                    8,996,384
                                                                    
                                                                    
                                                                    
                                                                    24,112,580
                                                                    
                                                                    
                                                                    
                                                                    20,340,867GROSS
      PROFIT
                                                                    
                                                                    
                                                                    2,643,882
                                                                    
                                                                    
                                                                    
                                                                    4,312,478
                                                                    
                                                                    
                                                                    
                                                                    12,054,185
                                                                    
                                                                    
                                                                    
                                                                    10,927,356OPERATING
      EXPENSESGeneral
      and administrative expenses
                                                                    
                                                                    
                                                                    2,410,261
                                                                    
                                                                    
                                                                    
                                                                    2,125,910
                                                                    
                                                                    
                                                                    
                                                                    6,707,592
                                                                    
                                                                    
                                                                    
                                                                    5,386,549General
      and administrative salaries
                                                                    
                                                                    
                                                                    1,051,214
                                                                    
                                                                    
                                                                    
                                                                    967,152
                                                                    
                                                                    
                                                                    
                                                                    3,146,617
                                                                    
                                                                    
                                                                    
                                                                    3,221,803Marketing
                                                                    
                                                                    
                                                                    560,231
                                                                    
                                                                    
                                                                    
                                                                    688,024
                                                                    
                                                                    
                                                                    
                                                                    2,017,804
                                                                    
                                                                    
                                                                    
                                                                    2,047,591T2
      expenses
                                                                    
                                                                    
                                                                    154,766
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    392,438
                                                                    
                                                                    
                                                                    
                                                                    -Research
      and development
                                                                    
                                                                    
                                                                    117,268
                                                                    
                                                                    
                                                                    
                                                                    170,784
                                                                    
                                                                    
                                                                    
                                                                    320,495
                                                                    
                                                                    
                                                                    
                                                                    539,936Settlement
      of litigation
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    63,441
                                                                    
                                                                    
                                                                    
                                                                    57,377Depreciation
                                                                    
                                                                    
                                                                    278,264
                                                                    
                                                                    
                                                                    
                                                                    266,434
                                                                    
                                                                    
                                                                    
                                                                    797,676
                                                                    
                                                                    
                                                                    
                                                                    548,869Total
      operating expenses
                                                                    
                                                                    
                                                                    4,572,004
                                                                    
                                                                    
                                                                    
                                                                    4,218,304
                                                                    
                                                                    
                                                                    
                                                                    13,446,063
                                                                    
                                                                    
                                                                    
                                                                    11,802,125(LOSS)
      INCOME FROM OPERATIONS
                                                                    
                                                                    
                                                                    (1,928,122
                                                                    )
                                                                    
                                                                    
                                                                    94,174
                                                                    
                                                                    
                                                                    
                                                                    (1,391,878
                                                                    )
                                                                    
                                                                    
                                                                    (874,769
                                                                    )OTHER
      INCOME (EXPENSE)Unrealized
      gain (loss) on adjustment of fair valueSeries
      A convertible preferred stock classified as a liability
                                                                    
                                                                    
                                                                    (498,407
                                                                    )
                                                                    
                                                                    
                                                                    126,228
                                                                    
                                                                    
                                                                    
                                                                    (1,183,719
                                                                    )
                                                                    
                                                                    
                                                                    1,302,722Unrealized
      gain (loss) on warrant liability
                                                                    
                                                                    
                                                                    10,674
                                                                    
                                                                    
                                                                    
                                                                    52,001
                                                                    
                                                                    
                                                                    
                                                                    (15,676
                                                                    )
                                                                    
                                                                    
                                                                    1,365,844Loss
      on deemed extinguishment of debt
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (2,613,630
                                                                    )
                                                                    
                                                                    
                                                                    -Other
      income (expense)
                                                                    
                                                                    
                                                                    (21,040
                                                                    )
                                                                    
                                                                    
                                                                    (332,406
                                                                    )
                                                                    
                                                                    
                                                                    (33,770
                                                                    )
                                                                    
                                                                    
                                                                    (335,345
                                                                    )Interest
      expense
                                                                    
                                                                    
                                                                    (663,527
                                                                    )
                                                                    
                                                                    
                                                                    (272,730
                                                                    )
                                                                    
                                                                    
                                                                    (1,444,675
                                                                    )
                                                                    
                                                                    
                                                                    (582,897
                                                                    )Interest
      expense - mandatory redeemable preferred stock dividends
                                                                    
                                                                    
                                                                    (450,000
                                                                    )
                                                                    
                                                                    
                                                                    (399,000
                                                                    )
                                                                    
                                                                    
                                                                    (1,200,000
                                                                    )
                                                                    
                                                                    
                                                                    (800,252
                                                                    )Interest
      income
                                                                    
                                                                    
                                                                    3
                                                                    
                                                                    
                                                                    
                                                                    24,152
                                                                    
                                                                    
                                                                    
                                                                    8,859
                                                                    
                                                                    
                                                                    
                                                                    114,233Finance
      charge
                                                                    
                                                                    
                                                                    (41,025
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (41,025
                                                                    )
                                                                    
                                                                    
                                                                    -Total
      other income (expense)
                                                                    
                                                                    
                                                                    (1,663,322
                                                                    )
                                                                    
                                                                    
                                                                    (801,755
                                                                    )
                                                                    
                                                                    
                                                                    (6,523,636
                                                                    )
                                                                    
                                                                    
                                                                    1,064,305(LOSS)
      INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES
                                                                    
                                                                    
                                                                    (3,591,444
                                                                    )
                                                                    
                                                                    
                                                                    (707,581
                                                                    )
                                                                    
                                                                    
                                                                    (7,915,514
                                                                    )
                                                                    
                                                                    
                                                                    189,536INCOME
      TAX PROVISION
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    -(LOSS)
      INCOME FROM CONTINUING OPERATIONS
                                                                    
                                                                    
                                                                    (3,591,444
                                                                    )
                                                                    
                                                                    
                                                                    (707,581
                                                                    )
                                                                    
                                                                    
                                                                    (7,915,514
                                                                    )
                                                                    
                                                                    
                                                                    189,536LOSS
      FROM DISCONTINUED OPERATIONS, NET OF TAX:Loss
      from operations of discontinued divison
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (100,352
                                                                    )
                                                                    
                                                                    
                                                                    -
                                                                    
                                                                    
                                                                    
                                                                    (216,816
                                                                    )NET
      LOSS
                                                                    
                                                                    $
                                                                    (3,591,444
                                                                    )
                                                                    
                                                                    $
                                                                    (807,933
                                                                    )
                                                                    
                                                                    $
                                                                    (7,915,514
                                                                    )
                                                                    
                                                                    $
                                                                    (27,280
                                                                    )Weighted
      Average Shares Outstanding (Basic and Diluted)
                                                                    
                                                                    
                                                                    45,513,965
                                                                    
                                                                    
                                                                    
                                                                    39,442,800
                                                                    
                                                                    
                                                                    
                                                                    42,388,377
                                                                    
                                                                    
                                                                    
                                                                    39,442,800EARNINGS
      PER SHARE - Basic and DilutedLoss
      from continuing operations
                                                                    
                                                                    $
                                                                    (0.08
                                                                    )
                                                                    
                                                                    $
                                                                    (0.02
                                                                    )
                                                                    
                                                                    $
                                                                    (0.19
                                                                    )
                                                                    
                                                                    $
                                                                    -Loss
      from discontinued operations
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    -
                                                                    
                                                                    
                                                                    $
                                                                    -Net (loss)
                                                                    
                                                                    $
                                                                    (0.08
                                                                    )
                                                                    
                                                                    $
                                                                    (0.02
                                                                    )
                                                                    
                                                                    $
                                                                    (0.19
                                                                    )
                                                                    
                                                                    $
                                                                    -




The
accompanying notes are an integral part of these condensed consolidated
financial statements.





4


AMERICAN
DEFENSE SYSTEMS, INC. and Subsidiaries
 CONDENSED
CONSOLIDATED STATEMENTS OF CASH
FLOWS
 Unaudited
 
 For the nine month ended September 30,2009
                                                                                            
                                                                                            
                                                                                            2008 (Restated)CASHFLOWS
      FROM OPERATING ACTIVITIES:NET
      LOSS
                                                                                            
                                                                                            $
                                                                                            (7,915,514
                                                                                            )
                                                                                            
                                                                                            $
                                                                                            (27,280
                                                                                            )Adjustments
      to reconcile net loss to net cash used in operating
      activities:Change
      in fair value associated with preferred stock and Warrants
      Liabilities
                                                                                            
                                                                                            
                                                                                            1,199,395
                                                                                            
                                                                                            
                                                                                            
                                                                                            (2,668,556
                                                                                            )Stock
      based compensation expense
                                                                                            
                                                                                            
                                                                                            220,198
                                                                                            
                                                                                            
                                                                                            
                                                                                            75,820Loss
      on deemed Extingishment of debt
                                                                                            
                                                                                            
                                                                                            2,613,630
                                                                                            
                                                                                            
                                                                                            
                                                                                            -Amortization
      of deferred financing costs
                                                                                            
                                                                                            
                                                                                            592,010
                                                                                            
                                                                                            
                                                                                            
                                                                                            292,631Amortization
      of Discount on Series A preferred stock
                                                                                            
                                                                                            
                                                                                            407,868
                                                                                            
                                                                                            
                                                                                            
                                                                                            288,098Depreciation
      and amortization
                                                                                            
                                                                                            
                                                                                            797,676
                                                                                            
                                                                                            
                                                                                            
                                                                                            548,869Non
      cash interest expense
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            800,252Changes
      in operating assets and liabilities:Accounts
      receivable
                                                                                            
                                                                                            
                                                                                            (966,873
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (1,797,173
                                                                                            )Accounts
      receivable-Factoring
                                                                                            
                                                                                            
                                                                                            (256,888
                                                                                            )
                                                                                            
                                                                                            
                                                                                            -Inventory
                                                                                            
                                                                                            
                                                                                            140,761
                                                                                            
                                                                                            
                                                                                            
                                                                                            (567,813
                                                                                            )Deposits
      and other assets
                                                                                            
                                                                                            
                                                                                            127,811
                                                                                            
                                                                                            
                                                                                            
                                                                                            174,697Cost
      in excess of billing on uncompleted contracts
                                                                                            
                                                                                            
                                                                                            (3,055,550
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (2,617,501
                                                                                            )Prepaid
      expenses and other assets
                                                                                            
                                                                                            
                                                                                            93,499
                                                                                            
                                                                                            
                                                                                            
                                                                                            (1,388,556
                                                                                            )Advances
      for future acquisitions
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            (76,427
                                                                                            )Investment
      in affiliate
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            (1,387,741
                                                                                            )Accounts
      payable
                                                                                            
                                                                                            
                                                                                            6,728,424
                                                                                            
                                                                                            
                                                                                            
                                                                                            569,470Accrued
      expenses
                                                                                            
                                                                                            
                                                                                            830,005
                                                                                            
                                                                                            
                                                                                            
                                                                                            321,814Due
      to related party
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            (38,286
                                                                                            )NET
      CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
                                                                                            
                                                                                            
                                                                                            1,556,452
                                                                                            
                                                                                            
                                                                                            
                                                                                            (7,497,682
                                                                                            )CASH
      FLOWS FROM INVESTING ACTIVTIES:Purchase
      of equipment
                                                                                            
                                                                                            
                                                                                            (340,536
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (2,772,104
                                                                                            )Cash
      paid for acquistion in excess of cash received
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            (100,000
                                                                                            )NET
      CASH USED IN INVESTING ACTIVITIES
                                                                                            
                                                                                            
                                                                                            (340,536
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (2,872,104
                                                                                            )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from notes payable
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            84,311Repayments
      of line of credit
                                                                                            
                                                                                            
                                                                                            (76,832
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (19,026
                                                                                            )Proceeds
      from the sale of common stock
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            203,152Proceeds
      from sale of Series A Convertible preferred shares, net of
      capitalizationcost
      of $1,050,000
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            
                                                                                            13,950,000Deferred
      Offering costs
                                                                                            
                                                                                            
                                                                                            (222,000
                                                                                            )
                                                                                            
                                                                                            
                                                                                            -Deferred
      financing costs
                                                                                            
                                                                                            
                                                                                            (1,184,160
                                                                                            )
                                                                                            
                                                                                            
                                                                                            (1,668,450
                                                                                            )NET
      CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES
                                                                                            
                                                                                            
                                                                                            (1,482,992
                                                                                            )
                                                                                            
                                                                                            
                                                                                            12,549,987NET
      (DECREASE) INCREASE IN CASH
                                                                                            
                                                                                            
                                                                                            (267,076
                                                                                            )
                                                                                            
                                                                                            
                                                                                            2,180,201CASH
      AT BEGINNING OF YEAR
                                                                                            
                                                                                            
                                                                                            374,457
                                                                                            
                                                                                            
                                                                                            
                                                                                            1,479,886CASH
      AT THE END OF PERIOD
                                                                                            
                                                                                            $
                                                                                            107,381
                                                                                            
                                                                                            
                                                                                            $
                                                                                            3,660,087Supplemental
      disclosure of cash flow information:Cash
      paid during the year for interest
                                                                                            
                                                                                            $
                                                                                            33,770
                                                                                            
                                                                                            
                                                                                            $
                                                                                            11,744Supplemental
      disclosure of non-cash investing and financing activitiesStock
      options issued in lieu of compensation
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            75,820Fair
      value of placement agent warrants
                                                                                            
                                                                                            
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            511,742Stock
      issued for payment of accrued dividends on preferred stock
                                                                                            
                                                                                            $
                                                                                            1,200,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            -Reclassification
      of derivatitve warrant liability upon exercise
                                                                                            
                                                                                            $
                                                                                            2,550,000
                                                                                            
                                                                                            
                                                                                            $
                                                                                            -Cumulative
      effect on a change in accounting principle on (note 2):Warrants
                                                                                            
                                                                                            $
                                                                                            165,777
                                                                                            
                                                                                            
                                                                                            $
                                                                                            -Additional
      Paid in Capital
                                                                                            
                                                                                            $
                                                                                            (837,954
                                                                                            )
                                                                                            
                                                                                            $
                                                                                            -Accumulated
      Deficit
                                                                                            
                                                                                            $
                                                                                            672,179
                                                                                            
                                                                                            
                                                                                            $
                                                                                            -Assets
      and liabilities received in acquisition of American Anti-Ram,
      Inc.Fixed
      assets
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            30,000Inventory
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            120,000Goodwill
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            280,000Accounts
      payable and accrued expense
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (30,000
                                                                                            )Shares
      issuable in connection with acquisition
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (200,000
                                                                                            )Cash
      paid to American Anti-Ram, Inc.
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (100,000
                                                                                            )Amounts
      due to American Anti-Ram, Inc
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (100,000
                                                                                            )Amounts
      due to American Anti-Ram, Inc
                                                                                            
                                                                                            $
                                                                                            -
                                                                                            
                                                                                            
                                                                                            $
                                                                                            (100,000
                                                                                            )
 
 The
accompanying notes are an integral part of these condensed consolidated
financial statements.




5




AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS





1.
            NATURE
      OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING
  POLICIES





Organization





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





On
May1, 2003, the
stockholder of A. J. Piscitelli & Associates, Inc. (“AJP”) exchanged all of
his issued and outstanding shares for shares of American Defense Systems, Inc.
The exchange was accounted for as a recapitalization of the Company, wherein the
stockholder retained all the outstanding stock of American Defense Systems, Inc.
At the time of the acquisition American Defense Systems, Inc. was substantially
inactive.





On
November 15, 2007, the Company entered into an Asset Purchase Agreement with
Tactical Applications Group (“TAG”), a North Carolina based sole proprietorship,
and its owner.   TAG has a retail establishment located in
Jacksonville, North Carolina that supplies tactical equipment to military and
security personnel.  As discussed more fully in Note 8, the operations
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 of acquiring the
assets of American Anti-Ram, Inc., a manufacturer of crash tested vehicle
barricades. This acquisition represents a new product line for the
Company.  APSG is located in North Carolina.





Interim
Review Reporting





The
accompanying interim unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
8 of Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In our opinion, all adjustments (consisting of normal
recurring accruals) considered necessary for a fair presentation have been
included. Operating results for the three and nine months periods ended
September 30, 2009 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2009. For further information, refer
to the financial statements and footnotes thereto included in the Company’s Form
10-K annual report filed on April 15, 2009. See Note 2 for reclassification
footnote.





Nature
of Business





The
Company designs and supplies transparent and opaque armor solutions for both
military and commercial applications. Its primary customers are United States
government agencies and general contractors who have contracts with governmental
entities. These products, sold under Vista trademarks, are used in transport and
fighting vehicles, construction equipment, sea craft and various fixed
structures which require ballistic and blast attenuation.





6





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The
Company also provides engineering and consulting services, develops and installs
detention and security hardware, entry control and monitoring systems, intrusion
detection systems, and security glass. The Company also supplies vehicle
anti-ram barriers.  Its primary customer for these services and
products are the detention and security industry.





Principles
of Consolidation





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





Terms
and Definitions





ADSI
                  
                  American
      Defense Systems, Inc. (the “Company”)AJP
                  
                  A.J.
      Piscitelli & Associates, Inc., a subsidiaryAPB
                  
                  Accounting
      Principles BoardARB
                  
                  Accounting
      Review BoardAPSG
                  
                  American
      Physical Security Group, LLC, a subsidiaryASC
                  
                  FASB
      Accounting Standards CodificationFASB
                  
                  Financial
      Accounting Standards BoardGAAP
                  
                  Generally
      Accepted Accounting PrinciplesPCAOB
                  
                  Public
      Companies Accounting Oversight BoardSEC
                  
                  Securities
      Exchange CommissionSFAS or FAS
                  
                  Statement
      of Financial Accounting StandardsTAG
                  
                  Tactical
      Applications Group, a
subsidiary





Management
Liquidity Plans





As of
September 30, 2009, the Company had working capital of $2,114,748, an
accumulated deficit of $8,565,138 and cash on hand of $107,381.  The
Company also had losses from operations of  $1,928,122 and $1,391,878 and
net losses of $3,591,444 and $7,915,514 for the three and nine months ended
September 30, 2009, respectively.  ADSI believes that its current
cash, cash equivalents, net accounts receivable and cost in excess of billing
together with its expected cash flows from operations and its ability to sell
accounts receivable under its factoring agreement, the Company will be
sufficient to meet its anticipated cash requirements for working capital for at
least 12 months, except with respect to its agreement to redeem $7.5 million in
stated value of its outstanding Series A Preferred stock by December 31, 2009,
if the company does not raise the $7.5 million in stated value by December 31,
2009, the Company can remedy the nonpayment by having the series A holder place
two members on the board and reducing the conversion price to $.50. In addition, restrictions
imposed pursuant to the General Corporation Law of the State of Delaware (the
“DGCL”), the Company’s state of
incorporation, would prohibit the Company from satisfying such redemption if it
lacks sufficient surplus, as such term is defined under the
DGCL. The company is currently seeking to raise capital in
public markets to finance such redemption, and provide additional working
capital although there are no assurances it will be able to do so on the terms
acceptable to them.  If ADSI is unable to timely raise such capital in
the public market or do not otherwise successfully raise capital or obtain
access to a credit facility sufficient to fund such redemption, its cash flow
could be adversely affected and business significantly harmed.





7





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Use
of Estimates





The
preparation of financial statements and related disclosures in conformity with
accounting principles generally accepted in the United States requires
management to make estimates and assumptions that affect the amounts reported in
the consolidated financial statements and accompanying notes.





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





Subsequent
Events





The Company has evaluated
events that occurred subsequent to September 30, 2009 through November 23, 2009,
the date on which the financial statements for the period ended September
30, 2009 were issued. Management concluded that no other events required
disclosure in these financial statements.





Concentrations





The
Company’s bank accounts are maintained in financial institutions. Deposits held
with banks may exceed the amount of insurance provided on such deposits.
Generally, these deposits may be redeemed upon demand and therefore bear minimal
risk.





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





For the
three months ended September 30, 2009 and 2008, the Company derived 60% and 86%
of its revenues from various U.S. government entities.  For the nine
months ended September 30, 2009 and 2008, the Company derived 75% and 78% of its
revenues from various U.S. government entities.





Inventory





Inventory,
which consists of spare parts, is stated at the lower of cost or market, with
cost determined using the first-in, first-out method.





8





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Earnings
per Share





Basic
earnings (loss) per share is computed using the weighted-average number of
common shares outstanding during the period. Diluted net income per share is
computed using the weighted-average number of common shares and dilutive
potential common shares outstanding during the period. Diluted net loss per
share is computed using the weighted-average number of common shares and
excludes dilutive potential common shares outstanding, as their effect is
anti-dilutive. Dilutive potential common shares would primarily consist of
employee stock options and warrants and convertible preferred
stock.





Securities
that could potentially dilute basic EPS in the future that were not included in
the computation of the diluted EPS because to do so would be anti-dilutive
consist of the following:





Three Months Ended
                                  Sept 30
                                
                                
                                Nine Months Ended
                                  Sept 30In Thousands
                                
                                2009
                                
                                
                                2008
                                
                                
                                2009
                                
                                
                                2008Warrants
      to purchase Common Stock
                                
                                
                                1,449
                                
                                
                                
                                5,198
                                
                                
                                
                                1,449
                                
                                
                                
                                5,198Options
      to Purchase Common Stock
                                
                                
                                2,095
                                
                                
                                
                                1,895
                                
                                
                                
                                2,095
                                
                                
                                
                                1,895Series
      A Convertible Preferred Stock
                                
                                
                                7,500
                                
                                
                                
                                7,500
                                
                                
                                
                                7,500
                                
                                
                                
                                7,500Total
      Potential Common Stock
                                
                                
                                11,044
                                
                                
                                
                                14,593
                                
                                
                                
                                11,044
                                
                                
                                
                                14,593





Debt
Extinguishment





The
Company accounted for the effects of the May 22, 2009 settlement agreements (see
Note 7) in accordance with the guidelines enumerated in EITF Issue No. 96-19 “
Debtor’s Accounting for a Modification of Exchange of Debt Instruments” as
codified in ASC 470-50.  ASC 470-50 provides that a substantial
modification of terms in an existing debt instrument should be accounted for
like, and reported in the same manner as, an extinguishment of debt. ASC 470-50
further provides that the modification of a debt instrument by a debtor and a
creditor in a non-troubled debt situation is deemed to have been accomplished
with debt instruments that are substantially different if the present value of
cash flows under the terms of the new debt instrument is at least ten percent
different from the present value of the remaining cash flows under the terms of
the original instrument at the date of the modifications.





