Table of Contents

 

 

 

**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

 

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

**OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarter Ended June 30, 2008**

 

**CommissionFile Number 000-53092**

 

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**AmericanDefense Systems, Inc.**

(Exact Name of Registrant asSpecified in Its Charter)

 

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

 

**230 Duffy Avenue****Hicksville, NY 11801****(516) 390-5300**

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

 

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

 

Yes  x  No  o

 

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

 

Large Accelerated Filer  o     Accelerated Filer o    Non-AcceleratedFiler  o    SmallerReporting Company  x

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

 

Yes  o  No  x

 

As of August 11, 2008, 39,358,202 shares of common stock, parvalue $0.001 per share, of the registrant were outstanding.

 

 

 

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TABLE OF CONTENTS

 
| **PART I – FINANCIAL  INFORMATION** |                                                                                                  |
|-----------------------------------------------|-------------------------------------------------------------------------------------------------------|
|                                          |                                                                                                  |   |
| Item 1.                                       | Condensed  Financial Statements                                                                       |   |
|                                          | Consolidated  Balance Sheets as of December 31, 2007 and June 30, 2008                      |   |
|                                          | Consolidated Statements of  Operations for the three and six months ended June 30, 2007 and 2008 |   |
|                                          | Consolidated Statements of  Cash Flows for the six months ended June 30, 2007 and 2008           |   |
|                                          | Notes to  Consolidated Financial Statements                                                           |   |
| Item 2.                                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations           |   |
| Item 4.                                       | Controls and  Procedures                                                                              |   |
|                                          |                                                                                                  |   |
| **PART II –  OTHER INFORMATION**    |                                                                                                  |
|                                          |                                                                                                  |   |
| Item 1.                                       | Legal Proceedings                                                                                     |   |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                          |   |
| Item 5.                                       | Other Information                                                                                     |   |
| Item 6.                                       | Exhibits                                                                                              |   |
|                                          |                                                                                                  |   |
| **SIGNATURES**                                |                                                                                                  |
|                                               |                                                                                                       |  |  |

 

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Table of Contents

 

**PART I**

 

**Item 1.    Consolidated Financial Statements**

 