The
Company evaluated the modification of the payment terms and the related
adjustment to financial instruments to determine whether these modifications
resulted in the issuance of a substantially different instrument. The Company
determined after giving effect to the changes in the due dates of payments and
the consideration paid to the debt holders, in the form of reduced conversion
and exercise prices, that the Company had issued substantially different debt
instruments, which resulted in a constructive extinguishment of the original
debt instrument. Accordingly, the Company recorded a loss on the extinguishment
of debt in the amount of $2,613,630 which represented the difference in the
carrying value of the old debt and fair value of the new debt. The debt
instrument charge is included in the accompanying statement of operations for
the nine months ended September 30, 2009.





9





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Fair
Value of Financial Instruments





Fair
value of certain of the Company’s financial instruments including cash and cash
equivalents, accounts receivable, note receivable, accrued compensation, and
other accrued liabilities approximate cost because of their short maturities.
The Company measures and reports fair value in accordance with ASC 820, “Fair
Value Measurements and Disclosure” defines fair value, establishes a framework
for measuring fair value in accordance with generally accepted accounting
principles and expands disclosures about fair value investments.




Fair
value, as defined in ASC 820, is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. The fair value of an asset should reflect
its highest and best use by market participants, principal (or most
advantageous) markets, and an in-use or an in-exchange valuation premise. The
fair value of a liability should reflect the risk of nonperformance, which
includes, among other things, the Company’s credit risk.




Valuation
techniques are generally classified into three categories: the market approach;
the income approach; and the cost approach. The selection and application of one
or more of the techniques may require significant judgment and are primarily
dependent upon the characteristics of the asset or liability, and the quality
and availability of inputs. Valuation techniques used to measure fair value
under ASC 820 must maximize the use of observable inputs and minimize the use of
unobservable inputs. ASC 820 also provides fair value hierarchy for inputs and
resulting measurement as follows:





Level
1




Quoted
prices (unadjusted) in active markets that are accessible at the measurement
date for identical assets or liabilities;




Level
2




Quoted
prices for similar assets or liabilities in active markets; quoted prices for
identical or similar assets or liabilities in markets that are not active;
inputs other than quoted prices that are observable for the asset or liability;
and inputs that are derived principally from or corroborated by observable
market data for substantially the full term of the assets or liabilities;
and





10





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Level
3




Unobservable
inputs for the asset or liability that are supported by little or no market
activity and that are significant to the fair values.





Fair
value measurements are required to be disclosed by the Level within the fair
value hierarchy in which the fair value measurements in their entirety fall.
Fair value measurements using significant unobservable inputs (in Level 3
measurements) are subject to expanded disclosure requirements including a
reconciliation of the beginning and ending balances, separately presenting
changes during the period attributable to the following: (i) total gains or
losses for the period (realized and unrealized), segregating those gains or
losses included in earnings, and a description of where those gains or losses
included in earning are reported in the statement of income.





The
following summarizes the Company’s assets and liabilities measured at fair value
as of September 30, 2009:





Fair Value Measurements at Reporting Date UsingQuoted
                                            Pricesin ActiveBalance as of
                                          
                                          Markets
                                            for
                                          
                                          Significant
                                            Other
                                          
                                          SignificantSeptember
                                          
                                          Identical
                                          
                                          Observable
                                          
                                          Unobservable30,
                                          
                                          Assets
                                          
                                          Inputs
                                          
                                          InputsDescription
                                          
                                          2009
                                          
                                          (Level 1)
                                          
                                          (Level 2)
                                          
                                          (Level 3)LiabilitiesSeries
      A Preferred (1)
                                          
                                          $
                                          12,860,814
                                          
                                          
                                          $
                                          —
                                          
                                          
                                          $
                                          —
                                          
                                          
                                          $
                                          12,860,8142005
      Warrants (1)
                                          
                                          
                                          18,907
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          18,9072006
      Warrants (1)
                                          
                                          
                                          6,463
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          6,463Placement
      Agent Warrants (1)
                                          
                                          
                                          61,390
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          —
                                          
                                          
                                          
                                          61,390Total
      Liabilities
                                          
                                          $
                                          12,947,574
                                          
                                          
                                          $
                                          —
                                          
                                          
                                          $
                                          —
                                          
                                          
                                          $
                                          12,947,574




(1)
            Methods
      and significant inputs and assumptions are discussed in Note 6
      below





11





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Income
Taxes





The
Company accounts for income taxes according to ASC 740 “Income Taxes” which
requires an asset and liability approach to financial accounting for income
taxes. Deferred income tax assets and liabilities are computed annually for the
difference between the financial statement and tax bases of assets and
liabilities that will result in taxable or deductible amounts in the future,
based on enacted tax laws and rates applicable to the periods in which the
differences are expected to affect taxable income. Valuation allowances are
established when necessary to reduce deferred tax assets to the amount expected
to be realized. Income tax expense is the tax payable or refundable for the
period, plus or minus the change during the period in deferred tax assets and
liabilities.





The
Corporation adopted the provisions of ASC 740-10 "Accounting for Uncertainty in
Income Taxes” effective January 1, 2007. ASC 740-10 prescribes a recognition
threshold and a measurement attribute for the financial statement recognition
and measurement of a tax position taken or expected to be taken in a tax return.
Benefits from tax positions should be recognized in the financial statements
only when it is more likely than not that the tax position will be sustained
upon examination by the appropriate taxing authority that would have full
knowledge of all relevant information. A tax position that meets the
more-likely-than-not recognition threshold is measured at the largest amount of
benefit that is greater than fifty percent likely of being realized upon
ultimate settlement. Tax positions that previously failed to meet the
more-likely-than-not recognition threshold should be recognized in the first
subsequent financial reporting period in which that threshold is met. Previously
recognized tax positions that no longer meet the more-likely-than-not
recognition threshold should be derecognized in the first subsequent financial
reporting period in which that threshold is no longer met. ASC 740-10 also
provides guidance on the accounting for and disclosure of unrecognized tax
benefits, interest and penalties. Adoption of ASC 740-10 did not have a
significant impact on the Company's financial statements.





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





Recent
accounting pronouncements





The
Financial Accounting Standards Board (“FASB”), in June 2009, issued new
accounting guidance that established the FASB Accounting Standards
Codification,  ("Codification" or “ASC”) as the single source of
authoritative GAAP to be applied by nongovernmental entities, except for
the rules and interpretive releases of the Securities and Exchange
Commission (“SEC”) under authority of federal securities laws, which
are sources of authoritative Generally Accepted Accounting Principles
(“GAAP”) for SEC registrants.  The FASB will no longer issue new standards
in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force
Abstracts; instead the FASB will issue Accounting Standards Updates. Accounting
Standards Updates will not be authoritative in their own right as they will only
serve to update the Codification. These changes and the Codification itself do
not change GAAP. This new guidance became effective for interim and annual
periods ending after September 15, 2009.  Other than the manner in which
new accounting guidance is referenced, the adoption of these changes did not
have a material effect on the Company’s consolidated financial
statements.





12





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





In
December 2007, the FASB issued new accounting guidance, under ASC Topic 805 on
business combinations, which establishes principles and requirements for
determining how an enterprise recognizes and measures the fair value of certain
assets and liabilities acquired in a business combination, including
noncontrolling interests, contingent considerations, and certain acquired
contingencies. This guidance also requires acquisition-related transaction
expenses and restructuring costs to be expensed as incurred rather than
capitalized as a component of the business combination.  This guidance is
effective for business combinations with an acquisition date on or after the
beginning of the first annual reporting period beginning on or after December
15, 2008. The adoption of this guidance will have an impact on accounting for
businesses acquired after the effective date of this pronouncement.




In
December 2007, the FASB issued new accounting guidance, under ASC Topic 805 on
business combinations, which establishes accounting and reporting standards for
the noncontrolling interest in a subsidiary (previously referred to as minority
interests).  This guidance also requires that a retained
noncontrolling interest upon the deconsolidation of a subsidiary be initially
measured at its fair value. Upon the adoption of this guidance, the Company will
be required to report any noncontrolling interests as a separate component of
consolidated stockholders’ equity. The Company will also be required to present
any net income allocable to noncontrolling interest and net income attributable
to the stockholders of the Company separately in its consolidated statements of
operations. This guidance is effective for fiscal years, and interim periods
within those fiscal years, beginning on or after January 1,
2009.  The implementation of this guidance would require retroactive
adoption of the presentation and disclosure requirements for existing minority
interests, with all other requirements of this guidance to be applied
prospectively. As the Company does not have noncontrolling interests in any
subsidiary, the adoption of this guidance did not have any impact upon the
Company’s consolidated financial position or results of operations.




In March
2008, the FASB issued new accounting guidance, under ASC Topic 815 on
derivatives and hedging,   which amends and expands existing
disclosure requirements to require qualitative disclosure about objectives and
strategies for using derivatives, quantitative disclosures about fair value
amounts of and gains and losses on derivative instruments, and disclosures about
credit-risk-related contingent features in derivative agreements. This guidance
is effective beginning January 1, 2009. The adoption of this guidance did
not have a material impact upon the Company’s consolidated financial position or
results of operations but changed the disclosures on its derivative
instruments.




In June
2008, the FASB issued new accounting guidance, under ASC Topic 815-40 on
derivatives and hedging, as to how an entity should determine whether an
instrument (or an embedded feature) is indexed to an entity’s own
stock. This guidance provides that an entity should use a two-step approach
to evaluate whether an equity-linked financial instrument (or embedded feature)
is indexed to its own stock, including evaluating the instrument’s contingent
exercise and settlement provisions.  This guidance is effective for
financial statements issued for fiscal years beginning after December 15,
2008.  Upon adoption of this guidance on January 1, 2009, the Company has
determined that certain of its warrants were not equity-linked financial
instruments, and accordingly, were derivative instruments.  The
Company has recorded the fair value of these instruments and the resulting
cumulative effect of this change in accounting method, as of January 1, 2009
(See Note 2).





13





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





In
April 2009, the FASB issued new accounting guidance, under ASC Topic 820 on
fair value measurements and disclosures, which established the requirements for
estimating fair value when market activity has decreased and on identifying
transactions that are not orderly.  Under this guidance, entities are
required to disclose in interim and annual periods the inputs and valuation
techniques used to measure fair value. This guidance is effective for
interim and annual periods ending after June 15, 2009. The adoption of this
guidance did not have a material impact on the Company’s consolidated financial
position or results of operations.





In
May 2009, the FASB issued new accounting guidance, under ASC Topic 855 on
subsequent events, which sets forth general standards of accounting for and
disclosure of events that occur after the balance sheet date but before
financial statements are issued or are available to be issued.  This
guidance is effective for interim and annual periods ending after June 15,
2009. The adoption of this guidance did not have a material impact on the
Company’s consolidated financial position or results of operations.





In
June 2009, the FASB issued new accounting guidance, under SFAS No. 167
“Amendments to FASB Interpretation No. 46(R)”, which modify how a company
determines when an entity that is insufficiently capitalized or is not
controlled through voting (or similar rights) should be consolidated. This
guidance clarified that the determination of whether a company is required to
consolidate an entity is based on, among other things, an entity’s purpose and
design and a company’s ability to direct the activities of the entity that most
significantly impact the entity’s economic performance. An ongoing reassessment
is required of whether a company is the primary beneficiary of a variable
interest entity. Additional disclosures are also required about a company’s
involvement in variable interest entities and any significant changes in risk
exposure due to that involvement. This guidance is effective as of the beginning
of each reporting entity’s first annual reporting period that begins after
November 15, 2009, for interim periods within that first annual reporting
period, and for interim and annual reporting periods thereafter. The adoption of
this guidance is not expected to have a material effect on the Company’s
consolidated financial position or results of operations. This guidance has not
yet been integrated into the FASB Accounting Standards
Codification.




In
October 2009, the FASB issued new accounting guidance, under ASC Topic 605
on revenue recognition, which amends revenue recognition policies for
arrangements with multiple deliverables. This guidance eliminates the residual
method of revenue recognition and allows the use of management’s best estimate
of selling price for individual elements of an arrangement when vendor specific
objective evidence (VSOE), vendor objective evidence (VOE) or third-party
evidence (TPE) is unavailable. This guidance is effective for all new or
materially modified arrangements entered into on or after January 1, 2011
with earlier application permitted as of the beginning of a fiscal year. Full
retrospective application of the new guidance is optional.  The Company has
not completed its assessment of this new guidance on its financial condition,
results of operations.





14





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




In
October 2009, the FASB issued new accounting guidance, under ASC Topic 985
on software, which amends the scope of existing software revenue recognition
accounting. Tangible products containing software components and non-software
components that function together to deliver the product’s essential
functionality would be scoped out of the accounting guidance on software and
accounted for based on other appropriate revenue recognition guidance. 
This guidance is effective for all new or materially modified arrangements
entered into on or after January 1, 2011 with earlier application permitted
as of the beginning of a fiscal year. Full retrospective application of this new
guidance is optional. This guidance must be adopted in the same period that the
company adopts the amended accounting for arrangements with multiple
deliverables described in the preceding paragraph. The Company has not completed
its assessment of this new guidance on its financial position or results of
operations.




2.
            Restatements





On
November 20, 2009, the Company’s management and the Audit Committee of its Board
of Directors concluded that the Company’s consolidated financial statements as
of and for the year ended December 31, 2008 and the interim periods within the
year and the interim periods ended March 31, 2009 and June 30, 2009 should be
restated and should no longer be relied upon as a result of certain errors
discovered as described below:





Series A Convertible
Preferred Stock:


On April
14, 2009, the Company received a Notice of Triggering Event Redemption from the
holder of 94% of the Series A Redeemable Convertible Preferred Stock. The notice
demanded the full redemption of the holders’ shares of Series A Redeemable
Convertible Preferred Stock pursuant to a right to require the Company to redeem
shares of Series A Redeemable Convertible Preferred Stock provided under the
Certificate of Designation, Preferences and Rights of the Series A Redeemable
Convertible Preferred Stock. The redemption right purportedly was triggered by
the Company’s breach of certain covenants under a Consent and Agreement, dated
May 23, 2008, between the Company and holders of the Series A Redeemable
Convertible Preferred Stock. Although such redemption notice had been received,
the entire carrying amount of the Series A Redeemable Convertible Preferred
Stock continued to be reflected as a long term liability as of December 31,
2008, March 31, 2009 and June 30, 2009 due to restrictions that precluded the
Company from satisfying such demand. These restrictions were imposed pursuant to
the General Corporation Law of the State of Delaware (the “DGCL”), the Company’s
state of incorporation, which would prohibit the Company from satisfying such
redemption demand due to its lack of sufficient surplus, as such term is
defined under the DGCL. In addition, the Company was restricted, under its
revolving line of credit with TD Bank, from affecting such a redemption. Based
on these external restrictions, management determined that the Company
could not have satisfied the redemption demand without violating Delaware law
and its contractual obligations under its credit facility with TD Bank. In May
2009 the Company and the Series A
Redeemable preferred stock holders entered into a settlement agreement which
amended the preferred stock to include payment of $7,500,000 on December 31,
2009 with provision to cure if not paid.
(See note 6).





15





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Management
has reconsidered the classification of the Series A RedeemableConvertible Preferred
Stock and determined that, notwithstanding the legal and contractual
restrictions to satisfying the demanded redemption, the obligation to redeem
such preferred stock purportedly remained outstanding. Accordingly, management
concluded that the entire carrying amount of the Series A RedeemableConvertible Preferred
Stock should be classified as a current liability as of December 31, 2008 and
March 31, 2009 and that $7,500,000 should be classified as a current liability
at September 30, 2009, rather than a non current liability, in accordance with
paragraph 5 of Statement of Financial Accounting Standard 78 as codified in ASC
, which indicates that liabilities due within one year should be presented
within the financial statements as current liabilities.





Investor
Warrants:


The
company has restated its financial statements as of December 31, 2008 and March
31, 2009 to reclassify its derivative warrant liability associated with its
detachable warrants issued to the investors in the Series A Preferred Stock (see
Note 7).  The warrant contains features that allow the holder to request
that the Company repurchase the warrant upon the occurrence of certain events as
defined in the agreement. The Company re-evaluated the classification of this
liability and determined that the warrant holder’s right to “put” the warrant to
the Company represented the ability to request cash on demand and as such should
be classified as a current liability. The Company previously recorded the
warrant liability as a long term liability.





Assets from Discontinued
Operations and Liabilities from Discontinued Operations:


In order
to reflect the nature of the assets and liabilities associated with the
Company’s discontinued operations, Management and its Audit Committee have
reclassified its balance sheet presentation from long term to short term. This
change was made to reflect that such assets and liabilities would be realized
within a period of less than one year.





Adoption of EITF
07-5


Effective
January 1, 2009, the Company was required to analyze its Outstanding Financial
Instruments following the guidance of EITF 07-5 (as codified in ASC 815-40): and
that pronouncements effect in interpreting Statement of Financial Accounting
Standards (“SFAS”) Statement No. 133 “Accounting for Derivative Instruments and
Hedging Activities” as codified in ASC 815. The Company determined that certain
warrants issued in 2005, 2006 and 2008 contained provisions whereby the exercise
price could be adjusted upon certain financing transactions at a lower price per
share could no longer be viewed as indexed to the Company’s common stock. As
such, the Company should have changed the accounting for this warrant to a
“derivative” at fair value under ASC 815. As a result the Company recorded the
warrant liability at the fair value of the warrant of $166,775 as of January 1,
2009 and reclassified its issuance date fair value from additional
paid-in-capital. The cumulative effect on adoption of ASC 815-40 as of
January 1, 2009 is as follows:





Additional Paid
                              in Capital
                            
                            
                            Retained
                              EarningsBalance
      December 31, 2008
                            
                            $
                            9,534,616
                            
                            
                            $
                            466,715Cumulative
      effect of a change in accounting principle
                            
                            
                            (837,
      954
                            )
                            
                            
                            672,179Balance
      – January 1, 2009
                            
                            $
                            8,696,662
                            
                            
                            $
                            1,138,894




16





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The
derivative warrant liability is recorded at fair value in each subsequent
reporting period with changes in fair value recorded in the statement of
operations.





Intangible
Asset:


The
Company has restated its balance sheet as of December 31, 2008, March 31, 2009
and June 30, 2009 to reclassify an acquired indefinite lived intangible asset of
approximately $606,000 from its acquisition of the assets of American Anti-Ram
in 2008 to a long term asset.  Previously this intangible asset was
recorded as a current asset included in prepaid expenses and other current
assets.





Certain legal expenses
recorded as current assets:


The
Company has restated its financial statements as of December 31, 2008 and for
the year then ended, as of March 31, 2009 and the three months then ended and as
of June 30, 2009 and for the three and six months then ended to reclassify and
expense certain legal fees that were originally capitalized in prepaid expenses
and other current assets.  The legal expenses pertained to fees incurred
related to a lawsuit and certain costs incurred in connection with the Series A
Redeemable Convertible Preferred Stock.  The litigation fees of
approximately $227,000, as of December 31, 2008, should have been expensed as
incurred and while the Series A Redeemable Convertible Preferred Stock fees of
approximately $222,700, as of December 31, 2008, should have been recorded as
deferred financing costs rather than as a current asset. Additionally the
amortization of these deferred financing costs should been recorded as interest
expense during the year ended 2008 and the interim periods in 2009. The company
previously recorded this amortization in general and administrative expense.
This revision was and continues to be immaterial to the statement of operations
for the year ended December 31,2008, however upon a SAB 99 and 108 analysis
performed subsequently by management, it was deemed necessary to record this
adjustment to keep the 2009 interim period financial statements from being
materially misstated.





Certain expenditures
recorded as additional paid in capital


The
Company recorded certain costs totaling approximately $1,561,000 incurred during
the year ended December 31, 2008 for the initial registering of its securities
(which were issued in previous periods) and obtaining stock exchange listing in
additional paid in capital.  The Company reviewed the provisions of SAB
Topic 5A, ASC 470 Debt, ASC 480 Distinguishing Liabilities from Equity and
505 Equity and determined that these costs were not directly attributable to a
proposed or actual offering of equity securities.  As such the Company
determined that a restatement was needed as of December 31, 2008 and for the
year then ended to expense these costs as incurred rather than as a reduction to
additional paid in capital.





Preferred Stock Dividends
and deemed extinguishment of debt:





“Distinguishing Liabilities from
Equity ” that accrued dividends
(whether or not declared) and any other amounts paid or to be paid to holders of
those contracts be reflected as interest cost, separately from payments to and
interest due to other creditors, because that is consistent with the reporting
of those shares as liabilities.




17





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS




As
disclosed in Note 1 the Company entered into a settlement agreement with its
Series A preferred stock holder on May 22, 2009 which resulted in a loss of
$2,613,630 for the three months ended June 30, 2009 on the deemed extinguishment
of the debt in accordance with the guidelines enumerated in EITF Issue No. 96-19
“ Debtor’s Accounting for a Modification of Exchange of Debt Instruments” as
codified in ASC 470-50. Previously this loss had been reported as part of the
unrealized gain (loss) on adjustment of fair value of the Series A preferred
stock and warrant liabilities.





Stock based
Compensation





The
Company, in reviewing its stock based compensation expense, determined that it
had not recorded certain expenses totaling $125,442 for the three months ended
March 31, 2009 and $41,229 and $166,671 for the three and six months ended June
30, 2009 related to the grant of common stock and stock options to an employee
and certain directors.





Management
has conducted an additional review of whether the matters discussed above were
material under Staff Accounting Bulletin No. 99, “Materiality” and Staff
Accounting Bulletin No. 108, “Considering Effects of Prior Misstatements When
Quantifying Misstatements in Current Year Financial Statements”, for the 2008
and 2009 periods. Management determined that the above errors were material for
the year ended December 31, 2008 and the three months ended March 31, 2009 and
the three and six months ended June 30, 2009. The adjustments related to the
restatement of the financial statements as of December 31, 2008 have not yet
been audited.  Accordingly, management recommended to the Audit
Committee that restatements were required.





18





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The
effect of the restatements on specific amounts provided in the condensed
consolidated financial statements is as follows:





Nine Months Ended
                    
                    
                    Three Months EndedSeptember 30, 2008
                    
                    
                    September 30, 2008Statement of Operations
                    
                    As previously
                      Reported
                    
                    
                    As Restated
                    
                    
                    As previously
                      Reported
                    
                    
                    AsRestatedGeneral & administrative expenses
                    
                    $
                    4,185,355
                    
                    
                    $
                    5,386,549
                    
                    
                    $
                    1,817,725
                    
                    
                    $
                    2,125,910Total
      operating expenses
                    
                    $
                    10,600,931
                    
                    
                    
                    11,802,125
                    
                    
                    
                    3,910,069
                    
                    
                    
                    4,218,304Income
      (loss) from operations
                    
                    
                    (106,345
                    )
                    
                    
                    (874,769
                    )
                    
                    
                    (402,409
                    )
                    
                    
                    94,174Interest
      expense - Mandatory redeemable preferred stock dividends
                    
                    
                    -
                    
                    
                    
                    (800,252
                    )
                    
                    
                    -
                    
                    
                    
                    (399,000
                    )Total
      other income (expense)
                    
                    
                    1,863,695
                    
                    
                    
                    1,064,305
                    
                    
                    
                    (402,271
                    )
                    
                    
                    (801,755
                    )Income
      from continuing operations
                    
                    
                    1,757,350
                    
                    
                    
                    189,536
                    
                    
                    
                    (346
                    )
                    
                    
                    (707,581
                    )Net
      Income (loss)
                    
                    
                    1,757,350
                    
                    
                    
                    (27,280
                    )
                    
                    
                    (346
                    )
                    
                    
                    (807,933
                    )Preferred
      stock dividends
                    
                    
                    (800,252
                    )
                    
                    
                    -
                    
                    
                    
                    (399,000
                    )
                    
                    
                    -Net
      Income (loss) allocated to common shareholders
                    
                    $
                    957,098
                    
                    
                    
                    -
                    
                    
                    $
                    (399,346
                    )
                    
                    
                    -Basic
      and Diluted Net Income (Loss) Per Share
                    
                    $
                    0.02
                    
                    
                    $
                    (0.00
                    )
                    
                    $
                    (0.01
                    )
                    
                    $
                    (0.02
                    )





19





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





December 31, 2008Balance Sheets
                      
                      As previously
                        Reported
                      
                      
                      As RestatedAssetsPrepaid
      expenses and other current assets
                      
                      $
                      3,144,601
                      
                      
                      $
                      2,088,801Assets
      of discontinued operations, current
                      
                      
                      -
                      
                      
                      
                      736,613Total
      current assets
                      
                      
                      16,701,840
                      
                      
                      
                      16,382,654Deferred
      financing costs, net
                      
                      
                      1,277,833
                      
                      
                      
                      1,500,533Intangible
      assets
                      
                      
                      -
                      
                      
                      
                      606,000Assets
      of discontinued operations
                      
                      
                      736,613
                      
                      
                      
                      -Total
      Assets
                      
                      
                      25,162,614
                      
                      
                      
                      24,935,515LiabilitiesInvestor
      warrant liability - current
                      
                      
                      -
                      
                      
                      
                      90,409Preferred
      stock - current
                      
                      
                      -
                      
                      
                      
                      10,981,577Liabilities
      from discontinued operations -current
                      
                      
                      -
                      
                      
                      
                      736,613Total
      current liabilities
                      
                      
                      3,313,099
                      
                      
                      
                      15,121,698Preferred
      stock
                      
                      
                      10,981,577
                      
                      
                      
                      -Investor
      warrant liability
                      
                      
                      90,409
                      
                      
                      
                      -Liabilities
      from discontinued operations
                      
                      
                      736,613
                      
                      
                      
                      -Total
      liabilities
                      
                      
                      15,121,698
                      
                      
                      
                      15,121,698EquityAdditional
      paid in capital
                      
                      
                      9,534,616
                      
                      
                      
                      11,096,031Retained
      earnings  (accumulated deficit)
                      
                      
                      (466,715
                      )
                      
                      
                      (1,321,800
                      )Total
      Equity
                      
                      
                      10,040,917
                      
                      
                      
                      9,813,817Total
      Liabilities and Equity
                      
                      
                      25,162,615
                      
                      
                      
                      24,935,515




20





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





June 30, 2009Balance Sheets
                      
                      As previously
                        Reported
                      
                      
                      As RestatedAssetsPrepaid
      expenses and other current assets
                      
                      $
                      4,933,040
                      
                      
                      $
                      2,666,102Total
      current assets
                      
                      
                      23,332,557
                      
                      
                      
                      21,065,619Deferred
      financing costs, net
                      
                      
                      979,917
                      
                      
                      
                      2,081,006Intangible
      assets
                      
                      
                      -
                      
                      
                      
                      606,000Total
      Assets
                      
                      
                      30,539,559
                      
                      
                      
                      29,979,710LiabiltiesAccrued
      expenses
                      
                      
                      898,163
                      
                      
                      
                      396,103Derivative
      warrant liability
                      
                      
                      -
                      
                      
                      
                      97,435Preferred
      stock - current
                      
                      
                      -
                      
                      
                      
                      7,500,000Total
      current liabilities
                      
                      
                      8,903,429
                      
                      
                      
                      16,000,864Preferred
      stock
                      
                      
                      12,223,642
                      
                      
                      
                      4,723,642Total
      liabilities
                      
                      
                      21,127,071
                      
                      
                      
                      20,724,506EquityCommon
      stock
                      
                      
                      45,281
                      
                      
                      
                      45,506Additional
      paid in capital
                      
                      
                      12,844,845
                      
                      
                      
                      14,184,752Retained
      earnings (accumulated deficit)
                      
                      
                      (3,477,638
                      )
                      
                      
                      (4,973,694
                      )Total
      Equity
                      
                      
                      9,412,488
                      
                      
                      
                      9,256,564Total
      Liabilities and Equity
                      
                      
                      30,539,559
                      
                      
                      
                      29,979,710





21





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Six Months Ended
                  
                  
                  Three Months EndedJune 30, 2009
                  
                  
                  June 30, 2009Statement of Operations
                  
                  As previously
                    Reported
                  
                  
                  As Restated
                  
                  
                  As previously
                    Reported
                  
                  
                  AsRestatedGeneral & administrative expenses
                  
                  $
                  3,538,245
                  
                  
                  $
                  4,297,331
                  
                  
                  $
                  1,889,767
                  
                  
                  $
                  2,223,336Total
      operating expenses
                  
                  
                  8,114,973
                  
                  
                  
                  8,874,059
                  
                  
                  
                  4,118,347
                  
                  
                  
                  4,451,096Income
      (loss) from operations
                  
                  
                  1,295,330
                  
                  
                  
                  (536,244
                  )
                  
                  
                  1,255,363
                  
                  
                  
                  920,974Unrealized
      gain (loss) on adjustment to fair value of Series A preferred
      stock
                  
                  
                  (972,961
                  )
                  
                  
                  (685,312
                  )
                  
                  
                  (278,507
                  )
                  
                  
                  9,142Unrealized
      loss on investor warrant liability
                  
                  
                  (2,420,671
                  )
                  
                  
                  (26,350
                  )
                  
                  
                  (2,434,725
                  )
                  
                  
                  (107,022
                  )Interest
      expense
                  
                  
                  (592,177
                  )
                  
                  
                  (781,151
                  )
                  
                  
                  (301,857
                  )
                  
                  
                  (439,041
                  )Interest
      expense - Mandatory redeemable preferred stock dividends
                  
                  
                  -
                  
                  
                  
                  (749,380
                  )
                  
                  
                  -
                  
                  
                  
                  (374,380
                  )Loss
      on extinguishment of debt
                  
                  
                  -
                  
                  
                  
                  (2,613,630
                  )
                  
                  
                  -
                  
                  
                  
                  (2,613,630
                  )Total
      other income (expense)
                  
                  
                  (3,989,683
                  )
                  
                  
                  (4,859,697
                  )
                  
                  
                  (3,027,809
                  )
                  
                  
                  (3,537,651
                  )Income
      tax provision
                  
                  
                  500,000
                  
                  
                  
                  -
                  
                  
                  
                  500,000
                  
                  
                  
                  -Net
      loss
                  
                  
                  (3,194,353
                  )
                  
                  
                  (4,323,453
                  )
                  
                  
                  (2,272,446
                  )
                  
                  
                  (2,615,037
                  )Preferred
      stock dividends
                  
                  
                  (749,380
                  )
                  
                  
                  -
                  
                  
                  
                  (374,380
                  )
                  
                  
                  -Net
      loss allocated to common shareholders
                  
                  
                  (3,943,733
                  )
                  
                  
                  -
                  
                  
                  
                  (2,647,446
                  )
                  
                  
                  -Basic
      and Fully Diluted Net Loss Per Share
                  
                  
                  (0.09
                  )
                  
                  
                  (0.10
                  )
                  
                  
                  (0.06
                  )
                  
                  
                  (0.06
                  )




22





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





3.
            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 purchase orders issued pursuant to
contracts reflects the accumulated costs incurred on purchase order in
production but not completed.  Upon completion, inspection and
acceptance by the customer, the purchase order is invoiced and the accumulated
costs are charged to statement of operations as costs of
revenues.  During the production cycle of the purchase order, should
any progress billings occur or any interim cash payments or advances be
received, such billings and/or receipts on uncompleted contracts are accumulated
as billings in excess of costs. The Company fully expects to collect net costs
incurred in excess of billing and periodically evaluates each purchase order and
contract for potential disputes related to overruns and uncollectable
amounts.  There was no bad debt expense recorded for the three and
nine months ended September 30, 2009 and 2008.





Net costs
incurred in excess of billing consisted of the following as of September 30,
2009, and December 31, 2008





2009
                  
                  
                  2008Cost
      in excess of billings on uncompleted contracts
                  
                  $
                  10,198,639
                  
                  
                  $
                  7,143,089Billings
      and/or receipts on uncompleted contracts
                  
                  
                  -
                  
                  
                  
                  -Net
      costs incurred in excess of billing on uncompleted
    contracts
                  
                  $
                  10,198,639
                  
                  
                  $
                  7,143,089





Accounts
Receivable


The
Company records accounts receivable related to its long-term contracts, based on
billings or on amounts due under the contractual terms.  Accounts
receivable consist primarily of receivables from completed purchase orders and
progress billings on uncompleted contracts.  Allowance for doubtful
accounts is based upon a review of outstanding receivables, historical
collection information, and existing economic conditions. Any amounts considered
recoverable under the customer’s surety bonds are treated as contingent gains
and recognized only when received.





Accounts
receivable throughout the year may decrease based on payments received, credits
for change orders, or back charges incurred. At September 30, 2009 and December
31, 2008, the Company had $5,948,023 and $4,981,150, respectively, of accounts
receivable, of which the Company considers all to be fully
collectible.  There was no bad debt expense recorded for the three and
nine months ended September 30, 2009 or 2008.





4.
            PROPERTY
      AND EQUIPMENT





Property
and equipment at September 30, 2009 and December 31, 2008 consisted of the
following:





23





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





September 30,
                  
                  
                  December 31,2009
                  
                  
                  2008Leasehold
      improvements
                  
                  $
                  1,778,474
                  
                  
                  $
                  1,749,367General
      equipment
                  
                  
                  763,723
                  
                  
                  
                  666,120Light
      vehicles and trailers
                  
                  
                  221,247
                  
                  
                  
                  221,247T2
      Demonstration range and firearms
                  
                  
                  744,454
                  
                  
                  
                  744,454Office
      equipment
                  
                  
                  1,066,286
                  
                  
                  
                  855,294Furniture
      and fixtures
                  
                  
                  192,224
                  
                  
                  
                  163,658Aircraft
                  
                  
                  868,750
                  
                  
                  
                  868,7505,635,158
                  
                  
                  
                  5,268,890Less:  accumulated
      depreciation and amortization
                  
                  
                  2,348,362
                  
                  
                  
                  1,524,954$
                  3,286,796
                  
                  
                  $
                  3,743,936





For the
three and nine months ended September 30, 2009 and 2008, the Company recorded
$278,264 and 266,434, $797,696 and $548,869 in depreciation and amortization
expense, respectively.





The
Company maintains its firearms under the custodianship of an individual in
accordance with New York State law. The firearms are used for testing and
demonstrating the effectiveness of the Company’s bullet resistant and blast
mitigation products.





5.
            COMMITMENTS
      AND CONTINGENCIES





Legal
Proceedings





Southern California Gold
Products d/b/a Gypsy Rack


On July
10, 2007, the Company filed a lawsuit against a former subcontractor, Southern
California Gold Products d/b/a Gypsy Rack, the subcontractor’s President and
owner, Glenn Harris, and an associated individual, James McAvoy in the United
States District Court, Eastern District of New York. Defendants moved to change
venue to the Central District of California based upon insufficient contacts to
the State of New York and on October 12, 2007 the matter was transferred to the
United States District Court for the Central District of California, Case Number
07-CV-02779. On February 21, 2008, pursuant to the court’s order, the Company
filed an amended complaint. The amended complaint names only Southern California
Gold Products and James McAvoy as defendants and asserts six counts as follows:
misappropriation of trade secrets and confidential information; breach of
contract; unfair competition; conversion; violation of the Lanham Act; and
interference with prospective economic advantage. The amended complaint seeks to
enjoin the defendants from misappropriating, disclosing, or using the
Company’s
confidential information and trade secrets, and recall and surrender all
products and trade secrets wrongfully misappropriated or converted by the
defendants. It also seeks compensatory damages in an amount to be established at
trial together with prejudgment and post judgment interest, exemplary damages,
disgorgement, restitution with interest, attorney’s fees and the 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 motion for summary
judgment on, among others, the grounds of collateral estoppel and res judicata.
The Company filed opposition to the motion. The defendants’ motion and a
subsequent application for an immediate interlocutory appeal were denied. A
mediation settlement conference was held on October 31, 2008, which was
unsuccessful. The defendants filed a second motion for summary judgment that was
denied in May 2009. After that denial, discovery continued. A second mediation
settlement conference was held in July 2009. As a result of that conference, theparties
believe they may have reached a settlement in principle. The parties requested
that the Court stay discovery and the trial for a period of sixty (60)
days.  On August 5, 2009, the Court vacated all dates in this action
and removed the case from its active caseload. On October 2, 2009, the parties
submitted to the Court a joint status report informing the Court that a
settlement was expected to be finalized within twenty (20) days. The settlement
was not finalized within the expected twenty day period, and negotiations are
ongoing.




24


AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Breach of
Contract


On
February 29, 2008, a former employee commenced an action against the Company for
breach of contract arising from his termination of employment in the Supreme
Court of the State of New York, Nassau County. The Complaint seeks damages of
approximately $87,000. The Company filed an answer to the complaint and will be
commencing discovery.  Meritorious defenses to the claims exist and the
Company intends to vigorously defend this action.





Breach of
Contract


On March
4, 2008, Thomas Cusack, the Company’s former General Counsel, commenced an
action with the United States Department of Labor, Occupational Safety and
Health and Safety Administration, alleging retaliation in contravention of the
Sarbanes-Oxley Act. The Complaint seeks damages in excess of $3,000,000. On
April 2, 2008, the Company filed a response to the charges. The Company believes
the allegations to be without merit and intend to vigorously defend against the
action. On March 7, 2008, Mr. Cusack also commenced against the Company for
breach of contract and related issues arising from his termination of employment
in New York State Supreme Court, Nassau County.  On May, 7 2008, the
Company served a motion to dismiss the complaint, and on or
about September 26, 2008, the Court dismissed several claims (tortious
interference with a contract, tortious interference with economic opportunity,
fraudulent inducement to enter into a contract and breach of good faith and fair
dealing). The remaining claims are Mr. Cusack’s breach of contract claims and
claims seeking the lifting of the transfer restrictions on his stock, as well as
one claim for conversion of his personal property which Mr. Cusack has also
asserted against the Company’s chief executive officer, chief operating officer
and chief financial officer. On October 13, 2008, Mr. Cusack filed an amended
complaint as to the remaining claims, and on November 5, 2008, the Company filed
an answer to the complaint and filed counterclaims against Mr. Cusack for fraud.
The parties are conducting discovery and have completed scheduled depositions.
The Company believes meritorious defenses to the claims exist and intends to
vigorously defend this action.





25


AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES
 NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


6.
            STOCKHOLDERS’
      EQUITY




The
following table summarizes the changes in shareholders' equity for the nine
months ended September 30, 2009:




Balance,
      December 31, 2008
                        
                        $
                        9,813,818Cumulative
      effect of change in accounting principle
                        
                        
                        (165,777
                        )Balance
      - January 1, 2009
                        
                        
                        9,648,041Stock
      based compensation
                        
                        
                        220,198Shares
      issued for payment of dividends recorded as interest
    expense
                        
                        
                        1,200,000Reclassification
      of Warrants upon exercise
                        
                        
                        2,550,000Net
      Loss
                        
                        
                        (7,915,514
                        )Balance
      - September 30, 2009
                        
                        $
                        5,702,725




Warrants





The
following is a summary of stock warrants outstanding at September 30,
2009:


Warrants
                    
                    
                    Weighted Avenue
                      Exercise PriceBalance
      – January 1, 2009
                    
                    
                    5,198,680
                    
                    
                    $
                    1.00Granted
                    
                    
                    3,750,000
                    
                    
                    $
                    0.01Exercised
                    
                    
                    (3,750,000
                    )
                    
                    $
                    (1.00
                    )Cancelled,
      Forfeited or expired
                    
                    
                    (3,750,000
                    )
                    
                    $
                    (1.00
                    )Balance
      – September 30, 20009
                    
                    
                    1,448,680
                    
                    
                    $
                    1.00




26





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Stock
Option Plan





The
Company accounts for all stock based compensation as an expense in the financial
statements and associated costs are measured at the fair value of the
award.  The Company also recognized the excess tax benefit related to
stock option exercises as financing cash inflows instead of operating
inflows.  As a result, the Company’s net loss before taxes for the
three month and nine months ended September 30, 2009 included approximately
$25,853 and $80,698, respectively, of stock based compensation.  The
three and nine months ended September 30, 2008 included approximately $21,523
and $75,820, respectively, of stock based compensation.  The stock
based compensation expense is included general and administrative expense in the
consolidated statements of operations.  The Company has selected a
“with-and-without” approach regarding the accounting for the tax effects of
share-based compensation awards.





The
following is a summary of stock options outstanding at September 30,
2009:





Stock Options
                                      
                                      Weighted-
                                        Average
                                        Exercise Price
                                      
                                      Aggregate
                                        Intrinsic
                                        ValueOutstanding,
      January 1, 2009
                                      
                                      1,995,000
                                      
                                      $
                                      1.92
                                      
                                      -Granted
                                      
                                      100,000
                                      
                                      $
                                      2.00
                                      
                                      -Exercised
                                      
                                      -
                                      
                                      
                                      -
                                      
                                      -Cancelled/forfeited
                                      
                                      -
                                      
                                      $
                                      -
                                      
                                      -Outstanding,
      September 30, 2009
                                      
                                      2,095,000
                                      
                                      $
                                      1.92
                                      
                                      -Exercisable,
      September 30, 2009
                                      
                                      379,000
                                      
                                      $
                                      1.91
                                      
                                      -Remaining
      weighted average contractual life (in years)
                                      
                                      5.35




As of
September 30, 2009, there was a total of $345,322 of unrecognized compensation
arrangements granted under the Plan.  The cost is expected to be recognized
through 2016.





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





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





Risk-Free
      rate
                  
                  
                  2.99
                  %Expected
      volatility
                  
                  
                  45.00
                  %Forfeiture
      rate
                  
                  
                  10.00
                  %Expected
      life
                  
                  5
      YearsExpected
      dividends
                  
                  
                  -





27





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Based on
the assumptions noted above, the fair market value of the options issued during
2009 was valued at $13,183 as of September 30, 2009.





Stock
Grants





In
January 2009, the Company granted 175,000 shares of its common stock to
non-employee directors. The fair value of these shares on the date of grant was
$96,250 based on the stock price on the date of issuance.  In May 2009 the
Company granted 50,000 shares of its common stock to two advisory board
members.  The fair value of these shares on the date of grant was $31,500
based on the stock price on the date of grant. In September 2009 the Company
granted 25,000 shares of its common stock to an employee. The fair value of
these shares on the date of grant was $11,750 based on the stock price on the
date of grant.   All of these awards were fully vested on the date of
grant.  The Company recorded stock based compensation of $11,750 and
$139,500 for the three and nine months ended September 30,
2009.