AMERICAN DEFENSE SYSTEMS,INC. AND SUBSIDIARIES

CONSOLIDATEDBALANCE SHEETS

 
| ** **                                                                                                                                                         | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                         | ** ** | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                         | ** ** | **(Unaudited)**   | ** ** | **(Audited)**         | ** ** |
| ASSETS                                                                                                                                                             | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current Assets:                                                                                                                                                    |       |              |       |                  |       |
| Cash                                                                                                                                                               |       | $                 | 6,613,517  |                  | $          | 1,479,886 |   |
| Accounts receivable, net                                                                                                                                           |       | 5,491,623         |       | 6,711,161             |       |
| Inventory                                                                                                                                                          |       | 1,271,365         |       | 737,458               |       |
| Prepaid expenses and other current assets                                                                                                                          |       | 2,940,532         |       | 1,856,236             |       |
| Deferred tax asset                                                                                                                                                 |       | 4,136,982         |       | 4,136,982             |       |
| Costs in excess of billings on uncompleted contracts                                                                                                               |       | 8,462,308         |       | 5,011,974             |       |
| Deposits                                                                                                                                                           |       | 656,430           |       | 608,020               |       |
| Total current assets                                                                                                                                               |       | 29,572,757        |       | 20,541,718            |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Property and equipment, net                                                                                                                                        |       | 3,151,815         |       | 1,194,676             |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Deferred financing cost                                                                                                                                            |       | 1,721,131         |       | —                |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Goodwill                                                                                                                                                           |       | 1,950,000         |       | 1,680,361             |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Advances for future acquisitions                                                                                                                                   |       | 525,350           |       | 138,000               |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Total assets                                                                                                                                                       |       | $                 | 36,921,053 |                  | $          | 23,554,754 |   |
|                                                                                                                                                               |       |              |       |                  |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                          |       |              |       |                  |       |
| Current liabilities:                                                                                                                                               |       |              |       |                  |       |
| Accounts payable                                                                                                                                                   |       | $                 | 3,827,283  |                  | $          | 4,381,930 |   |
| Accrued payroll                                                                                                                                                    |       | 374,847           |       | 205,230               |       |
| Accrued expenses                                                                                                                                                   |       | 329,914           |       | 599,258               |       |
| Dividends payable                                                                                                                                                  |       | 401,252           |       | —                |       |
| Due to Tactical Applications Group                                                                                                                                 |       | 250,000           |       | 1,512,741             |       |
| Deferred tax liability                                                                                                                                             |       | 3,965,150         |       | 3,965,150             |       |
| Short term notes payable                                                                                                                                           |       | 142,903           |       | 64,947                |       |
| Total current liabilities                                                                                                                                          |       | 9,291,349         |       | 10,729,256            |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Long term notes payable                                                                                                                                            |       | —            |       | 27,670                |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Mandatorily redeemable Series A Convertible  Preferred Stock (cumulative). 5,000,000 shares authorized, 15,000 shares  issued and outstanding                      |       | 12,437,584        |       | —                |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Investor warrant liability                                                                                                                                         |       | 265,604           |       | —                |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Total liabilities                                                                                                                                                  |       | 21,994,537        |       | 10,756,926            |       |
|                                                                                                                                                               |       |              |       |                  |       |
| Stockholders’ equity:                                                                                                                                         |       |              |       |                  |       |
| Common stock, $0.001 par value, 100,000,000 shares  authorized, 39,349,050 and 38,957,950 shares issued and outstanding as of  June 30, 2008 and December 31, 2007 |       | 49,055            |       | 48,379                |       |
| Additional paid-in capital                                                                                                                                         |       | 10,219,832        |       | 9,765,432             |       |
| Retained earnings                                                                                                                                                  |       | 4,657,629         |       | 2,984,017             |       |
| Total stockholders’ equity                                                                                                                                    |       | 14,926,516        |       | 12,797,828            |       |
| Total liabilities and stockholders’ equity                                                                                                                    |       | $                 | 36,921,053 |                  | $          | 23,554,754 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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AMERICAN DEFENSE SYSTEMS,INC. AND SUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 