7.
            SERIES
      A CONVERTIBLE PREFERRED STOCK AND WARRANT
  LIABILITIES




Features
of the Series A Preferred and Warrants Liabilities





2005
Warrants





On June
30, 2005, in connection with the closing of its 2005 private placement offering,
the Company issued purchase warrants for up to 555,790 shares of common stock at
the exercise price of $1.10 per share and with the expiration date of June 30,
2010 (the “2005 Warrant”). Subsequent to the issuance of the 2005 Warrant, the
Company issued common stock at an effective price per share of $1.00 and, in
accordance with the terms of the 2005 Warrants agreement, the exercise price was
adjusted to $1.00 per share and resulted in 611,369 warrants. The following is a
summary of the 2005 Warrants outstanding as of September 30, 2009:





2005
                    Warrants
                  
                  
                  Exercise
                    PriceBeginning
      balance, January 1, 2009
                  
                  
                  576,587
                  
                  
                  $
                  1.00Add:
      Grants
                  
                  
                  -
                  
                  
                  
                  n/aLess:
      Exercised
                  
                  
                  -
                  
                  
                  
                  n/aEnding
      balance, September 30, 2009
                  
                  
                  576,587
                  
                  
                  $
                  1.00





2006
Warrants





On
October 24, 2006, in accordance with the terms and conditions of the Company’s
closing of its 2005 private placement offering, the Company issued purchase
warrants for up to 179,175 shares of common stock at the exercise price of $1.10
per share and with the expiration date of June 30, 2010 (the “2006 Warrant”).
Subsequent to the issuance of the 2006 Warrant, the Company issued common stock
at an effective price per share of $1.00 and, in accordance with the terms of
the 2006 Warrants agreement, the exercise price was adjusted to $1.00 per share
and resulted in 17,918 warrants. The following is a summary of the 2006 Warrants
outstanding as of September 30, 2009:





28





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





2006
                    Warrants
                  
                  
                  Exercise
                    PriceBeginning
      balance, January 1, 2009
                  
                  
                  197,093
                  
                  
                  $
                  1.00Add:
      Grants
                  
                  
                  -
                  
                  
                  
                  -Less:
      Exercised
                  
                  
                  -
                  
                  
                  
                  n/aEnding
      balance, September 30, 2009
                  
                  
                  197,093
                  
                  
                  $
                  1.00





Series A
Redeemable Convertible Preferred Stock and Investor Warrants and Placement Agent
Warrants





The
Company entered into a Securities Purchase Agreement (“Purchase Agreement”) on
March 7, 2008 to sell shares of its Series A Redeemable Convertible
Preferred Stock (“Series A Preferred”) and warrants (“Investor Warrants”)
to purchase shares of its common stock, and to conditionally sell shares of the
Company’s common stock, to three investors (the “Series A Holders”). The
investors purchased an aggregate of 15,000 shares of Series A Preferred and
Investor Warrants to purchase up to 3,750,000 shares of common stock, and to
conditionally purchase 100,000 shares of common stock. The aggregate purchase
price for the Series A Preferred and Investor Warrants was $15,000,000 and
the aggregate purchase price for the common stock was $500,000.  The
Company completed the sale of the Series A Preferred and Investor Warrants
in two rounds, on March 7, 2008 and April 4, 2008, and the Company and
investors determined not to complete the conditional sale of the 100,000 shares
of common stock. The Series A Holders are entitled to receive cumulative
dividends, due at each subsequent calendar quarter-end until maturity, at a rate
of 9% if settled via cash or at a rate of 10% if settled via shares (at the
option of the Company) of the Company’s common stock. The dividends rate is
subject to increase in the event of a “Triggering Event” under the Certificate
of Designation and in the event of an “Equity Condition Failure” under the
Certificate of Designation, settlement via shares would not be allowed for the
remaining dividend payments.





The
Series A Holders may convert shares of Series A Preferred, plus the amount of
accrued but unpaid dividends, into shares of the Company’s common stock at the
conversion price of $2.00 (“Conversion Price”). The Conversion Price is subject
to certain adjustments upon issuance of certain securities, under the
Certificate of Designation, with a lower exercise price and/or with negative
dilutive effect. The Series A Holders may require the Company to redeem, at the
amount of 100% if settled in cash or 110% if settled in cash, all or any
portion of the outstanding shares of Series A Preferred upon a Triggering Event
or Equity Condition Failure.





The
Company may redeem all or any portion of the outstanding shares of Series A
Preferred in cash at the amount of (i) 100% of the “Conversion Amount” at any
time after either the two-year anniversary of the “Public Company Date” , if
certain other conditions are met, or the six-month anniversary of the “Qualified
Public Offering Date”, if certain other conditions are met under
the Certificate of Designation (ii) 110% of the Conversion Amount upon an
Equity Condition Failure or (iii) 115% of the Conversion Amount prior to any
“Fundamental Transaction” under the Certificate of Designation.





29





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The
Company is required to redeem, in cash, any outstanding shares of Series A
Preferred on December 31, 2010.




Settlement
Agreements




In
connection with a Notice of Triggering Event Redemption received by the Company
on April 14, 2009, the Company entered into a Settlement Agreement, Waiver
and Amendment with the Series A Holders on May 22, 2009 (the “Settlement Agreement
”) pursuant to which, among other things, (i) the Series A Holders
waived any breach by the Company of certain financial covenants or its
obligation to timely pay dividends on the Series A Preferred for any period
through September 30, 2009 and waived any Equity Conditions Failure and any
Triggering Event otherwise arising from such breaches  (ii) the
Warrants were amended to reduce the exercise price thereof from $2.40 per share
to $0.01 per share, (iii) the Company issued the Holders an aggregate of
2,000,000 shares of the Company’s common stock (the “Dividend Shares ”),
in full satisfaction of the Company’s obligation to pay dividends under the
Certificate of Designations as of March 31, 2009, June 30, 2009 and
September 30, 2009, and (iv) the Company agreed to redeem $7,500,000
in stated value of the Series A Preferred by December 31, 2009 (the
“December 2009 Redemption”).  The Company agreed that, if it fails to so
redeem $7,500,000 in stated value of the Series A Preferred by that date (a
“Redemption
Failure ”), then, in lieu of any other remedies or damages available to
the Series A Holders (absent fraud), (i) the redemption price payable
by the Company will increase by an amount equal to 10% of the stated value,
(ii) the Company will use its best efforts to obtain stockholder approval
to reduce the conversion price of the Series A Preferred from $2.00 to
$0.50 (which would increase the number of shares of common stock into which
the Series A preferred is convertible), and (iii) the Company will
expand the size of its board of directors by two, will appoint two persons
designated by the Series A Holders to fill the two newly-created vacancies,
and will use its best efforts to amend the Company’s certificate of
incorporation to grant the Series A Holders the right to elect two persons
to serve on the board.




Pursuant
to the terms of the Settlement Agreement, the Company entered into a
Registration Rights Agreement with the Series A Holders pursuant to which,
among other things, the Company agreed to file with the Securities and Exchange
Commission, by June 1, 2009, a registration statement covering the resale
of the Dividend Shares, and to use its best efforts to have such registration
statement declared effective as soon as practicable thereafter.  The
Company further agreed with the Series A Holders to include in such
registration statement the shares of common stock issued upon the exercise of
the Investor Warrants in May and June 2009.  A registration
statement was filed, and subsequently declared effective on August 10,
2009.





30





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Pursuant
to the terms of the Settlement Agreement, each of the Company’s directors and
executive officers has entered into a Lock-Up Agreement, pursuant to which each
such person has agreed that, for so long as any shares of Series A
Preferred remain outstanding, he will not sell any shares of the Company’s
common stock owned by him as of May 22, 2009. Also pursuant to the terms of
the Settlement Agreement, the Company’s Chief Executive Officer, President and
Chairman, entered into an Irrevocable Proxy and Voting Agreement with the
Series A Holders (the “Voting Agreement”),
pursuant to which the Company’s CEO agreed, among other things, that if a
Redemption Failure occurs he will vote all shares of the Company’s voting stock
owned by him in favor of (i) reducing the conversion price of the
Series A Preferred from $2.00 to $0.50 and (ii) amending the Company’s
certificate of incorporation to grant the Series A Holders the right to
elect two persons to serve on the board of directors (collectively, the “Company Actions
”).  The Company’s CEO also appointed WCOF as his proxy to vote his shares
of the Company’s voting stock in favor of the Company Actions, and against
approval of any opposing or competing proposal, at any stockholder meeting or
written consent of the Company’s stockholders at which such matters are
considered.




2008 Investor
Warrants





In
connection with the sale of the Series A Preferred, Investor Warrants to
purchase up to 3,750,000 shares of Common Stock at $2.40 per share were issued
and with an expiration date of April 11, 2011 (the “2008 Investor Warrant”). The
warrant holder may require the Company to repurchase the warrant upon the
occurrence of certain defined events in the Agreement.  As such the
Company recorded the warrants as a derivative at fair value at issuance and
subsequent reporting periods in accordance with ASC 815 “Derivatives and
Hedging”. Changes in the fair value from period to period are reported in the
statement of operations.  In accordance with the Settlement Agreement
entered into on May 22, 2009, the 2008 Investor Warrants were amended to
reduce the exercise price from $2.40 to $.01.  The 2008 Investor Warrants
were fully exercised on May 27, 2009, June 1, 2009, and June 8,
2009.





Placement Agent
Warrants





In
connection with the sale of the Series A Preferred and 2008 Investor
Warrants, the placement agent was entitled to receive warrants (the “Placement
Agent Warrants”) to purchase a total of 6% of the number of common stock issued
in the Series A Preferred financing or 675,000 shares at the exercise price of
$2.00 per share and with the expiration date of March 7, 2013.  The
following is a summary of the Placement Agent Warrants outstanding as of
September 30, 2009:





Placement
                    Agent
                    Warrants
                  
                  
                  Exercise
                    PriceBeginning
      balance, January 1, 2009
                  
                  
                  675,000
                  
                  
                  $
                  2.00Add:
      Grants
                  
                  
                  0
                  
                  
                  
                  n/aLess:
      Exercised
                  
                  
                  0
                  
                  
                  
                  n/aEnding
      balance, September 30, 2009
                  
                  
                  675,000
                  
                  
                  $
                  2.00








31





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Accounting
for the Series A Preferred and Warrant Liabilities





2005
Warrants, 2006 Warrants, and Placement Agent Warrants





Upon
issuance, the 2005 Warrants, 2006 Warrants, and Placement Agent Warrants met the
requirements for equity classification set forth in EITF Issue 00-19, Accounting for Derivative Financial
Instruments Indexed to, and Potentially Settled in a Company’s Own Stock, and SFAS No.
133, as codified in ASC 815. However, effective January 1, 2009 the Company was
required to analyze its then outstanding financial instruments in accordance
with EITF 07-5 as codified in ASC 815-40. Based on the Company’s analysis, its
2005 Warrants, 2006 Warrants, and Placement Agent Warrants, include price
protection provisions whereby the exercise price could be adjusted upon certain
financing transaction at a lower price per share and could no longer be viewed
as indexed to the Company’s common stock. As a result, the 2005 Warrants, 2006
Warrants, and Placement Agent Warrants are accounted for as “derivatives” under
ASC 815 and recorded as liabilities at fair value as of January 1, 2009 with
changes in subsequent period fair value recorded in the statement of operations
(See Note 2). The following summarizes the changes in the fair value of the
warrant liabilities as of September 30, 2009:





Fair Value
                      of Derivative
                      Warrants
                      LiabilitiesBalance
      at January 1, 2009 (1)
                    
                    $
                    165,775Fair
      value adjustment (2)
                    
                    (79,014)Balance
      at September 30, 2009 (1)
                    
                    $
                    86,761




(1)
            Methods
      and significant inputs and assumptions are discussed
  below


(2)
            Amounts
      included in change in fair value of warrant liabilities on statement of
      operations.





Series A
Preferred





The
Series A Preferred Stock is redeemable on December 31, 2010 and convertible into
shares of common stock at $2.00 per share subject to adjustment should the
Company issue future common stock at a lesser price. As a result the Company
elected to record the hybrid instrument, preferred stock and conversion option
together, at fair value. Subsequent reporting period changes in fair value are
to be reported in the statement of operations.





The
proceeds from the issuance of the Series A Preferred and accompanying
common stock warrants, net of direct costs including the fair value of warrants
issued to placement agent in connection with the transaction, were allocated to
the instruments based upon relative fair value upon issuance as these
instruments must be measured initially at fair value.





32





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Therefore,
after the initial recording of the Series A Preferred based upon net
proceeds received, the carrying value of the Series A Preferred was
adjusted to the fair value at the date of issuance, with the difference recorded
as a gain or loss. The following summarizes the changes in the fair value of the
Series A Preferred as of September 30, 2009:




Fair Value
                          of Series A
                          Preferred
                          LiabilitiesBalance
      at January 1, 2009 (1)
                        
                        $
                        10,981,577Fair
      value adjustment (2)
                        
                        
                        1,l83,719Amortization
      of debt discount
                        
                        
                        407,868Loss
      on deemed extinguishment of debt
                        
                        
                        287,649Balance
      at September 30, 2009 (1)
                        
                        $
                        12,860,813




(1)
            Methods
      and significant inputs and assumptions are discussed
  below


(2)
            Amounts
      included in change in fair value of Series A Preferred liabilities on
      statement of operations.





The
Settlement Agreement provides that $7,500,000 in stated value of the
Series A Preferred is to be redeemed at December 31, 2009.
Accordingly, the Company records $7,500,000 of the total fair value of
Series A Preferred as a current liability.





Deferred Financing
Costs





Deferred
financing costs include the corresponding amount associated with the Placement
Agent Warrants as indicated above, along with all other direct costs associated
with obtaining the Series A Preferred financing.  Since the Series A
Preferred and Investor Warrants are classified as liabilities, the carrying
value of the Placement Agent Warrants has been recorded as deferred financing
costs on the balance sheet and is amortized as additional financing costs over
the term of the Series A Preferred using the interest method.





33





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Deferred
financing costs included the following:




Placement
      agent costs
                          
                          $
                          900,000Investor
      expenses
                          
                          
                          60,000Legal
      and other related costs
                          
                          
                          306,541Fair
      market value of placement agent warrants on date of grant
                          
                          
                          511,742Chart
      Group Related to Settlement Agreement
                          
                          
                          500,000Legal
      Fee Related to West Coast Settlement
                          
                          
                          834,0003,112,283Less:  accumulated
      amortization
                          
                          
                          (980,680
                          )Deferred
      financing costs, net
                          
                          $
                          2,131,603





Valuation
– Methodology and Significant Inputs Assumptions





Fair
values for the Company’s derivatives and financial instruments are estimated by
utilizing valuation models that consider current and expected stock prices,
volatility, dividends, market interest rates, forward yield curves and discount
rates.  Such amounts and the recognition of such amounts are subject to
significant estimates which may change in the future. The methods and
significant inputs and assumptions utilized in estimating the fair value of the
2005 Warrants, 2006 Warrants, Placement Agent Warrants, and Series A Preferred
are discussed below. Each of the measurements is considered a Level 3
measurement as a result of at least one unobservable input.





2005
Warrants




A
Black-Scholes-Merton option-pricing model was utilized to estimate the fair
value of the 2005 Warrants as of September 30, 2009. This model is subject to
the significant assumptions discussed below and requires the following key
inputs with respect to the Company and/or instrument:





Input
                  
                  
                  
                  
                  Sep.30,
                    2009Stock
      Price
                  
                  
                  
                  
                  $
                  0.53Exercise
      Price
                  
                  
                  
                  
                  $
                  1.00Time
      to Maturity (in years)
                  
                  
                  
                  
                  
                  0.75Stock
      Volatility
                  
                  
                  
                  
                  
                  
                  70
                  %Risk-Free
      Rate
                  
                  
                  
                  
                  
                  
                  0.29
                  %Dividend
      Rate
                  
                  
                  
                  
                  
                  
                  0
                  %




34





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





2006
Warrants




A
Black-Scholes-Merton option-pricing model was utilized to estimate the fair
value of the 2006 Warrants as of September 30, 2009. This model is subject to
the significant assumptions discussed below and requires the following key
inputs with respect to the Company and/or instrument:





Input
                  
                  
                  
                  
                  Sep.30,
                    2009Quoted
      Stock Price
                  
                  
                  
                  
                  $
                  0.53Exercise
      Price
                  
                  
                  
                  
                  $
                  1.00Time
      to Maturity (in years)
                  
                  
                  
                  
                  
                  0.75Stock
      Volatility
                  
                  
                  
                  
                  
                  
                  70
                  %Risk-Free
      Rate
                  
                  
                  
                  
                  
                  
                  0.29
                  %Dividend
      Rate
                  
                  
                  
                  
                  
                  
                  0
                  %





Placement Agent
Warrants




A
Black-Scholes-Merton option-pricing model was utilized to estimate the fair
value of the Placement Agent Warrants as of September 30, 2009. This model is
subject to the significant assumptions discussed below and requires the
following key inputs with respect to the Company and/or instrument:





Input
                  
                  
                  
                  
                  Sep.30,
                    2009Quoted
      Stock Price
                  
                  
                  
                  
                  $
                  0.53Exercise
      Price
                  
                  
                  
                  
                  $
                  2.00Expected
      Life (in years)
                  
                  
                  
                  
                  
                  3.25Stock
      Volatility
                  
                  
                  
                  
                  
                  
                  70
                  %Risk-Free
      Rate
                  
                  
                  
                  
                  
                  
                  1.57
                  %Dividend
      Rate
                  
                  
                  
                  
                  
                  
                  0
                  %





Series A
Preferred





A
binomial lattice model was utilized to estimate the fair value of the Series A
Preferred as of September 30, 2009. The binomial model considers the key
features of the Series A Preferred, as noted above, and is subject to the
significant assumptions discussed below. First, a discrete simulation of the
Company’s stock price was conducted at each node and throughout the expected
life of the instrument. Second, an analysis of the higher position of a
conversion position, redemption position, or holding position (i.e. fair value
of the respective future nodes value discounted using the applicable discount
rate) was conducted relative to each node until a final fair value of the
instrument is conducted at the node representing the measurement date. This
model requires the following key inputs with respect to the Company and/or
instrument:




35





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Input
                        
                        Sep.30,
                          2009Risk-Free
      Rate
                        
                        
                        0.54
                        %Expected
      volatility
                        
                        
                        80.00
                        %Expected
      remaining term until maturity
                        
                        1.25
      yearsExpected
      dividends
                        
                        
                        0.00
                        %Strike
      price (through 12/31/09)
                        
                        $
                        2.00Strike
      price (following 12/31/09)
                        
                        $
                        1.25Quoted
      Stock price
                        
                        $
                        0.53Effective
      discount rate
                        
                        
                        29.00
                        %Probability
      of meeting December 2009 Redemption
                        
                        
                        50
                        %




The
following are significant assumptions utilized in developing the
inputs





·
            Stock
      volatility was estimated by considering (i) the annualized daily
      volatility of the Company’s stock price during the historical period
      preceding the respective valuation dates and measured over a period
      corresponding to the remaining life of the instruments and (ii) the
      annualized daily volatility of comparable companies’ stock price during
      the historical period preceding the respective valuation dates and
      measured over a period corresponding to the remaining life of the
      instrument. Historic prices of the Company and comparable companies’
      common stock were used to estimate volatility as the Company did not have
      traded options as of the valuation
dates;





·
            Based
      on the Company’s historical operations and management’s expectations for
      the near future, the Company’s stock was assumed to be a
      non-dividend-paying stock;





·
            Based
      on management’s expectations for the near future, the Company is expected
      to settle the future quarterly dividends due to the Series A Holders via
      shares;





·
            The
      quoted market price of the Company’s stock was utilized in the valuations
      because ASC 820-10 requires the use of quoted market prices, if available,
      without considerations of blockage discounts (if the input is considered
      as a Level 1 input). Because the stock is thinly traded, the quoted market
      price may not reflect the market value of a large block of stock;
      and





·
            The
      quoted market price of the Company’s stock as of measurement dates and
      expected future stock prices were assumed to reflect the effect of
      dilution upon conversion of the instruments to shares of common
      stock.





·
            The
      probability of approving the reducing in Conversion Price (from $2.00 to
      $0.50) if the December 2009 Redemption is not met was as assumed to be 100
      percent.





36





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The
changes in fair value estimate between reporting periods are  related
to the changes in the price of the Company’s common stock as of the measurement
dates, the volatility of the Company’s common stock during the remaining term of
the instrument, changes in the conversion price, effective discount rate, and
probabilities of meeting the conditions underlying various Company and Series A
Holders’ redemptions rights, meeting the December 2009 Redemption and approving
the reduction in the conversion price (if the December 2009 Redemption is not
met).





8.
            DISCONTINUED
      OPERATIONS





On
January 2, 2009, the Company entered into an agreement with the prior owners of
TAG to sell the assets and liabilities back to TAG.  TAG was accounted
for as a discontinued operation under GAAP, which requires the income statement
information be reformatted to separate the divested business from the Company’s
continuing operations.





The
following amounts represent TAG’s operations and have been segregated from
continuing operations and reported as discontinued operations for the three and
nine month periods ended September 30, 2008.





Three months
                  ended
                  September 30,
                  2008
                
                
                Nine months
                  ended
                  September 30, 2008Contract
      Revenues Earned
                
                $
                186,439
                
                
                $
                783,276Cost
      of Revenues Earned
                
                
                (105,184
                )
                
                
                (529,274
                )Gross
      Profit
                
                
                81,255
                
                
                
                254,002Operating
      Expenses
                
                
                (181,660
                )
                
                
                (470,387
                )Other
      Income (Expenses)
                
                
                53
                
                
                
                (431
                )Net
      Loss
                
                $
                (100,352
                )
                
                $
                (216,816
                )









37





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





The
following is a summary of assets and liabilities of TAG discontinued operations
as of December 31, 2008.





2008AssetsCash
                      
                      $
                      75,103Inventory
                      
                      
                      591,688Prepaid
      Expenses
                      
                      
                      174Property
      and Equipment, net
                      
                      
                      69,648Deferred
      Financing Costs
                      
                      
                      -Total
      Assets
                      
                      $
                      736,613LiabilitiesAccounts
      Payable
                      
                      $
                      700,287Short
      Term Notes
                      
                      
                      36,326Total
      Liabilities
                      
                      $
                      736,613


In
accordance with the terms of the agreement, the original owners of TAG agreed to
repay $1,000,000 of the original $2,000,000 in consideration as
follows:





2009
                  
                  $
                  75,0002010
                  
                  $
                  100,0002011
                  
                  $
                  175,0002012
                  
                  $
                  275,0002013
                  
                  $
                  375,000Total
                  
                  $
                  1,000,000





The
Company has included the entire amount as notes receivable on its balance 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
have collateralized the note receivable with their personal residence and the
250,000 shares issued to them on the date of acquisition.  These
shares are being held by the Company in escrow since January 2009 and will be
returned upon final payment toward the note receivable.





9.  ACCOUNTS
RECEIVABLE PURCHASE AGREEMENT





On July
27, 2009, the Company entered into an accounts Receivable Purchase Agreement
with Republic Capital Access, LLC “RCA”), as of July 23, 2009 (the “RCA”
Purchase Agreement”).  Under the RCA Purchase Agreement, the Company
can sell eligible accounts receivables to RCA.  Eligible accounts
receivable, subject to the full definition of such term in the RCA Purchase
Agreement, generally are our receivables under prime government
contracts.





38





AMERICAN
DEFENSE SYSTEMS, INC. AND SUBSIDIARIES


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





Under the
terms of the RCA Purchase Agreement, the Company may offer eligible accounts
receivable to RCA and if RCA purchases such receivables, the Company will
receive an initial upfront payment equal to 90% of the
receivable.  Following RCA’s receipt of payment from customers for
such receivables, RCA will pay the remaining 10% of the receivable less its
fees.  In addition to the Discount Factor fee and an initial
enrollment fee, the Company is required to pay RCA a program access fee equal to
a stated percentage of the sold receivable, a quarterly program access fee if
the average daily amount of the sold receivables is less than $2,250,000 and
RCA’s initial expenses in negotiating the RCA Purchase Agreement and other
expenses in certain specified situations.  The RCA Purchase Agreement
also provides that in the event, but only to the extent, that the conveyance of
receivables by the Company is characterized by a court or other governmental
authority as a loan rather than a sale, the Company shall be deemed to have
granted RCA effective as of the date of the first purchase under the RCA
Purchase Agreement, a security interest in all of the Company’s right, title and
interest in, to and under all of the receivables sold by the Company to RCA,
whether now or hereafter owned, existing or arising.  The initial term
of the RCA Purchase Agreement ends on December 31, 2009 and was subsequently
extended to October 15, 2010.





The sale
of the receivables is accounted for in accordance with the accounting guidance
for transfers and servicing of financial assets and extinguishments of
liabilities. In accordance with the Codification, receivables are considered
sold when they are transferred beyond the reach of the Company and its
creditors, the purchaser has the right to pledge or exchange the receivables,
and the Company has surrendered control over the transferred receivables.
Receivables factored net of advances from the factor were $256,888 as of
September 30, 2009.





10.
            TD Bank Loan
      Repayment





As of
July 24, 2009, the Company repaid in full the entire outstanding balance under
that certain Loan Agreement, dated as of May 2, 2007, among the Company, its
wholly owned subsidiary A.J. Piscitelli & Associates, Inc. (“AJP”) and TD
Bank, N.A. (formerly Commerce Bank, N.A., the “Bank”), as assumed by American
Physical Security Group, LLC (A wholly owned subsidiary of the Company, “APSG”
and together with the Company and AJP, the “Borrowing Companies”), as amended
(the “Loan Agreement”), and related agreements, including but not limited to the
Revolving Credit Note and the Term Note, each date May 2, 2007 (collectively the
“Loan Documents”).  As of such date, (i) each of the Loan Documents
have automatically terminated, (ii) the Bank’s lien or security interest in the
Borrowing Companies’ assets have been terminated, and (iii) all obligations of
the Borrowing Companies under the Loan Documents have been satisfied in
full.




39




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




The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements and related notes that appear elsewhere in this report and in our
annual report on Form 10-K for the year ended December 31,
2008.




Except
for statements of historical fact, certain information described in this report
contains “forward-looking statements” that involve substantial risks and
uncertainties. You can identify these statements by forward-looking words such
as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,”
“should,” “project,” “will,” “would” or similar words. The statements that
contain these or similar words should be read carefully because these statements
discuss our future expectations, contain projections of our future results of
operations or of our financial position, or state other “forward-looking”
information. We believe that it is important to communicate our future
expectations to our investors. However, there may be events in the future that
we are not able accurately to predict or control. Further, we urge you to be
cautious of the forward-looking statements which are contained in this report
because they involve risks, uncertainties and other factors affecting our
operations, market growth, service and products.  You should not place
undue reliance on any forward-looking statement, which speaks only as of the
date made. Our actual results could differ materially from those discussed in
the forward-looking statements. Factors that could cause or contribute to these
differences include those discussed below and elsewhere in this report,
particularly in “Risk Factors” in Item 1A of Part II.




Overview




We are a defense and security products
company engaged in three business areas: customized transparent and opaque armor
solutions for construction equipment and tactical and non-tactical transport
vehicles used by the military; architectural hardening and perimeter defense,
such as bullet and blast resistant transparent armor, walls and doors, as well
as vehicle anti-ram barriers such as bollards, steel gates and steel wedges that
deploy out of the ground; and tactical training products and services consisting
of our live-fire interactive T2 Tactical Training System and our American
Institute for Defense and Tactical Studies.





We primarily serve the defense market
and our sales are highly concentrated within the U.S. government. Our customers
include various branches of the U.S. military through the 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 sector
customers.





Our recent historical revenues have
been generated primarily from a limited number of large contracts and a series
of purchase orders from a single customer. To continue expanding our business,
we are seeking to broaden our customer base and to diversify our product and
service offerings. Our strategy to increase our revenue, grow our company and
increase stockholder value involves the following key elements:





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


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


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


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


·
              pursue
      strategic acquisitions.





40





We are pursuing each of these growth
strategies simultaneously, and expect one or more of them to result in
additional revenue opportunities within the next 12 months.




Sources
of Revenues




We derive
our revenues by fulfilling orders under master contracts awarded by branches of
the United States military, law enforcement and corrections agencies and private
companies involved in the defense market and other customer purchase orders.
Under these contracts and purchase orders, we provide customized transparent and
opaque armor products for transport and construction vehicles used by the
military, group protection kits and spare parts. We also derive revenues from
sales of our architectural hardening and perimeter defense products, which we
sometimes refer to as physical security products. To date, we have generated
nominal revenues from our T2 and other training solutions and we are evaluating
the continued offering of such training products and services and expect to
continue that process over the next several months.




Our
contract backlog as of September 30, 2009 and September 30, 2008 was
$46.0 million and $55.0 million, respectively, and of our $46.0 million of
contract backlog as of September 30, 2009, we estimate that $13.0 million
will be filled in 2009. Accordingly, in order to maintain our current revenue
levels and to generate revenue growth, we will need to win more contracts with
the U.S. government and other commercial entities, achieve significant
penetration into critical infrastructure and public safety protection markets,
and successfully further develop our relationships with OEM’s and strategic
partners.  Notwithstanding the possible significant troop reductions in
Afghanistan and Iraq, we expect that demand in those countries for armored
military construction vehicles will continue in order to repair significant war
damage and for nation-building purposes. In addition, we are exploring interest
in armored construction equipment in other countries with mine-infested
regions.




We
continue to aggressively bid on projects and are in preliminary talks with a
number of international firms to pursue long-term government and commercial
contracts, including with respect to Homeland Security. While no assurances can
be given that we will obtain a sufficient number of contracts or that any
contracts we do obtain will be of significant value or duration, we are
confident that we will continue to have the opportunity to bid and win contracts
as we have in 2008.




Cost
of Revenues and Operating Expenses




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




Sales and
Marketing.    Expenses related to sales and marketing
consist primarily of compensation for our sales and marketing personnel, sales
commissions and incentives, trade shows and related travel.  Sales and
marketing costs are charged to expense as incurred.





Research and
Development.    Research and development expenses are
incurred as we perform ongoing evaluations of materials and processes for
existing products, as well as the development of new products and processes.
Such expenses typically include compensation and employee benefits of
engineering and testing personnel, materials, travel and costs associated with
design and required testing procedures associated with our product line. We
expect that in 2009, research and development expenses will increase in absolute
dollars as we upgrade and extend our service offerings and develop new
protections products, but will remain relatively consistent or decrease slightly
as a percentage of revenues. Research and development costs are charged to
expense as incurred.




General and
Administrative.    General and administrative
expenses consist of compensation and related expenses for executive, finance,
accounting, administrative, legal, professional fees, other corporate expenses
and allocated overhead. We expect that in 2009, general and administrative
expenses will remain at the same or a slightly higher level in absolute dollars
but decrease as a percentage of revenues.





41




Critical
Accounting Policies




Our
consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States. The preparation of these
consolidated financial statements requires us to make estimates and assumptions
that affect the reported amounts of assets, liabilities, revenues, costs and
expenses and related disclosures. On an ongoing basis, we evaluate our estimates
and assumptions. Our actual results may differ from these estimates under
different assumptions or conditions.




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




Revenue and Cost
Recognition.    We recognize revenue in accordance
with the provisions of the Securities and Exchange Commission (SEC) Staff
Accounting Board (SAB) No. 104, “Revenue Recognition”, which
states that revenue is realized and earned when all of the following criteria
are met: (a) persuasive evidence of the arrangement exists,
(b) delivery has occurred or services have been rendered, (c) the
seller’s price to the buyer is fixed and determinable and
(d) collectability is reasonably assured. Under this provision, revenue is
recognized upon delivery and acceptance of the order.




We
recognize revenue and report profits from purchases orders filled under master
contracts when an order is complete, as defined below. Purchase orders received
under master contracts may extend for periods in excess of one year. Purchase
order costs are accumulated as deferred assets and billings and/or cash received
are charged to a deferred revenue account during the periods of construction.
However, no revenues, costs or profits are recognized in operations until the
period upon completion of the order. An order is considered complete when all
costs, except insignificant items, have been incurred and, the installation or
product is operating according to specification or the shipment has been
accepted by the customer. Provisions for estimated contract losses are made in
the period that such losses are determined. As of September 30, 2009 and
December 31, 2008, there were no such provisions made.




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




All billings associated with
uncompleted purchase orders under contract are recorded on the balance sheet as
a deferred liability called “Billings in Excess of Costs on Uncompleted
Contracts”. Upon completion of a purchase order, all such associated billings
would be reclassified from the balance sheet to the statement of operations as
revenues. Due to the structure of our contracts, billing is not done until the
purchase order is complete, therefore there are no amounts recorded as deferred
liabilities as of September 30, 2009 or December 31,
2008.




Stock-Based
Compensation.    Stock based compensation consists of
stock or options issued to employees, directors and contractors for services
rendered. We accounted for the stock issued using the estimated current market
price per share at the date of issuance. Such cost was recorded as compensation
in our statement of operations at the date of issuance.




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




We have
adopted the provisions of Accounting Standards Codification (ASC) 718
“Compensation–Stock Compensation” (ASC 718). In accordance with ASC 718,
we use the Black-Scholes option pricing model to measure the fair value of
our option awards. The Black-Scholes model requires the input of highly
subjective assumptions including volatility, expected term, risk-free interest
rate and dividend yield. In 2005, the SEC issued Staff Accounting Bulletin (SAB)
No. 107, as codified in ASC 718-10-599, which provides supplemental
implementation guidance for ASC 718.





42




Because
we have only recently become a public entity, we will have a limited trading
history.  The expected term of an award is based on the “simplified” method
allowed by ASC 718-10-599, whereby the expected term is equal to the midpoint
between the vesting date and the end of the contractual term of the award. The
risk-free interest rate will be based on the rate on U.S. Treasury zero coupon
issues with maturities consistent with the estimated expected term of the
awards. We have not paid and do not anticipate paying a dividend on our common
stock in the foreseeable future and accordingly, use an expected dividend yield
of zero. Changes in these assumptions can affect the estimated fair value of
options granted and the related compensation expense which may significantly
impact our results of operations in future periods.




Stock-based
compensation expense recognized will be based on the estimated portion of the
awards that are expected to vest. We will apply estimated forfeiture rates based
on analyses of historical data, including termination patterns and other
factors.




We
recognized $220,198 and $75,820 in stock compensation expense for the nine
months ended September 30, 2009 and 2008, respectively.




Fair
Value Measurements




We have
adopted the provisions of ASC 820, “Fair Value Measurements and
Disclosures” (ASC 820). ASC 820 defines fair value, establishes a framework
for measuring fair value in accordance with generally accepted accounting
principles and expands disclosures about fair value investments. ASC
820 was effective for financial assets and liabilities on January 1,
2008. The statement deferred the implementation of the provisions of ASC
820 relating to certain non-financial assets and liabilities until
January 1, 2009.




Fair
value, as defined in ASC 820, is the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date. The fair value of an asset should reflect
its highest and best use by market participants, whether using an in-use or an
in-exchange valuation premise. The fair value of a liability should reflect the
risk of nonperformance, which includes, among other things, the company’s credit
risk.




Valuation techniques are generally
classified into three categories: the market approach; the income approach; and
the cost approach. The selection and application of one or more of the
techniques requires significant judgment and are primarily dependent upon the
characteristics of the asset or liability, the principal (or most advantageous)
market in which participants would transact for the asset or liability and the
quality and availability of inputs. Inputs to valuation techniques are classified
as either observable or unobservable within the following
hierarchy:





·
              Level
      1 Inputs:  These inputs come from quoted prices (unadjusted) in
      active markets for identical assets or
  liabilities.





·
              Level 2 Inputs: 
      These inputs are other than quoted prices that are observable, for an
      asset or liability. This includes: quoted prices for similar assets or
      liabilities in active markets; quoted prices for identical or similar
      assets or liabilities in markets that are not active; inputs other than
      quoted prices that are observable for the asset or liability; and inputs
      that are derived principally from or corroborated by observable market
      data by correlation or other
means.





·
              Level 3 Inputs: 
      These are unobservable inputs for the asset or liability which require the
      company’s own assumptions.







43




Series A
Convertible Preferred Stock, Investor Warrants and Placement Agent
Warrants




Series A Preferred
Stock.The Series A Convertible Preferred Stock is
redeemable on December 31, 2010 and convertible into shares of common stock at
$2.00 per share subject to adjustment should we issue future common stock
at a lesser price.  As a result we elected to record the hybrid
instrument, preferred stock and conversion option together, at fair
value.  Subsequent reporting period changes in fair value are to be
reported in the statement of operations.


The
proceeds from the issuance of the Series A Preferred and accompanying
common stock warrants, net of direct costs including the fair value of warrants
issued to the Placement Agent in connection with the transaction, must be
allocated to the instruments based upon relative fair value upon issuance as
they must be measured initially at fair value. Therefore, after the initial
recording of the Series A Preferred based upon net proceeds received, the
carrying value of the Series A Preferred must be adjusted to the fair value
at the date of issuance, with the difference recorded as a gain or loss. On
March 7, 2008, the date of initial issuance, we recorded a derivative
liability of $9.8 million. On April 4, 2008, the date of the second
issuance, we recorded a derivative liability of $3.6 million.  These
liabilities were subsequently adjusted to fair value as of September 30,
2009, which resulted in a loss of $498,400 and $1,183,700 for the three and nine
months ended September 30, 2009. As of September 30, 2009, the
Series A Preferred liability was $12.9 million.




Derivative
Warrants




Investor
Warrants.    The warrants issued with the
Series A Preferred (or Investor Warrants) meet the criteria under ASC
815 “Derivatives and Hedging”. Under ASC 815, the warrants are recorded at
fair value upon the date of issuance, with changes in the value fair value
recognized as a gain or loss as they occur. On March 7, 2008, the date of
initial issuance, we recorded a derivative liability of $1.1 million. On
April 4, 2008, the date of the second issuance, we recorded a derivative
liability of $0.4 million.  As of September 30, 2009, the Investor Warrant
liability was $0.




On
May 22, 2009 we entered into a Settlement Agreement, Waiver and Amendment
with the Series A Holders (or Settlement Agreement) pursuant to which,
among other things, the Warrants were amended to reduce the exercise price
thereof from $2.40 per share to $0.01 per share.  The warrants were
exercised in full during May and June, 2009 and the Investor Warrant
liability was accordingly reclassified to Additional Paid In
Capital.




For
additional information, see “Liquidity and Capital Resources - Series A
Convertible Preferred Stock” below.





Placement Agent
Warrants.    The warrants issued to the
Placement Agent with respect to the sale of the Series A Preferred and
Investor Warrants (or Placement Agent Warrants) were accounted for as a
transaction cost associated with the issuance of the Series A Preferred.
The Placement Agent Warrants are recorded at fair value at the date of issuance.
Under EITF 00-19 “Accounting for Derivative Financial Instruments Indexed
to, and Potentially Settled in, a Company’s Own Stock”, as codified in ASC 815,
we satisfy the criteria for classification of the Placement Agent Warrants as
equity on the date of issuance. We have recorded the corresponding amount
recorded as a Deferred Financing Cost since the Series A Preferred and
Investor Warrants are classified as liabilities and are amortized as
additional financing costs over the term of the Series A Preferred using
the interest method. At the date of each issuance, we recorded $1.0 million and
$0.4 million in deferred financing costs. Effective
January 1, 2009, we were required to analyze these instruments in accordance
with EITF 07-5 as codified in ASC 815-40. Based on our analysis, the Placement
Agent Warrants include price protection provisions whereby the exercise price
could be adjusted upon certain financing transaction at a lower price per share
and could no longer be viewed as indexed to our common stock. As a result, we
accounted for these warrants as a “derivative” under  ASC 815 and
recorded as liabilities at fair value on January 1, 2009 of $91,743. The fair
value of these warrants was $86,762 as of September 30, 2009 and we recorded
gain of $2,305 and $30,353 on the changes in fair value in the statement of
operations for the three and nine months ended September 30, 2009.




2005
Warrants and 2006 Warrants
  Upon
issuance, the 2005 Warrants and 2006 Warrants met the requirements for equity
classification set forth in EITF Issue 00-19, “Accounting for Derivative
Financial Instruments Indexed to, and Potentially Settled in a Company’s Own
Stock”, and SFAS No. 133 as codified in ASC 815. However, effective January 1,
2009, we were required to analyze these instruments in accordance with EITF 07-5
as codified in ASC 815-40. Based on our analysis, the 2005 Warrants and 2006
Warrants include price protection provisions whereby the exercise price could be
adjusted upon certain financing transaction at a lower price per share and could
no longer be viewed as indexed to our common stock. As a result, the 2005
Warrants and 2006 Warrants were accounted for as “derivatives” under ASC
and recorded as liabilities at fair value on January 1, 2009 of $74,032. The
fair value of these warrants was $25,571 as of September 30, 2009 and we
recorded loss of $8,369 and $48,661 on the changes in fair value in the
statement of operations for the three and nine months ended September 30,
2009.
 Debt
Extinguishment
 
 We
accounted for the effects of the May 22, 2009 settlement agreement (see Note 7
of the accompanying condensed consolidated financial statements) in accordance
with the guidelines enumerated in EITF Issue No. 96-19 “ Debtor’s Accounting for
a Modification of Exchange of Debt Instruments” as codified in ASC
470-50.  ASC 470-50 provides that a substantial modification of terms
in an existing debt instrument should be accounted for like, and reported in the
same manner as, an extinguishment of debt. ASC 470-50 further provides that the
modification of a debt instrument by a debtor and a creditor in a non-troubled
debt situation is deemed to have been accomplished with debt instruments that
are substantially different if the present value of cash flows under the terms
of the new debt instrument is at least ten percent different from the present
value of the remaining cash flows under the terms of the original instrument at
the date of the modifications.
 
 We
evaluated the modification of the payment terms and the related adjustment to
financial instruments to determine whether these modifications resulted in the
issuance of a substantially different instrument. We determined after giving
effect to the changes in the due dates of payments and the consideration paid to
the debt holders, in the form of reduced conversion and exercise prices, that we
had issued substantially different debt instruments, which resulted in a
constructive extinguishment of the original debt instrument. Accordingly, we
recorded a loss on the extinguishment of debt in the amount of $2,613,630 which
represented the difference in the carrying value of the old debt and fair value
of the new debt. The debt instrument charge is included in the accompanying
statement of operations for the nine months ended September 30,
2009.


Consolidated
Results of Operations





The
following discussion should be read in conjunction with the information set
forth in the consolidated financial statements and the related notes thereto
appearing elsewhere in this report.





44





Comparison
of the Three Months Ended September 30, 2009 and 2008





Revenues.  Revenues from
continuing operations for the three months ended September 30, 2009 were $12.6
million, a decrease of  $0.7 million, or 5.0%, over revenues of $13.3
million in the comparable period in 2008.  This decrease was due
primarily to $2.0 million in orders under our Marine Corps contract
no. M67854-09-D-5069 that had been completed and expected to ship in the
quarter ended September 30, 2009 but were not shipped until the beginning of
October 2009 due to a delay in the inspection of the order by a third party,
partially offset by an increase in our physical security product
business.  For the three months ended September 30, 2009 the
revenues for our security product business was $1.2 million, an increase
of  $0.7 million or 58.0% over revenues of $0.5 million for the three
months ended September 30, 2008.