| ** **                                                                                       | ** ** | **For the three months ended June 30,** | ** ** | **For the six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2008**                                                              | ** ** | **2007**                                                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                                       | ** ** | **(Unaudited)**                                                       | ** ** | **(Unaudited)**                                                     | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Contract revenues earned                                                                         |       | $                                                                     | 9,136,078  |                                                                | $          | 10,403,510 |   | $ | 18,556,198 |   | $ | 16,567,366 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Cost of revenues earned                                                                          |       | 6,301,895                                                             |       | 6,303,969                                                           |       | 11,768,573 |   | 9,612,296 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Gross profit                                                                                     |       | 2,834,183                                                             |       | 4,099,541                                                           |       | 6,787,625 |   | 6,955,070 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Operating expenses                                                                               |       |                                                                  |       |                                                                |       |   |   |   |   |
| Research and development expense                                                                 |       | 203,956                                                               |       | 97,972                                                              |       | 369,152 |   | 235,625 |   |
| Marketing expense                                                                                |       | 727,260                                                               |       | 609,488                                                             |       | 1,359,567 |   | 1,279,683 |   |
| General and administrative expense                                                               |       | 728,099                                                               |       | 828,101                                                             |       | 2,656,407 |   | 1,419,234 |   |
| General and administrative salaries expense                                                      |       | 1,097,243                                                             |       | 747,147                                                             |       | 2,254,651 |   | 1,473,569 |   |
| Depreciation                                                                                     |       | 147,666                                                               |       | 91,008                                                              |       | 282,435 |   | 174,979 |   |
| Settlement of litigation                                                                         |       | —                                                                |       | 2,400                                                               |       | 57,377 |   | 85,587 |   |
| Loss on disposal of fixed assets                                                                 |       | —                                                                |       | —                                                              |       | — |   | 136 |   |
| Total operating expenses                                                                         |       | 2,904,224                                                             |       | 2,376,116                                                           |       | 6,979,589 |   | 4,668,813 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Income (loss) from operations                                                                    |       | (70,041                                                               | )          | 1,723,425                                                           |       | (191,964 | ) | 2,286,257 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Other income and (expense):                                                                      |       |                                                                  |       |                                                                |       |   |   |   |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Gain on adjustment of fair value Series A  convertible preferred stock classified as a liability |       | 2,605,159                                                             |       | —                                                              |       | 1,176,494 |   | — |   |
| Gain on investor warrant liability                                                               |       | 1,421,432                                                             |       | —                                                              |       | 1,313,843 |   | — |   |
| Other income (expense)                                                                           |       | 10,159                                                                |       | 33,387                                                              |       | (3,423 | ) | 33,387 |   |
| Interest expense                                                                                 |       | (243,780                                                              | )          | (3,716                                                              | )          | (310,167 | ) | 3,716 |   |
| Interest income                                                                                  |       | 48,305                                                                |       | 65,542                                                              |       | 90,081 |   | (65,542 | ) |
| Total other income (expense)                                                                     |       | 3,841,275                                                             |       | 95,213                                                              |       | 2,266,828 |   | (28,439 | ) |
| Net income before income taxes                                                                   |       | 3,771,234                                                             |       | 1,818,638                                                           |       | 2,074,864 |   | 2,257,818 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Provision for income taxes                                                                       |       | —                                                                |       | 283,638                                                             |       | — |   | 283,638 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net income                                                                                       |       | $                                                                     | 3,771,234  |                                                                | $          | 1,535,000 |   | $ | 2,074,864 |   | $ | 1,974,180 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Preferred stock dividend payable                                                                 |       | (401,252                                                              | )          | —                                                              |       | (401,252 | ) | — |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net income allocated to common stock shareholders                                                |       | 3,369,982                                                             |       | 1,535,000                                                           |       | 1,673,612 |   | 1,974,180 |   |
|                                                                                             |       |                                                                  |       |                                                                |       |   |   |   |   |
| Net income per share – basic and diluted                                                    |       | $                                                                     | 0.09       |                                                                | $          | 0.04 |   | $ | 0.04 |   | $ | 0.05 |   |
| Weighted average number of shares outstanding during  the year – basic and diluted          |       | 39,204,753                                                            |       | 37,300,000                                                          |       | 39,069,337 |   | 37,300,000 |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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AMERICAN DEFENSE SYSTEMS,INC.

AND SUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

For the six months endedJune 30,

 
| ** **                                                                                                 | ** ** | **2008**        | ** ** | **2007**        | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                                                                                                 | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
|                                                                                                       |       |            |       |            |       |
| Cash flows from operating activities:                                                                      |       |            |       |            |       |
| Net income                                                                                                 |       | $               | 2,074,864  |            | $          | 1,974,180 |   |
|                                                                                                       |       |            |       |            |       |
| Adjustments to reconcile net income to net cash used  in operating activities:                             |       |            |       |            |       |
| Change in fair value associated with preferred stock  and warrants                                         |       | (2,490,337      | )          | —          |       |
| Stock based compensation expense                                                                           |       | 54,297          |       | —          |       |
| Amortization of deferred financing costs                                                                   |       | 147,747         |       | —          |       |
| Discount on Series A preferred stock                                                                       |       | 154,604         |       | —          |       |
| Depreciation and amortization                                                                              |       | 282,435         |       | 145,986         |       |
|                                                                                                       |       |            |       |            |       |
| Changes in operating assets and liabilities:                                                               |       |            |       |            |       |
| Restricted cash                                                                                            |       | —          |       | 216,101         |       |
| Accounts receivable                                                                                        |       | 1,219,538       |       | (2,119,473      | )          |
| Inventories                                                                                                |       | (533,907        | )          | 18,050          |       |
| Deposits and other assets                                                                                  |       | (48,410         | )          | —          |       |
| Cost in excess of billing on uncompleted contracts                                                         |       | (3,450,334      | )          | (1,747,650      | )          |
| Prepaid expenses and other assets                                                                          |       | (1,485,548      | )          | (725,324        | )          |
| Deferred financing costs                                                                                   |       | (416,886        | )          | —          |       |
| Advances for future acquisitions                                                                           |       | (387,350        | )          | —          |       |
| Investment in affiliate                                                                                    |       | (1,669,350      | )          | (40,000         | )          |
| Accounts payable and accrued expenses                                                                      |       | (604,801        | )          | (515,308        | )          |
| Accrued liabilities                                                                                        |       | 169,617         |       | 617,114         |       |
| Due to related party                                                                                       |       | 262,741         |       | —          |       |
|                                                                                                       |       |            |       |            |       |
| Net cash used in operating activities                                                                      |       | (6,721,080      | )          | (2,176,324      | )          |
|                                                                                                       |       |            |       |            |       |
| Cash flows from investing activities:                                                                      |       |            |       |            |       |
| Purchase of equipment                                                                                      |       | (2,239,575      | )          | (436,067        | )          |
| Cash paid for acquisition in excess of cash received                                                       |       | (100,000        | )          | —          |       |
|                                                                                                       |       |            |       |            |       |
| Net cash used in investing activities                                                                      |       | (2,339,575      | )          | (436,067        | )          |
|                                                                                                       |       |            |       |            |       |
| Cash flows from financing activities:                                                                      |       |            |       |            |       |
| Proceeds from notes payable                                                                                |       | 62,970          |       | 140,859         |       |
| Repayments of short term financing                                                                         |       | (12,684         | )          | (11,396         | )          |
| Proceeds from the sale of common stock                                                                     |       | 194,000         |       | 260,000         |       |
| Proceeds from sale of Series A Convertible Preferred  Shares, net of of capitalization costs of $1,050,000 |       | 13,950,000      |       | —          |       |
|                                                                                                       |       |            |       |            |       |
| Net cash provided by financing activities                                                                  |       | 14,194,286      |       | 389,463         |       |
|                                                                                                       |       |            |       |            |       |
| NET INCREASE (DECREASE) IN CASH                                                                            |       | 5,133,631       |       | (2,222,928      | )          |
|                                                                                                       |       |            |       |            |       |
| CASH AT BEGINNING OF YEAR                                                                                  |       | 1,479,886       |       | 4,951,302       |       |
|                                                                                                       |       |            |       |            |       |
| CASH AT END OF PERIOD                                                                                      |       | $               | 6,613,517  |            | $          | 2,728,374 |   |
|                                                                                                       |       |            |       |            |       |
| Supplemental disclosure of cash flow information:                                                          |       |            |       |            |       |
| Cash paid during the year for interest                                                                     |       | $               | 7,816      |            | $          | 787 |   |
| Cash paid for taxes                                                                                        |       | $               | —     |            | $          | — |   |
|                                                                                                       |       |            |       |            |       |
| Supplemental disclosure of non-cash financing  activities                                                  |       |            |       |            |       |
| Stock options issued in lieu of compensation                                                               |       | $               | 54,297     |            | $          | — |   |
| Dividends payable                                                                                          |       | $               | 401,252    |            | $          | — |   |
| Fair value of placement agent warrants                                                                     |       | $               | 374,933    |            | $          | — |   |
|                                                                                                       |       |            |       |            |       |
| Assets and liabilities received in acquisition of  American Anti-Ram, Inc.                                 |       |            |       |            |       |
| Fixed assets                                                                                               |       | $               | 30,000     |            | $          | — |   |
| Inventory                                                                                                  |       | $               | 120,000    |            | $          | — |   |
| Goodwill                                                                                                   |       | $               | 280,000    |            | $          | — |   |
| Accounts payable and accrued expense                                                                       |       | $               | (30,000    | )               | $          | — |   |
| Shares issuable in connection with acquisition                                                             |       | $               | (200,000   | )               | $          | — |   |
| Cash paid to American Anti-Ram, Inc.                                                                       |       | $               | (100,000   | )               | $          | — |   |
| Amounts due to American Anti-Ram, Inc.                                                                     |       | $               | (100,000   | )               | $          | — |   |
| Amounts due to American Anti-Ram, Inc.                                                                     |       | $               | (100,000   | )               | $          | — |   |

 

The accompanying notesare an integral part of these consolidated financial statements.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.     NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTINGPOLICIES**

 

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

 

OnNovember 15, 2007, the Company entered into an Asset Purchase Agreementwith Tactical Applications Group (TAG), a North Carolina based soleproprietorship, and its owner.   TAG hasa retail establishment located in Jacksonville, North Carolina that suppliestactical equipment to military and security personnel.