On
January 2, 2009, we discontinued the operations of our Tactical Application
Group, a tactical equipment supply business.  Revenues from our
discontinued operations for the three months ended September 30, 2008 was $0.2
million.  There were no revenues generated from discontinued operations
during the three months ended September 30, 2009.





Cost of Revenues. Cost
of revenues for the three months ended September 30, 2009 was $10.0
million, an increase of $1.0 million, or 11.1%, over cost of revenues of $9.0
million in the comparable period in 2008.  This increase reflects
additional costs with respect to our increased production under the Marine Corps
contract mentioned above, and increased sales of our physical security products
as well as increased sales of certain of our crew protection kits (or CPKs),
which have lower gross margins than our other CPKs, as compared to the three
months ended September 30, 2008.  The costs of revenue also increased
due to additional costs of sales from our physical security product business
during the quarter ended September 30, 2009.





Cost of
revenues from discontinued operations for the three months ended
September 30, 2008 was $105,184.  There were no costs of revenues
generated from discontinued operations for the three months ended
September 30, 2009.





Gross profit.   The
gross profit margin for the three months ended September 30, 2009 and
September 30, 2008 were $2.6 million and $4.3 million, respectively. 
The gross profit margin percentage was 21.0% and 32.0% for the three months
ended September 30, 2009 and September 30, 2008,
respectively.  The decrease in gross profit margin percentage from
continuing operations from 2008 to 2009 resulted primarily from an increase in
overall costs incurred during the three months ended September 30, 2009
that were associated with a product mix that did not have favorable gross margin
for the third quarter of 2009, as discussed above in “Cost of
Revenues.”





Sales and Marketing
Expenses.  Sales and marketing expenses for the three months
ended September 30, 2009 and September 30, 2008 were $560,000 and
$688,000, respectively, representing a decrease of $128,000, or
23.0%.  The decrease was due primarily to a decrease in trade
show expenses and related expenses from selling and marketing.  There
were no sales or marketing expenses for discontinued operations during the three
months ended September 30, 2009 and 2008.





Research and Development
Expenses.  Research and development expenses for the three
months ended September 30, 2009 and September 30, 2008 were $117,000
and $170,000, respectively.  The decrease of $53,000 or 31.0% from 2008 to
2009 was primarily the result of additional testing of our CPKs, and to a lesser
extent, improvements of existing products and continued work on our products in
development during the three months ended September 30, 2008, that did not
take place in the three months ended September 30, 2009.  There were no
research and development expenses for discontinued operations during the three
months ended September 30, 2009 and 2008.





General and Administrative
Expenses.  General and administrative expenses from continuing
operations for the three months ended September 30, 2009 and
September 30, 2008 were $2.4 million and $2.1 million, respectively. 
The increase of $0.3 million, or 13.0%, was primarily due to general increases
in expenses of $0.2 million relating to consulting and other costs associated
with compliance efforts under Section 404 of the Sarbanes-Oxley Act as well as
additional general and administrative expenses associated with the facilities
for our physical security product business of $0.1 million.





45





General
and administrative expenses associated with discontinued operations was $182,000
for the three months ended September 30, 2008.  There were no such
expenses incurred during the three months ended September 30,
2009.





General and Administrative Salaries
Expense.  General and administrative salaries expense for the
three months ended September 30, 2009 and September 30, 2008 were $1.1
million and $1.0 million, respectively. The increase of $0.1 million, or
9.0% was due in part to the increase in salary expense at our headquarters and
main facility in Hicksville, New York.  We incurred no salary expense
with regard to our discontinued operations during the quarters ended
September 30, 2008 and 2009.  As of September 30, 2009, there
were 44 employees that were classified as general and administrative personnel,
versus 41 employees as of September 30, 2008.





Depreciation expense. 
Depreciation expense was $278,000 and $266,000 for the three months ended
September 30, 2009 and September 30, 2008, respectively.  The
increase of $12,000, or 4%, was the result of our higher property and equipment
balance as of September 30, 2009 versus September 30, 2008.  This
increase was the result of additional leasehold improvements and equipment
associated with the expansion of our facility during 2008, property and
equipment purchased in 2008 and 2009 for our Hicksville facility and physical
security product business, and T2 equipment.  This higher capital balance
as of September 30, 2009 resulted in higher depreciation
expense.





Other (income) and
expense.  As a result of our agreement to sell our Series A
Convertible Preferred Stock and related warrants to purchase common stock (or
investor warrants), we incurred losses which occurred upon the valuation of the
Series A Convertible Preferred Stock.  Such valuation took into account the
features, rights and obligations of the Series A Convertible Preferred Stock,
which ultimately resulted in a higher fair value than the proceeds
received.  Since the Series A Convertible Preferred Stock is
required to be recorded at fair value, we recorded a loss on such
securities.  The investor warrants were exercised in full during the
quarter ended June 30, 2009.  We experienced a loss on adjustment of
fair value with respect to our Series A Convertible Preferred Stock of
$498,000 and a gain on adjustment of $126,000 for the three months ended
September 30, 2009 and 2008, respectively.  We did not recognize any
gain or loss on the related investor warrants for the three months ended
September 30, 2009 as the warrants had been exercised in full during the three
months ended June 30, 2009.  We recognized a gain on the related
investor warrants of $52,000 for the three months ended September 30,
2008. In addition,
we incurred interest expense associated with the amortization of the deferred
financing costs and discount on the Series A Convertible Preferred Stock of
$588,765 and $270,000 for the three months ended September 30, 2009 and
2008, respectively.




Comparison
of the Nine Months Ended September 30, 2009 and 2008





Revenues.  Revenues from
continuing operations for the nine months ended September 30, 2009 were
$36.2 million, an increase of  $4.9 million, or 15.7%, over revenues
of $31.3 million in the comparable period in 2008.  This increase was
due primarily to increased order fulfillment under our Marine Corp Contract
No. M67854-07-D-5069 during the nine months ended September 30, 2009
versus the same period in 2008, including orders that had been expected in the
fourth quarter of 2008 that were delayed into the first and second quarters of
2009.  The revenue increase also was due to additional sales generated
from our physical security product business for the nine months ended
September 30, 2009 of  $1.2 million an increase
of  $0.2 million or 20.0% over revenues of  $1.0 million for
the nine months ended September 30, 2008.





Revenues
from our discontinued operations for the nine months ended September 30,
2008 was $783,000.  There were no revenues generated from discontinued
operations during the nine months ended September 30,
2009.





Cost of Revenues. Cost
of revenues for the nine months ended September 30, 2009
was  $24.1 million, an increase of  $3.8 million, or 19%,
over cost of revenue of $20.3 million in the comparable period in 2008. 
This increase reflects additional costs with respect to our increased production
under the Marine Corps contract mentioned above, and increased sales of our
physical security products as well as increased sales of certain of our CPKs,
which have lower gross margins than our other CPKs, as compared to the three
months ended September 30, 2008.





46





Cost of
revenues from discontinued operations for the nine months ended
September 30, 2008 was  $0.5 million.  There were no costs
of revenues generated from discontinued operations for the nine months ended
September 30, 2009.





Gross profit.   The
gross profit margin for the nine months ended September 30, 2009 and
September 30, 2008 were  $12.0 million and $11.0 million,
respectively.  The gross profit margin percentage was 33.0% and 35.0% for
the nine months ended September 30, 2009 and September 30, 2008,
respectively. The decrease in gross profit margin percentage from continuing
operations from the nine months ended September 30, 2008 to the nine months
ended September 30, 2009 resulted primarily from amounts incurred during the
nine months ended September 30, 2009 that were associated with a product
mix that did not have favorable gross margin, as discussed above in “Cost of
Revenues.”





Sales and Marketing
Expenses.  Sales and marketing expenses for the nine months
ended September 30, 2009 and September 30, 2008  remained
unchanged at $2.0 million, respectively.  Although we expected to
increase our sales and marketing as our revenues increased for 2009, during the
quarter ended September 30, 2009, we have sought to keep such expenses
relatively low as we continue to monitor our costs.  We did not offer
the T2 during the nine months ended September 30, 2008 and, therefore,
incurred no marketing expense for its promotion.  There were no sales or
marketing expenses for discontinued operations for the nine months ended
September 30, 2009 and 2008.





Research and Development
Expenses.  Research and development expenses for the nine
months ended September 30, 2009 and September 30, 2008
were  $321,000 and $540,000, respectively.  The decrease of
$219,000 or 41.0% from the nine months ended September 30, 2008 to the nine
months ended September 30, 2009 was the result of additional testing of our
CPKs, and to a lesser extent, improvements of existing products and continued
work on our products in development during the nine months ended
September 30, 2009, that did not take place in the nine months ended
September 30, 2009.  There were no research and development expenses for
discontinued operations for the nine months ended September 30, 2009 and
2008.





General and Administrative
Expenses.  General and administrative expenses from continuing
operations for the nine months ended September 30, 2009 and
September 30, 2008 were  $6.7 million and $5.4 million,
respectively.  The increase of  $1.3 million, or 24.5%, was
primarily due to general increases in expenses of  $1.0 million
relating to professional fees, board of director compensation, general and
liability insurance, rent and general supplies and our compliance efforts with
regard to Section 404 of the Sarbanes-Oxley Act, as well as additional general
and administrative expenses associated with the facilities for our physical
security product business of  $130,000.





General
and administrative expenses associated with discontinued operations
was  $0.5 million for the nine months ended September 30,
2008.  There were no such expenses incurred during the nine months ended
September 30, 2009.





General and Administrative Salaries
Expense.  General and administrative salaries expense for the
nine months ended September 30, 2009 and September 30, 2008 remained
at approximately $3.2 million.  We incurred no salary expense
with regard to our discontinued operations during the quarters ended
September 30, 2008 and 2009.  As of September 30, 2009,
there were 44 employees that were classified as general and administrative
personnel, versus 41 employees as of September 30, 2008.





Depreciation
expense.Depreciation expense was  $0.8 million and $0.5 million for the nine
months ended September 30, 2009 and September 30, 2008,
respectively.  The increase of $0.2 million, or 45.3%, was the result
of our higher property and equipment balance as of September 30, 2009
versus September 30, 2008.  This increase was the result of
additional leasehold improvements and equipment associated with the expansion of
our facility during 2009, property and equipment purchased in 2008 and 2009 for
our Hicksville facility and physical security product business, and T2 equipment.  This
higher capital balance as of September 30, 2009 resulted in higher
depreciation expense.





47





Other (income) and
expense.  As a result of our agreement to sell our Series A
Convertible Preferred Stock and related investor warrants to purchase common
stock and the subsequent Settlement Agreement that reduced the exercise price of
the investor warrants from $2.40 to $.01, we incurred losses which occurred upon
the valuation of the Series A Convertible Preferred Stock.  Such valuation
took into account the features, rights and obligations of the Series A
Convertible Preferred Stock, which ultimately resulted in a higher fair value
than the proceeds received.  Since the Series A Convertible
Preferred Stock and related investor warrants are required to be recorded at
fair value, we recorded a loss on such securities.  We experienced a loss
on adjustment of fair value with respect to our Series A Convertible
Preferred Stock of $1.2 million and a gain on adjustment of $1.4 million for the
nine months ended September 30, 2009 and 2008, respectively.  We also
recognized a loss of  $15,676 and a gain on the related investor
warrants of $1.4 million as of September 30, 2009 and 2008,
respectively.  The $2.3 million loss related to the investor warrants for
the nine months ended September 30, 2009 was the result of the reduction in
the exercise price from $2.40 to $.01.  In addition, we incurred interest
expense associated with the amortization of the deferred financing costs and
discount on the Series A Convertible Preferred Stock of $1.6 million and
$0.6 million for the nine months ended September 30, 2009 and 2008. We also
had a loss on deemed extinguishment of debt related to our Series A Convertible
Preferred Stock for the nine months ended September 30, 2009 of $2.6
million.




Liquidity
and Capital Resources





The
primary sources of our liquidity during the nine months ended September 30,
2009 have come from operations and to a lesser extent under our bank credit
facility.  As of September 30, 2009, our principal sources of
liquidity were net accounts receivable of  $5.9 million, costs in
excess of billings of  $10.2 million and the sale of accounts
receivable under accounts receivable purchase agreement with Republic Capital
Access (or RCA), of which RCA has not received payment from our customers for
$2.2 million.




As of
September 30, 2008, our principal sources of liquidity were cash and cash
equivalents totaling  $3.7 million, net accounts receivable
of  $8.5 million and costs in excess of billings of  $7.6
million.  The primary sources of our liquidity during the nine months ended
September 30, 2008 came from operations and the proceeds from the sale of
our Series A Convertible Preferred Stock.





We believe that our current cash, cash
equivalents, net accounts receivable and costs in excess of billings together
with our expected cash flows from operations, ability to sell accounts
receivable to RCA (as described below) will be sufficient to meet our
anticipated cash requirements for working capital and capital expenditures for
at least the next 12 months, except with respect to our agreement to redeem $7.5
million in stated value of our outstanding Series A Convertible Preferred Stock
(or Series A Preferred) by December 31, 2009 as described below. We currently
are seeking to raise capital in the public markets to finance such redemption.
In addition, restrictions imposed pursuant to the General Corporation Law of the
State of Delaware (the “DGCL”), our state of
incorporation, would prohibit us from satisfying such redemption if we lack
sufficient surplus, as such term is defined under the DGCL.If we are
unable to timely raise such capital in the public market or we do not otherwise
successfully raise capital or obtain access to a credit facility sufficient to
fund such redemption, our cash flow could be adversely affected and our business
significantly harmed.




Cash Flows from
Operating Activities.Net cash used in operating activities
was  $1.6 million for the nine months ended September 30, 2009
compared to net cash used in operating activities of  $7.5 million for
the nine months ended September 30, 2008.  Net cash used in operating
activities during the nine months ended September 30, 2009 consisted primarily
of changes in our operating assets and liabilities of  $3.6
million, including changes in accounts receivable, cost in excess of billing,
prepaid expense, accounts payable and accrued liabilities.  The changes
in accounts receivable and
costs in excess of billing of $1.0 million and $3.1 million, respectively,
reflects the increases in receivables from completed projects and costs incurred
on projects in process as of September 30, 2009.  Our prepaid expenses
and other current assets decreased  $0.1 million due to amounts paid
in advance in connection with prepayment of legal expense and insurance. 
As of September 30, 2008, we experienced an increase in accounts receivable
of $1.8 million, due to increased collections during the nine month
period.  The increase in our costs in excess of billings of $2.6 million as
of September 30, 2008, reflects increases in projects in process as of
September 30, 2008.  Our prepaid expenses increased  $1.4
million due to amounts paid in advance in connection with our intent to enter
the public market and obtain outside financing.  In addition, the changes
in accounts payable and accrued liabilities reflect the related increase in
expenses incurred, with no funds paid out.





As of
September 30, 2009, we had net operating loss carryforwards
of  $4.6 million available to reduce future taxable income. In
the future, we may utilize our net operating loss carryforwards and would begin
making cash tax payments at that time. In addition, the limitations on utilizing
net operating loss carryforwards and other minimum taxes may also increase our
overall tax obligations. We expect that if we generate taxable income and/or we
are not allowed to use net operating loss carryforwards, our cash generated from
operations will be adequate to meet our income tax
obligations.





48





Net Cash Used In Investing
Activities.  Net
cash used in investing activities for the nine months ended September 30,
2009 and 2008 was  $0.3 million and $2.9 million, respectively. 
Net cash used in investing activities for the nine months ended
September 30, 2009 consisted of amounts paid out for the general and
computer equipment and miscellaneous leasehold improvements.  Net cash used
in investing activities for the nine months ended September 30, 2008 consisted
primarily of cash paid for the acquisition of equipment for the T2 facility and
general shop equipment and machinery.  During the nine months ended
September 30, 2008, we also paid out cash associated with leasehold
improvements and office equipment and furniture for the expansion of our
Hicksville corporate offices and warehouse.





Net Cash Provided by
Financing Activities.  Net
cash used in financing for the nine months ended September 30,
2009 was  $1.5 million and net cash provided by financing for the nine
months ended September 30, 2009 was $12.5 million. Net cash used
in financing activities during the nine months ended September 30, 2009
consisted of deferred financing costs of $1.2 million and deferred offering
costs of $0.2 million. Net cash provided by financing activities during the nine
months ended September 30, 2008 consisted primarily of net proceeds of $14.0
million received from the sale of the Series A Preferred.  In
addition, we received  $0.2 million of proceeds from the sale of common
stock and $62,000 from the term loan with TD Bank, offset by deferred financing
costs of $1.7 million.





Accounts
Receivable Purchase Agreement





In July 2009, we entered into an
accounts receivable purchase agreement with Republic Capital Access, LLC (RCA),
which was amended in October 2009. Under the purchase agreement, we can sell
eligible accounts receivables to RCA. Eligible accounts receivable, subject to
the full definition of such term in the purchase agreement, generally are our
receivables under prime government contracts.





Under the terms of the purchase
agreement, we may offer eligible accounts receivable to RCA and if RCA purchases
such receivables, we will receive an initial upfront payment equal to 90% of the
receivable. Following RCA’s receipt of payment from our customer for such
receivable, they will pay to us the remaining 10% of the receivable less its
fees. In addition to a discount factor fee and an initial enrollment fee, we are
required to pay RCA a program access fee equal to a stated percentage of the
sold receivable, a quarterly program access fee if the average daily amount of
the sold receivables is less than $2.25 million and RCA’s initial expenses in
negotiating the purchase agreement and other expenses in certain specified
situations. The purchase agreement also provides that in the event, but only to
the extent, that the conveyance of receivables by us is characterized by a court
or other governmental authority as a loan rather than a sale, we shall be deemed
to have granted RCA effective as of the date of the first purchase under the
Purchase Agreement, a security interest in all of our right, title and interest
in, to and under all of the receivables sold by us to RCA, whether now or
hereafter owned, existing or arising.





The initial term of the purchase
agreement ends on December 31, 2009 and will renew annually after the initial
term, unless earlier terminated by either of the parties. Pursuant to the
October 2009 amendment, the term during which we may offer and sell eligible
accounts receivable to RCA (Availability Period) has been extended from December
31, 2009 to October 15, 2010, and the discount factor rate has been reduced from
0.524% to 0.4075%. As of September 30, 2009, RCA holds $ 2.2 million of accounts
receivable for which RCA has not received payment from our
customers.





Bank Facility





In May 2007, we entered into a loan
agreement with TD Bank (formerly known as Commerce Bank, N.A.) pursuant to which
we had access to a revolving credit facility up to a maximum of $12.0 million
depending upon the periodic balance of our qualified accounts receivable. As of
September 30, 2009 and 2008,  we had no outstanding balance under the
revolving credit facility. As part of the same loan facility, we borrowed $0 and
$130,000 as of September 30, 2009 and 2008, respectively, under a term loan due
July 1, 2010, which was payable in equal monthly installments. The credit
facility was secured by all of our assets, and bore interest at a variable rate
equal to LIBOR plus a margin of between 1.75% and 2.45%. As of July 24, 2009, we
repaid in full the entire outstanding balance under the loan agreement with TD
Bank, following an initial notice of default from the bank with respect to
certain financial covenants on April 1, 2009, and a forbearance agreement, as
amended.





49




Series A Convertible Preferred
Stock





In March and April 2008, we sold shares
of our Series A Convertible Preferred Stock and warrants to purchase our common
stock (or the Investor Warrants). We received aggregate gross proceeds of $15.0
million, before fees and expenses of the placement agent in the transaction and
other expenses.





In connection with our application to
list our common stock on the NYSE Amex, we entered into a Consent and Agreement
(or Consent Agreement) on May 23, 2008 with the holders of our Series A
Preferred (or Series A Holders) where the Series A Holders agreed to limit the
number of shares of common stock issuable upon conversion of, or as dividends
on, the Series A Preferred and upon the exercise of the Investor Warrants
without approval of our common stockholders (which stockholder approval was
received on December 12, 2008). In return, among other things, we agreed for the
fiscal year ending December 31, 2008 (A) to achieve (i) revenues equal to or
exceeding $50,000,000 and (ii) consolidated EBITDA equal to or exceeding
$13,500,000, and (B) to publicly disclose and disseminate, and to certify to the
Series A Holders, our operating results for such period, no later than February
15, 2009 (we collectively refer to these as the Financial Covenants). Under the
Consent Agreement, the breach of the Financial Covenants were each deemed a
‘‘Triggering Event’’ under the Certificate of Designations, Preferences and
Rights of the Series A Convertible Preferred Stock (or Certificate of
Designations), which would purportedly give the Series A Holders the right to
require us to redeem all or a portion of their Series A Preferred shares at a
price per share calculated under the Certificate of Designations.





50





We did not satisfy the terms of the
Financial Covenants as of December 31, 2008 and in April 2009 we received a
Notice of Triggering Event Redemption from the holder of 94% of our Series A
Preferred. The notice demanded the full redemption of such holder’s Series A
Preferred as a consequence of the breach of the Financial Covenants, and
demanded payment of accrued dividends on the Series A Preferred and legal fees
and expenses incurred in connection with negotiations concerning the breach of
the Financial Covenants.





On May 22, 2009, we entered into a
Settlement Agreement, Waiver and Amendment with the Series A Holders (Settlement
Agreement) pursuant to which, among other things, (i) the Series A Holders
waived any breach by us of the Financial Covenants or our obligation to timely
pay dividends on the Series A Preferred for any period through September 30,
2009, and waived any ‘‘Equity Conditions Failure’’ and any ‘‘Triggering Event’’
under the certificate of designations of the Series A Preferred otherwise
arising from such breaches, (ii) the Investor Warrants were amended to reduce
their exercise price from $2.40 per share to $0.01 per share, (iii) we issued
the Series A Holders an aggregate of 2,000,000 shares of our common stock
(Dividend Shares), in full satisfaction of our obligation to pay dividends under
the Certificate of Designations as of March 31, 2009, June 30, 2009 and
September 30, 2009, and (iv) we agreed to redeem $7.5 million in stated value of
the Series A Preferred Stock by December 31, 2009. We agreed that, if we fail to
so redeem $7.5 million in stated value of the Series A Preferred Stock by that
date (a Redemption Failure), then, in lieu of any other remedies or damages
available to the Series A Holders (absent fraud), (i) the redemption price
payable by us will increase by an amount equal to 10% of the stated value, (ii)
we will use our best efforts to obtain stockholder approval to reduce the
conversion price of the Series A Preferred from $2.00 to $0.50 (which would
increase the number of shares of common stock into which the Series A Preferred
is convertible), and (iii) we will expand the size of our board of directors by
two, will appoint two persons designated by the Series A Holders to fill the two
newly-created vacancies, and will use our best efforts to amend our certificate
of incorporation to grant the Series A Holders the right to elect two persons to
serve on the board.





The
Settlement Agreement provides that if as of December 1, 2009, we do not
reasonably believe that we can fund the required redemption on or before
December 31, 2009, we need to take actions required to seek to obtain the
stockholder approval for an amendment to our certificate of incorporation
necessary for reducing the conversion price and granting the Series A Holders
the right to elect two directors designated by such preferred stockholder,
including, without limitation, (i) calling a meeting of our stockholders to
consider such amendment; (ii) submitting to the SEC a preliminary proxy
statement for such meeting of stockholders; and (iii) upon receipt of the
requisite stockholder approval, filing the amendment to our certificate of
incorporation. See ‘‘Risk Factors — We have entered into a Settlement Agreement,
Waiver and Amendment with holders of our Series A Convertible Preferred Stock,
pursuant to which, among other things, we have agreed to redeem $7,500,000 in
stated value of the Series A Convertible Preferred Stock by December 31, 2009,
in addition to our prior obligation to redeem any such Preferred Stock
outstanding as of December 31, 2010. If we fail to redeem such Series A
Convertible Preferred Stock, our cash flow could be adversely affected and our
business significantly harmed.”





Item 3.    Quantitative and Qualitative Disclosure
About Market Risk




We are a
smaller reporting company as defined by Rule 12b-2 of the Exchange Act and
are not required to provide the information required under this
Item 3.




Item 4.    Controls and Procedure




Evaluation
of Disclosure Controls and Procedures




An
evaluation was carried out under the supervision and with the participation of
our management, including our Chief Executive Officer and Chief Financial
Officer, of the effectiveness of the design and operation of our disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the
Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end
of the period covered by this report. Based on the evaluation of our disclosure
controls and procedures, our Chief Executive Officer and our Chief Financial
Officer determined that a material weakness exists with respect to our reporting
of complex and non-routine transactions.  As a result of this material
weakness, on November 23, 2009 we restated our financial statements for the year
ended December 31, 2008 and for the quarters ended March 31, 2009 and June 30,
2009.





51




To address this material weakness, we
intend to engage outside experts to provide counsel and guidance in areas where
we cannot economically maintain the required expertise internally (e.g., with
the appropriate classifications and treatments of complex and non-routine
transactions).





As a result of the material weakness
identified with respect to our reporting of complex transactions, our Chief
Executive Officer and Chief Financial Officer have concluded that our disclosure
controls and procedures were not effective to ensure that the information
required to be disclosed by us in the reports that we file or submit under the
Exchange Act was recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms and that such information
required to be disclosed is accumulated and communicated to management,
including our Chief Executive Officer and Chief Financial Officer, to allow
timely decisions regarding required disclosure.





Changes
in Internal Controls




There
were no changes in our internal controls over financial reporting during the
quarter ended September 30, 2009 that have materially affected, or are
reasonably likely to affect, our internal control over financial
reporting.




Limitations
on the Effectiveness of Controls




Our
management, including our CEO and CFO, does not expect that our Disclosure
Controls and internal controls will prevent all error and all fraud. A control
system, no matter how well conceived and operated, can provide only reasonable,
not absolute, assurance that the objectives of the control system are met.
Further, the design of a control system must reflect the fact that there are
resource constraints, and the benefits of controls must be considered relative
to their costs. Because of the inherent limitations in all control systems, no
evaluation of controls can provide absolute assurance that all control issues
and instances of fraud, if any, with American Defense Systems have been
detected. These inherent limitations include the realities that judgments in
decision-making can be faulty and that breakdowns can occur because of simple
error or mistake. Additionally, controls can be circumvented by the individual
acts of some persons, by collusion of two or more people or by management
override of the controls.




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




Item 1.    Legal Proceedings





On July
10, 2007, we filed a lawsuit against a former subcontractor, Southern California
Gold Products d/b/a Gypsy Rack, the subcontractor’s President and owner, Glenn
Harris, and an associated individual, James McAvoy in the United States District
Court, Eastern District of New York. Defendants moved to change venue to the
Central District of California based upon insufficient contacts to the State of
New York and on October 12, 2007 the matter was transferred to the United States
District Court for the Central District of California, Case Number 07-CV-02779.
On February 21, 2008, pursuant to the court’s order, we filed an amended
complaint. The amended complaint names only Southern California Gold Products
and James McAvoy as defendants and asserts six counts as follows:
misappropriation of trade secrets and confidential information; breach of
contract; unfair competition; conversion; violation of the Lanham Act; and
interference with prospective economic advantage. The amended complaint seeks to
enjoin the defendants from misappropriating, disclosing, or using our
confidential information and trade secrets, and recall and surrender all
products and trade secrets wrongfully misappropriated or converted by the
defendants. It also seeks compensatory damages in an amount to be established at
trial together with prejudgment and post judgment interest, exemplary damages,
disgorgement, restitution with interest, attorney’s fees and the 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 motion for summary
judgment on, among others, the grounds of collateral estoppel and res judicata.
We filed opposition to the motion. The defendants’ motion and a subsequent
application for an immediate interlocutory appeal were denied. A mediation
settlement conference was held on October 31, 2008, which was unsuccessful. The
defendants filed a second motion for summary judgment that was denied in May
2009. After that denial, discovery continued. A second mediation settlement
conference was held in July 2009. As a result of that conference, the parties
believe they may have reached a settlement in principle. The parties requested
that the Court stay discovery and the trial for a period of sixty (60) days. On
August 5, 2009, the Court vacated all dates in this action and removed the case
from its active caseload. On October 2, 2009, the parties submitted to the Court
a joint status report informing the Court that a settlement was expected to be
finalized within twenty (20) days.  The settlement was not finalized
within the expected twenty day period, and negotiations are
ongoing.





52




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





On March
4, 2008, Thomas Cusack, our former General Counsel, commenced an action with the
United States Department of Labor, Occupational Safety and Health and Safety
Administration, alleging retaliation in contravention of the Sarbanes-Oxley Act.
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 be without merit and
intend to vigorously defend against the action. On March 7, 2008, Mr. Cusack
also commenced a second action against us for breach of contract and related
issues arising from his termination of employment in New York State Supreme
Court, Nassau County. On May 7, 2008, we served a motion to dismiss the
complaint, and on or about September 26, 2008, the Court dismissed several
claims (tortious interference with a contract, tortious interference with
economic opportunity, fraudulent inducement to enter into a contract and breach
of good faith and fair dealing). The remaining claims are Mr. Cusack’s breach of
contract claims and claims seeking the lifting of the transfer restrictions on
his stock, as well as one claim for conversion of his personal property which
Mr. Cusack has also asserted against our chief executive officer, chief
operating officer and chief financial officer. On October 13, 2008, Mr. Cusack
filed an amended complaint as to the remaining claims, and on November 5, 2008,
we filed an answer to the complaint and filed counterclaims against Mr. Cusack
for fraud. The parties are conducting discovery and have completed scheduled
depositions. We believe meritorious defenses to the claims exist and we intend
to vigorously defend this action.




Item 1A.  Risk Factors




Our
business, industry and common stock are subject to numerous risks and
uncertainties. Any of the following risks, if realized, could materially and
adversely affect our revenues, operating results, profitability, financial
condition, prospects for future growth and overall business, as well as the
value of our common stock.




Risks
Relating to Our Company




We
depend on the U.S. Government for a substantial amount of our sales and if we do
not continue to experience demand for our products within the U.S. Government,
our business may fail. Moreover, our growth in the last few years has been
attributable in large part to U.S. wartime spending in support of troop
deployments in Iraq and Afghanistan. If such troop levels are reduced, our
business may be harmed.




We
primarily serve the defense market and our sales are highly concentrated within
the U.S. government. Customers for our products include the U.S. DoD, including
the U.S. Marine Corps and U.S. Army Tank Automotive and Armaments Command
(TACOM), and the U.S. Department of Homeland Security. Government tax revenues
and budgetary constraints, which fluctuate from time to time, can affect
budgetary allocations for these customers. Many government agencies have in the
past experienced budget deficits that have led to decreased spending in defense,
law enforcement and other military and security areas. Our results of operations
may be subject to substantial period-to-period fluctuations because of these and
other factors affecting military, law enforcement and other governmental
spending.





53




U.S.
defense spending historically has been cyclical. Defense budgets have received
their strongest support when perceived threats to national security raise the
level of concern over the country’s safety, such as in Iraq and Afghanistan. As
these threats subside, spending on the military tends to decrease. Accordingly,
while U.S. DoD funding has grown rapidly over the past few years, there is no
assurance that this trend will continue. Rising budget deficits, the cost of the
war on terror and increasing costs for domestic programs continue to put
pressure on all areas of discretionary spending, and the new administration has
signaled that this pressure will most likely impact the defense budget. A
decrease in U.S. government defense spending, including as a result of planned
significant U.S. troop level reductions in Iraq or Afghanistan, or changes in
spending allocation could result in our government contracts being reduced,
delayed or terminated. Reductions in our government contracts, unless offset by
other military and commercial opportunities, could adversely affect our ability
to sustain and grow our future sales and earnings.




Our
revenues historically have been concentrated in a small number of contracts
obtained through the U.S. DoD and the loss of, or reduction in estimated revenue
under, any of these contracts, or the inability to contract further with the
U.S. DoD could significantly reduce our revenues and harm our
business.




Our
revenues historically have been generated by a small number of contracts. During
2008, four contracts with U.S. DoD organizations and several purchase orders
from JCB represented approximately 78% of our revenue, and during the first nine
months of 2009, four contracts with U.S. DoD organizations and orders from JCB
represented 75% of our revenue. While we believe we have satisfied and continue
to satisfy the terms of these contracts, there can be no assurance that we will
continue to receive orders under such contracts. Our government customers
generally have the right to cancel any contract, or ongoing or planned orders
under any contract, at any time. If any of our significant contracts were
canceled, or our customers reduce their orders under any of these contracts, or
we were unable to contract further with the U.S. DoD, our revenues could
significantly decrease and our business could be severely harmed.




We
have entered into a Settlement Agreement, Waiver and Amendment with holders of
our Series A Convertible Preferred Stock, pursuant to which, among other things,
we have agreed to redeem $7,500,000 in stated value of the Series A Convertible
Preferred Stock by December 31, 2009, in addition to our prior obligation to
redeem any such Preferred Stock outstanding as of December 31, 2010. If we fail
to redeem such Series A Convertible Preferred Stock, our cash flow could be
adversely affected and our business significantly harmed.




At the
time we issued and sold our Series A Convertible Preferred Stock (Series A
Preferred) and related warrants, our securities were not yet listed on the NYSE
Amex (formerly known as the American Stock Exchange) and thus such issuance and
sale was not subject to the rules and regulations of the NYSE Amex including
rules requiring stockholder approval of the issuance of securities with certain
conversion and other provisions. Although we were not a SEC reporting company
and our securities did not yet trade publicly on the NYSE Amex or elsewhere, in
furtherance of our application to list our common stock on the NYSE Amex, we
agreed not to issue more than a total 7,858,358 shares of common stock upon the
conversion of, and as stock dividends on, the Series A Preferred and upon the
exercise of the related warrants without stockholder approval. In connection
with the foregoing agreement with the NYSE Amex, we entered into a consent
agreement with holders of the Series A Preferred (or Series A Holders) in which
the Series A Holders, among other things, consented to the requirement for such
stockholder approval. Subsequently, we did not meet the financial performance
targets set forth in the consent agreement. Our breach purportedly gave the
Series A Holders the right to require us to redeem all or a portion of their
shares of such stock. On April 14, 2009, we received a notice from the holder of
approximately 94% of the Series A Preferred that it was exercising such
redemption right. The Series A Holders also demanded that we pay them 12%
dividends they assert accrued from January 1, 2009 to April 13, 2009, on our
Series A Convertible Preferred Stock, in cash, as well as certain of their legal
fees in connection with related matters. On May 22, 2009, we entered into a
Settlement Agreement, Waiver and Amendment with the Series A Holders pursuant to
which, among other things, we have agreed to redeem $7,500,000 in stated value
of Series A Preferred by December 31, 2009. If we fail to so redeem $7,500,000
in stated value of the Series A Preferred by that date (a Redemption Failure),
then, in lieu of any other remedies or damages available to the Series A Holders
(absent fraud), (i) the redemption price payable by us will increase by an
amount equal to 10% of the stated value, (ii) we will use our best efforts to
obtain stockholder approval to reduce the conversion price of the Series A
Preferred from $2.00 to $0.50 (which would increase the number of shares of
common stock into which the Series A Preferred is convertible), and (iii) we
will expand the size of our board of directors by two, will appoint two persons
designated by the Series A Holders to fill the two newly-created vacancies, and
will use our best efforts to amend our third amended and restated certificate of
incorporation to grant the Series A Holders the right to elect two persons to
serve on the board. In addition, pursuant to the original terms of the Series A
Preferred, we are required to redeem in full any remaining outstanding shares of
Series A Preferred on December 31, 2010.  If we do not successfully
raise capital or obtain access to a credit facility sufficient to fund the
Series A Preferred Stock redemption, our business could be significantly
harmed.





54




Pursuant
to the terms of the Settlement Agreement, we also entered into a Registration
Rights Agreement with the Series A Holders, in which we agreed to file with the
SEC, by June 1, 2009, a registration statement covering the resale of the shares
of common stock issued as dividends on the Series A Preferred, and to use our
best efforts to have such registration statement declared effective as soon as
practicable thereafter. We further agreed with the Series A Holders to include
in such registration statement the shares of common stock issued upon the
exercise of the warrants acquired by the Series A Holders in connection with
their investment in the Series A Preferred in May and June 2009. A registration
statement was filed, and subsequently declared effective on August 10,
2009.




Also
pursuant to the terms of the Settlement Agreement, each of our directors and
executive officers entered into a Lock-Up Agreement, pursuant to which each such
person agreed that, for so long as any shares of Series A Preferred remain
outstanding, he will not sell any shares of our common stock owned by him as of
May 22, 2009.




Also
pursuant to the terms of the Settlement Agreement, on May 22, 2009 our Chief
Executive Officer, President and Chairman, entered into an Irrevocable Proxy and
Voting Agreement with the Series A Holders, pursuant to which he agreed, among
other things, that if a Redemption Failure occurs he will vote all shares of
voting stock owned by him in favor of (i) reducing the conversion price of the
Series A Preferred Stock from $2.00 to $0.50 and (ii) amending our certificate
of incorporation to grant the Series A Holders the right to elect two persons to
serve on the board of directors (collectively referred to as the Company
Actions). Our CEO also appointed one of the Series A Holders as his proxy to
vote his shares of voting stock in favor of the Company Actions, and against
approval of any opposing or competing proposal, at any stockholder meeting or
written consent of our stockholders at which such matters are
considered.




We
are required to comply with complex laws and regulations relating to the
procurement, administration and performance of U.S. government contracts, and
the cost of compliance with these laws and regulations, and penalties and
sanctions for any non-compliance could adversely affect our
business.




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




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




·
            The
      Truth in Negotiations Act: Requires certification and disclosure of all
      cost and pricing data in connection with contract
      negotiations;




·
            The
      Cost Accounting Standards and Cost Principles: Imposes accounting
      requirements that govern our right to reimbursement under certain
      cost-based federal government contracts;
and




·
            Laws,
      regulations and executive orders restricting the use and dissemination of
      information classified for national security purposes and the export of
      certain products and technical data. We engage in international work
      falling under the jurisdiction of U.S. export control laws. Failure to
      comply with these control regimes can lead to severe penalties, both civil
      and criminal, and can include debarment from contracting with the U.S.
      government.





55




Our
contracting agency customers periodically review our performance under and
compliance with the terms of our federal government contracts. We also routinely
perform internal reviews. As a result of these reviews, we may learn that we are
not in compliance with all of the terms of our contracts. If a government review
or investigation uncovers improper or illegal activities, we may be subject to
civil or criminal penalties or administrative sanctions, including:




·      Termination
of contracts;




·      Forfeiture
of profits;




·      Cost
associated with triggering of price reduction clauses;




·      Suspension
of payments;




·      Fines;
and




·      Suspension
or debarment from doing business with federal government agencies.




If we
fail to comply with these laws and regulations, we may also suffer harm to our
reputation, which could impair our ability to win awards of contracts in the
future or receive renewals of existing contracts. If we are subject to civil and
criminal penalties and administrative sanctions or suffer harm to our
reputation, our current business, future prospects, financial condition, and/or
operating results could be materially harmed. In addition, we are subject to the
industrial security regulations, protocols, and procedures of the U.S.
Government as set forth in the National Industrial Security Program Operating
Manual (NISPOM), which are designed to protect and safeguard classified
information from unauthorized release to individuals and organizations not
possessing a security clearance or the requisite level of clearance necessary to
access that information. Accordingly, any failure to adhere to the requirements
of the NISPOM could expose us to severe legal and administrative consequences,
including, but not limited to, our suspension or debarment from government
contracts, the revocation of our clearance, and the termination of our
government contracts, the occurrence of any of which could substantially harm
our existing business and preclude us from competing for or receiving future
government contracts.




Government
contracts are usually awarded through a competitive bidding process that entails
risks not present in the acquisition of commercial contracts.




A
significant portion of our contracts and task orders with the U.S. government is
awarded through a competitive bidding process. We expect that much of the
business we seek in the foreseeable future will continue to be awarded through
competitive bidding. Budgetary pressures and changes in the procurement process
have caused many government customers to increasingly purchase goods and
services through indefinite delivery/indefinite quantity (IDIQ) contracts,
General Services Administration (GSA) schedule contracts and other
government-wide acquisition contracts (GWACs). These contracts, some of which
are awarded to multiple contractors, have increased competition and pricing
pressure, requiring us to make sustained post- award efforts to realize revenue
under each such contract. Competitive bidding presents a number of risks,
including without limitation:




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




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




·
            the
      need to estimate accurately the resources and cost structure that will be
      required to service any contract we are awarded;
  and




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





56




If we are
unable to consistently win new contract awards over any extended period, our
business and prospects will be adversely affected, and that could cause our
actual results to be adversely affected. In addition, upon the expiration of a
contract, if the customer requires further services of the type provided by the
contract, there is frequently a competitive rebidding process. There can be no
assurance that we will win any particular bid, or that we will be able to
replace business lost upon expiration or completion of a contract, and the
termination or non-renewal of any of our significant contracts would cause our
actual results to be adversely affected.




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




Because
we 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 our
business will depend on our continued successful participation in federal
contracting programs. The current administration has signed a Memorandum for the
Heads of Executive Departments and Agencies on Government Contracting, which
orders significant changes to government contracting, including the review of
existing federal contracts to eliminate waste and the issuance of
government-wide guidance to implement reforms aimed at cutting wasteful spending
and fraud. The federal procurement reform called for in the Memorandum requires
the heads of several federal agencies to develop and issue guidance on review of
existing government contracts and authorizes that any contracts identified as
wasteful or otherwise inefficient be modified or cancelled. If any of our
contracts were to be modified or cancelled, our actual results could be
adversely affected and we can give no assurance that we would be able to procure
new U.S. Government contracts to offset the revenues lost as a result of any
modification or cancellation of our contracts. In addition, there may be
substantial costs or management time required to respond to government review of
any of our current contracts, which could delay or otherwise adversely affect
our ability to compete for or perform contracts. Further, if the ordered reform
of the U.S. Government’s procurement practices involves the adoption of new
cost-accounting standards or the requirement that competitors submit bids or
perform work through teaming arrangements, that could be costly to satisfy or
could impair our ability to obtain new contracts. The reform may also involve
the adoption of new contracting methods to GSA or other government-wide
contracts, or new standards for contract awards intended to achieve certain
socio-economic or other policy objectives, such as establishing new set-aside
programs for small or minority-owned businesses. In addition, the U.S.
government may face restrictions from other new legislation or regulations, as
well as pressure from government employees and their unions, on the nature and
amount of services the U.S. government may obtain from private contractors.
These changes could impair our ability to obtain new contracts. Any new
contracting methods could be costly or administratively difficult for us to
implement and, as a result, could harm our operating results.




Our
contracts with the U.S. government and its agencies are subject to audits and
cost adjustments. Unfavorable government audits could force us to adjust
previously reported operating results, could affect future operating results and
could subject us to a variety of penalties and sanctions.




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




57




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




Obtaining
and maintaining personal security clearances (PCLs) for employees involves a
lengthy process, and it can be difficult to identify, recruit and retain
employees who already hold security clearances. If our employees are unable to
obtain or retain security clearances, or if such employees who hold security
clearances terminate their employment with us, the customer whose work requires
cleared employees could terminate their contract with us or decide not to
exercise available options, or to not renew it. To the extent we are not able to
engage employees with the required security clearances for a particular
contract, we may not be able to bid on or win new contracts, or effectively
re-bid on expiring contracts, which could adversely affect our
business.




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




We
may not realize the full amount of revenues reflected in our backlog, which
could harm our operations and significantly reduce our future
revenues.




There can
be no assurances that our backlog estimates will result in actual revenues in
any particular fiscal period because our customers may modify or terminate
projects and contracts and may decide not to exercise contract options. We
define backlog as the future revenue we expect to receive from our contracts. We
include potential orders expected to be awarded under IDIQ contracts. Our
revenue estimates for a particular contract are based, to a large extent, on the
amount of revenue we have recently recognized on that contract, our experience
in utilizing capacity on similar types of contracts, and our professional
judgment. Our revenue estimate for a contract included in backlog can be lower
than the revenue that would result from our customers utilizing all remaining
contract capacity. Our backlog includes estimates of revenues the receipt of
which require future government appropriation, option exercise by our clients
and/or is subject to contract modification or termination. At September 30,
2009, our backlog was approximately $46.0 million, of which $13.0 million is
estimated to be realized in 2009. These estimates are based on our experience
under such contracts and similar contracts, and we believe such estimates to be
reasonable. However, we believe that the receipt of revenues reflected in our
backlog estimate for the following twelve months will generally be more certain
than our backlog estimate for periods thereafter. If we do not realize a
substantial amount of our backlog, our operations could be harmed and our future
revenues could be significantly reduced.




U.S.
government contracts often contain provisions that are typically not found in
commercial contracts and that are unfavorable to us, which could adversely
affect our business.




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




·
            terminate
      existing contracts for convenience, as well as for
  default;




·
            establish
      limitations on future services that can be offered to prospective
      customers based on conflict of interest
  regulations;




·
            reduce
      or modify contracts or
subcontracts;




·
            decline
      to make orders under existing
contracts;




·
            cancel
      multi-year contracts and related orders if funds for contract performance
      for any subsequent year become
unavailable;




·
            decline
      to exercise an option to renew a multi-year contract;
  and




·
            claim
      intellectual property rights in products provided by
  us.





58




The
ownership, control or influence of our company by foreigners could result in the
termination, non-renewal of or our inability to obtain certain U.S. government
contracts, which would reduce our revenues and harm our business.




We are
subject to industrial security regulations of the U.S. DoD and other federal
agencies that are designed to safeguard against unauthorized access by
foreigners and others to classified and other sensitive information. If we were
to come under foreign ownership, control or influence, our clearances could be
revoked and our U.S. government customers could terminate, or decide not to
renew, our contracts, and such a situation could also impair our ability to
obtain new contracts and subcontracts. Any such actions would reduce our
revenues and harm our business.




We
depend on our suppliers and three, in particular, currently provide us with
approximately 55% to 65% of our supply needs. If we cannot obtain certain
components for our products or we lose any of our key suppliers, we would have
to develop alternative designs that could increase our costs or delay our
operations.




We depend
upon a number of suppliers for components of our products. Of these suppliers,
Action Group supplies approximately 35% and Standard Bent Glass and W.W.
Williams each supplies between 10% and 15% of our overall supply needs.
Moreover, Action Group supplies all of our steel pieces and hardware, Standard
Bent Glass supplies all of our glass requirements and W.W. Williams supplies all
of our vehicle air conditioning and heating equipment for our CPKs. There is an
inherent risk that certain components of our products will be unavailable for
prompt delivery or, in some cases, discontinued. We have only limited control
over any third-party manufacturer as to quality controls, timeliness of
production, deliveries and various other factors. Should the availability of
certain components be compromised through the loss of, or impairment of the
relationship with, any of our three key suppliers or otherwise, it could force
us to develop alternative designs using other components, which could add to the
cost of goods sold and compromise delivery commitments. If we are unable to
obtain components in a timely manner, at an acceptable cost, or at all, we would
need to select new suppliers, redesign or reconstruct processes we use to build
our transparent and opaque armored products. We may not be able to manufacture
one or more of our products for a period of time, which could materially
adversely affect our business, results from operations and financial
condition.




If
we fail to keep pace with the ever-changing market of security-related defense
products, our revenues and financial condition will be negatively
affected.




The
security-related defense product market is rapidly changing, with evolving
industry standards. Our future success will depend in part upon our ability to
introduce new products, designs, technologies and features to meet changing
customer requirements and emerging industry standards; however, there can be no
assurance that we will successfully introduce new products or features to our
existing products or develop new products that will achieve market acceptance.
Any delay or failure of these products to achieve market acceptance would
adversely affect our business. In addition, there can be no assurance that
products or technologies developed by others will not render our products or
technologies non-competitive or obsolete. Should we fail to keep pace with the
ever-changing nature of the security-related defense product market, our
revenues and financial condition will be negatively affected.




We
believe that, in order to remain competitive in the future, we will need to
continue to invest financial resources to develop new and adapt or modify our
existing offerings and technologies, including through internal research and
development, acquisitions and joint ventures or other teaming arrangements.
These expenditures could divert our attention and resources from other projects,
and we cannot be sure that these expenditures will ultimately lead to the timely
development of new offerings and technologies. Due to the design complexity of
our products, we may in the future experience delays in completing the
development and introduction of new products. Any delays could result in
increased costs of development or deflect resources from other projects. In
addition, there can be no assurance that the market for our offerings will
develop or continue to expand as we currently anticipate. The failure of our
technology to gain market acceptance could significantly reduce our revenues and
harm our business. Furthermore, we cannot be sure that our competitors will not
develop competing technologies which gain market acceptance in advance of our
products.





59




We
may be subject to personal liability claims for our products and if our
insurance is not sufficient to cover such claims, our expenses may increase
substantially.




Our
products are used in applications where the failure to use our products properly
or their malfunction could result in bodily injury or death, and we may be
subject to personal liability claims. Although we currently maintain general
liability insurance which includes $1 million of product liability coverage, our
insurance may not be adequate to cover such claims. As a result, a significant
lawsuit could adversely affect our business. We may be exposed to liability for
personal injury or property damage claims relating to the use of our products.
Any future claim against us for personal injury or property damage could
materially adversely affect our business, financial condition, and results of
operations and result in negative publicity. We currently maintain insurance for
this type of liability as well as seek Support Antiterrorism by Fostering
Effective Technologies Act of 2002 (also known as the SAFETY Act) certification
for our products where we deem appropriate. However, although we maintain
insurance coverage, we may experience legal claims outside of our insurance
coverage, or in excess of our insurance coverage, or that insurance will not
cover. Even if we are not found liable, the costs of defending a lawsuit can be
high.




We
are subject to substantial competition.




We are
subject to significant competition that could harm our ability to win business
and increase the price pressure on our products. We face strong competition from
a wide variety of firms, including large, multinational, defense and aerospace
firms. Most of our competitors have considerably greater financial, marketing
and technological resources than we do, which may make it difficult to win new
contracts and we may not be able to compete successfully. Certain competitors
operate larger facilities and have longer operating histories and presence in
key markets, greater name recognition and larger customer bases. As a result,
these competitors may be able to adapt more quickly to new or emerging
technologies and changes in customer requirements. They may also be able to
devote greater resources to the promotion and sale of their products. Moreover,
we may not have sufficient resources to undertake the continuing research and
development necessary to remain competitive.




We
must comply with environmental regulations or we may have to pay expensive
penalties or clean up costs.




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




We
may not be able to adequately safeguard our intellectual property rights and
trade secrets from unauthorized use, and we may become subject to claims that we
infringe on others’ intellectual property rights.




We rely
on a combination of trade secrets, trademarks, and other intellectual property
laws, nondisclosure agreements and other protective measures to preserve our
proprietary rights to our products and production processes.




We
currently have five utility and one provisional U.S. pending patent
applications. We do not know whether any of our pending patent applications will
result in the issuance of patents or whether the examination process will
require us to narrow our claims. We have not emphasized, and do not presently
intend to emphasize, patents as a source of significant competitive advantage,
however, if we are issued patents we intend to seek to enforce them as
commercially appropriate.




These
measures afford only limited protection and may not preclude competitors from
developing products or processes similar or superior to ours. Moreover, the laws
of certain foreign countries do not protect intellectual property rights to the
same extent as the laws of the United States, and we may face other obstacles to
enforcing our intellectual property rights outside the United States including
the ability to enforce judgments, the possibility of conflicting judgments among
courts and tribunals in different jurisdictions and locating, hiring and
supervising local counsel in such other countries.





60




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




Furthermore,
third parties may assert that our products or processes infringe their patent or
other intellectual property rights. Our patents, if granted, may be challenged,
invalidated or circumvented. Although there are no pending or threatened
intellectual property lawsuits against us, we may face litigation or
infringement claims in the future. Infringement claims could result in
substantial costs and diversion of our resources even if we ultimately prevail.
A third party claiming infringement may also obtain an injunction or other
equitable relief, which could effectively block the distribution or sale of
allegedly infringing products. Although we may seek licenses from third parties
covering intellectual property that we are allegedly infringing, we may not be
able to obtain any such licenses on acceptable terms, if at all.




We
depend on management and other key personnel and we may not be able to execute
our business plan without their services.




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




We
may partner with foreign entities, and domestic entities with foreign contacts,
which may affect our business plans by increasing our costs.




We
recognize that there may be opportunities for increased product sales in both
the domestic and global defense markets. We have recently initiated plans to
strategically team with foreign entities as well as domestic entities with
foreign business contacts in order to better compete for both domestic and
foreign military contracts. In order to implement these plans, we may incur
substantial costs which may include additional research and development,
prototyping, hiring personnel with specialized skills, implementing and
maintaining technology control plans, technical data export licenses,
production, product integration, marketing, warehousing, finance charges,
licensing, tariffs, transportation and other costs. In the event that working
with foreign entities and/or domestic entities with foreign business contacts
proves to be unsuccessful, this strategy may ineffectively use our resources
which may affect our profitability and the costs associated with such work may
preclude us from pursuing alternative opportunities.




We
are presently classified as a small business and the loss of our small business
status may adversely affect our ability to compete for government
contracts.




We are
presently classified as a small business as determined by the Small Business
Administration based upon the North American Industry Classification Systems
(NAICS) industry and product specific codes which are regulated in the United
States by the Small Business Administration. While we do not presently derive a
substantial portion of our business from contracts which are set-aside for small
businesses, we are able to bid on small business set-aside contracts as well as
contracts which are open to non-small business entities. It is also possible
that we may become more reliant upon small business set-aside contracts. Our
continuing growth may cause us to lose our designation as a small 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 sustain an adverse impact on
our current competitive advantage. The loss of small business status could
adversely impact our ability to compete for government contracts, maintain
eligibility for special small business programs and limit our ability to partner
with other business entities which are seeking to team with small business
entities as may be required under a specific contract.





61




We
intend to pursue international sales opportunities which may require export
licenses and controls and result in the commitment of significant resources and
capital.




In order
to pursue international sales opportunities, we have initiated a program to
obtain product classifications, commodity jurisdictions, licenses, technology
control plans, technical data export licenses and export related programs. Due
to our diverse products, it is possible that some products may be subject to
classification under the United States State Department International Traffic in
Arms Regulations (ITAR). In the event that a product is classified as an
ITAR-controlled item, we will be required to obtain an ITAR export 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 may have a
significant adverse impact on our ability to sell products internationally.
Alternatively, our products may be subject to classification under the United
States Commerce Department’s Export Administration Regulations (EAR). We also
anticipate that we may be required to comply with international regulations,
tariffs and controls and we intend to work closely with experienced freight
forwarders and advisors. We anticipate that an internal compliance program for
international sales will require the commitment of significant resources and
capital.




Increases
in our international sales may expose us to unique and potentially greater risks
than are presented in our domestic business, which could negatively impact our
results of operations and financial condition.




If our
international sales grow, we may be exposed to certain unique and potentially
greater risks than are presented in our domestic business. International
business is sensitive to changes in the budgets and priorities of international
customers, which may be driven by potentially volatile worldwide economic
conditions, regional and local economic and political factors, as well as U.S.
foreign policy. International sales will also expose us to local government
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 and other economic
risks. International contracts may also require the use of foreign
representatives and consultants or may require us to commit to financial support
obligations, known as offsets, and provide for penalties if we fail to meet such
requirements. As a result of these and other factors, we could experience award
and funding delays on international projects or could incur losses on such
projects, which could negatively impact our results of operations and financial
condition.




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




In
pursuing our business strategies, we continually review, evaluate and consider
potential investments and acquisitions. In evaluating such transactions, we are
required 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 and uncertainties, including the difficulty in integrating
newly-acquired businesses, the challenges in achieving strategic objectives and
other benefits expected from acquisitions or investments, the diversion of our
attention and resources from our operations and other initiatives, the potential
impairment of acquired assets and the potential loss of key employees of the
acquired businesses.




The
outcome of litigation in which we have been named as a defendant is
unpredictable and an adverse decision in any such matter could have a material
adverse effect on our financial position or results of operations.




We are
defendants in a number of litigation matters. These matters may divert financial
and management resources that would otherwise be used to benefit our operations.
Although we believe that we have meritorious defenses to the claims made in the
litigation matters to which we have been named a party and intend to contest
each lawsuit vigorously, no assurances can be given that the results of these
matters will be favorable to us. An adverse resolution or outcome of any of
these lawsuits, claims, demands or investigations could have a negative impact
on our financial condition, results of operations and liquidity. Please see
“Business- Legal Proceedings” below.




62




Unanticipated
changes in our tax provisions or exposure to additional income tax liabilities
could affect our profitability.





We are
subject to income taxes in the United States. In the ordinary course of our
business, there are many transactions and calculations where the ultimate tax
determination is uncertain. Furthermore, changes in domestic or foreign income
tax laws and regulations, or their interpretation, could result in higher or
lower income tax rates assessed or changes in the taxability of certain sales or
the deductibility of certain expenses, thereby affecting our income tax expense
and profitability. Although we believe our tax estimates are reasonable, the
final determination of tax audits could be materially different from our
historical income tax provisions and accruals. Additionally, changes in the
geographic mix of our sales could also impact our tax liabilities and affect our
income tax expense and profitability.




Risks
Relating to Our Common Stock




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




Effective
internal controls are necessary for us to provide accurate financial reports. We
are in the process of documenting and testing our internal control procedures to
satisfy the requirements of Section 404 of the Sarbanes Oxley Act of 2002 and
the related rules of the SEC, which require, among other things, our management
to assess annually the effectiveness of our internal control over financial
reporting and our independent registered public accounting firm to issue a
report on that assessment. During the course of this documentation and testing,
we may identify significant deficiencies or material weaknesses that we may be
unable to remediate before the deadline for those reports.




To
address this material weakness, we intend to engage outside experts to provide
counsel and guidance in areas where we cannot economically maintain the required
expertise internally (e.g., with the appropriate classifications and treatments
of complex and non-routine transactions).




As a
result of the material weakness identified with respect to our reporting of
complex transactions, our Chief Executive Officer and Chief Financial Officer
have concluded that our disclosure controls and procedures were not effective to
ensure that the information required to be disclosed by us in the reports that
we file or submit under the Exchange Act was recorded, processed, summarized and
reported within the time periods specified in the SEC’s rules and forms and that
such information required to be disclosed is accumulated and communicated to
management, including our Chief Executive Officer and Chief Financial Officer,
to allow timely decisions regarding required disclosure.




There can
be no assurance that we will maintain adequate controls over our financial
processes and reporting in the future or that those controls will be adequate in
all cases to uncover inaccurate or misleading financial information that could
be reported by members of management. If our controls failed to identify any
misreporting of financial information or our management or independent
registered public accounting firm were to conclude in their reports that our
internal control over financial reporting was not effective, investors could
lose confidence in our reported financial information and the trading price of
our shares could drop significantly. In addition, we could be subject to
sanctions or investigations by the stock exchange upon which our common stock
may be listed, the SEC or other regulatory authorities, which would require
additional financial and management resources.




Volatility
of our stock price could adversely affect stockholders.




The
market 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 analysts
      or investors in a particular
period;




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




·
            operating
      and stock price performance of other companies that investors deem
      comparable 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;




·
            sales
      of substantial amounts of common stock by our directors, executive
      officers or significant stockholders or the perception that such sales
      could occur;





63




·
            general
      economic and political conditions such as recessions and acts of war or
      terrorism; and




·
            other
      matters discussed in the risk
factors.




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




We
currently do not intend to pay dividends on our common stock and consequently
your only opportunity to achieve a return on your investment is if the price of
common stock appreciates.




We
currently do not plan to declare dividends on our common stock in the
foreseeable future. Any payment of cash dividends will depend upon our financial
condition, capital requirements, earnings and other factors deemed relevant by
our board of directors. Agreements governing future indebtedness will likely
contain restrictions on our ability to pay cash dividends. Consequently, your
only opportunity to achieve a return on your investment in the common stock of
our company will be if the market price of our common stock appreciates and you
sell your common stock at a profit.




In
addition, under the Certificate of Designations for the Series A Preferred, an
affirmative vote at a meeting duly called or the written consent without a
meeting of Series A Holders representing at least a majority of the outstanding
shares of Series A Preferred is required for us to pay dividends or any other
distribution on our common stock.




Provisions
in our certificate of incorporation and bylaws or Delaware law might discourage,
delay or prevent a change of control of our company or changes in our management
and, therefore, depress the trading price of our stock.




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




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




·
            provide
      that directors may be removed only “for cause” and only with the approval
      of 662⁄3 percent of our
stockholders;




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




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




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




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




·
            prohibit
      stockholder action by written consent, which requires all stockholder
      actions 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 do the
      same by super-majority vote of stockholders;
and




·
            establish
      advance notice requirements for nominations for election to our board of
      directors or for proposing matters that can be acted upon by stockholders
      at stockholder meetings.




In
addition, Section 203 of the Delaware General Corporation Law may discourage,
delay or prevent a change in control of our company.




64




These and
other provisions contained in our amended and restated certificate of
incorporation and bylaws could delay or discourage transactions involving an
actual or potential change in control of us or our management, including
transactions in which our stockholders might otherwise receive a premium for
their shares over then current prices, and may limit the ability of stockholders
to remove our current management or approve transactions that our stockholders
may deem to be in their best interests and, therefore, could adversely affect
the price of our common stock.




Shares
of stock issuable pursuant to our stock options, warrants and Series A
Convertible Preferred Stock may adversely affect the market price of our common
stock.




As of
September 30, 2009, we had outstanding stock options to purchase an aggregate of
2,095,000 shares of common stock under our 2007 Incentive Compensation Plan and
warrants to purchase an aggregate of 1,448,680 shares of common stock. In
addition, we have 2,530,000 shares of common stock reserved for issuance under
our 2007 Incentive Compensation Plan and 7,500,000 shares reserved for issuance
upon the conversion of our Series A Convertible Preferred Stock.  Our
outstanding warrants and Series A Convertible Preferred Stock also contain
provisions that increase, subject to limited exceptions, the number of shares of
common stock that may be acquired upon the conversion or exercise of such
securities in the event we issue (or are deemed to have issued) shares of our
common stock at a per share price that is less than their then existing exercise
price, in the case of the warrants, and conversion price, in the case of the
Series A Convertible Preferred Stock.  The exercise of the stock
options and warrants would further reduce a stockholder’s percentage voting and
ownership interest. Further, the stock options and warrants are likely to be
exercised when our common stock is trading at a price that is higher than the
exercise price of these options and warrants, and we would be able to obtain a
higher price for our common stock than we will receive under such options and
warrants. The exercise, or potential exercise, of these options and warrants or
conversion of our Series A Convertible Preferred Stock could adversely affect
the market price of our common stock and adversely affect the terms on which we
could obtain additional financing.




Future
Sales, or the availability for sale, of our common stock may cause our stock
price to decline.




We have
registered shares of our common stock that are subject to outstanding stock
options, or reserved for issuance under our stock option plan, which shares can
generally be freely sold in the public market upon issuance. Pursuant to a
settlement with the holders of our Series A Convertible Preferred Stock in May
2009, we also have registered the resale of up to 5,695,505 shares of our common
stock held by such preferred stockholders.  Sales, or the availability
for sale, of substantial amounts of our common stock in the public market could
adversely affect the market price of our common stock and could materially
impair our future ability to raise capital through offerings of our common
stock.




Item 2.         Unregistered
Sales of Equity Securities and Use of Proceeds




None.




Item 3.         Defaults
Upon Senior Securities





None.




Item 4.        
Submission of Matters to a Vote of Security Holders





None.





Item
5.           Other
Information




None.





65





Item
6.          
Exhibits




Exhibit
                  Number
                
                Exhibit3.1
      (1)
                
                Third
      Amended and Restated Certificate of Incorporation3.2
      (2)
                
                Amended
      and Restated Bylaws10.1
      (3)
                
                Accounts
      Receivable Purchase Agreement between the Company and Republic Capital
      Access, LLC, dated July 23, 200910.2
      (4)
                
                First
      Amendment to Accounts Receivable Purchase Agreement, dated October 20,
      2009, between the Company and Republic Capital Access,
  LLC31.1*
                
                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.*




(1)
 Previously filed as an Exhibit to Amendment No. 3 to the Form 10, filed on
April 22, 2008.




(2)
 Previously filed as an Exhibit to Amendment No.1 to the Form 10, filed on
March 21, 2008.





(3)  Previously
filed as an Exhibit to the Current Report on Form 8-K, filed on July 28,
2009.





(4)  Previously
filed as an Exhibit to the Current Report on Form 8-K, filed on October 26,
2009.





*    
 Filed herewith.




SIGNATURES




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




AMERICAN
      DEFENSE SYSTEMS, INC.Date:
      November 23, 2009
                By:
                /s/ Gary SidorskyChief
      Financial Officer





66





Index
to Exhibits





Exhibit
                Number
              
              Exhibit31.1
              
              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.*





67