 

InJanuary 2008, American Physical Security Group, LLC (APSG), a wholly ownedsubsidiary of the Company, acquired the assets of American Anti-Ram, Inc.,a manufacturer of crash tested vehicle barricades.    APSG is located in North Carolina.

 

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

 

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

 

The accompanying interimunaudited condensed financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Article 8 of Regulation S-X.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for complete financial statements.In our opinion, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included. Operatingresults for the six-month period ended June 30, 2008 are not necessarilyindicative of the results that may be expected for the year endingDecember 31, 2008. For further information, refer to the financialstatements and footnotes thereto included in the Company’s Form 10 registrationstatement filed with the SEC on April 22, 2008.

 

**Principlesof Consolidation—** The consolidated financial statementsinclude the accounts of American Defense Systems, Inc. and itswholly-owned subsidiaries, A.J Piscitelli & Associates, Inc. andAmerican Physical Security Group, LLC. All significant intercompany accountsand transactions have been eliminated in consolidation.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

**Cash andCash Equivalents—**The Company considers all highly liquidinvestments with maturities of three months or less at the time of purchase tobe cash equivalents.

 

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

 

The Companyreceived certain of its components from sole suppliers. Additionally, theCompany relies on a limited number of contract manufacturers and suppliers toprovide manufacturing services for its products. The inability of any contractmanufacturer or supplier to fulfill supply requirements of the Company couldmaterially impact future operating results.

 

For the six monthsended June 30, 2008 and 2007, the Company derived 99% of its revenues fromvarious U. S. government entities.

 

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

 

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

 

**Goodwilland Indefinite-Lived Intangible Assets—**In accordance with SFAS No. 142,“Goodwill and Other Intangible Assets,” goodwill, represents the excessof the purchase price and related costs over the value assigned to net tangibleand identifiable intangible assets of businesses acquired and accounted forunder the purchase method, acquired inbusiness combinations is assigned to reporting units that are expected tobenefit from the synergies of the combination as of the acquisition date. Underthis standard, goodwill and intangibles with indefinite useful lives are nolonger amortized.  The Company assessesgoodwill and indefinite-lived intangible assets for impairment annually duringthe fourth quarter, or more frequently if events and circumstances indicateimpairment may have occurred in accordance with SFAS No. 142. If thecarrying value of a reporting unit’s goodwill exceeds its implied fair value,the Company records an impairment loss equal to the difference. SFASNo. 142 also requires that the fair value of indefinite-lived purchasedintangible assets be estimated and compared to the carrying value. The Companyrecognizes an impairment loss when the estimated fair value of theindefinite-lived purchased intangible assets is less than the carrying value.   The Company has recorded goodwill associatedwith the asset purchase agreements with TAG and APSG in the amount of$1,950,000 and $1,680,361 as of June 30, 2008 and December 31, 2007.  No impairment loss was recognized as ofJune 30, 2008 or December 31, 2007.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Long-LivedAssets—**The Company reviews long-lived assets and certainidentifiable assets related to those assets for impairment whenevercircumstances and situations change, such that there is an indication that thecarrying amounts may not be recoverable. If the undiscounted cash flows of thelong-lived assets are less than the carrying amount, their carrying amounts arereduced to fair value, and an impairment loss is recognized.

 

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

 

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

 

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

 

Retail revenue - The Companyrecognizes revenue from its retail location upon point of sale.   Due to the nature of the merchandise sold,the Company does not accept returns and, therefore, no provision for returnshas been recorded as of June 30, 2008 or 2007.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**AdvertisingCosts**—The Companyexpenses all advertising costs as incurred.

 

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

 

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

 

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

 

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

 

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

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**Recentaccounting pronouncements**

 

*Business Combinations*

 

In December, 2007,the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards (SFAS) No. 141 (revised 2007), “BusinessCombinations” (hereinafter “SFAS No. 141 (revised 2007)”). This statementestablishes principles and requirements for how an acquirer a) recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed and any noncontrolling interest in the acquiree, b)recognizes and measures the goodwill acquired in the business combination or again from a bargain purchase and c) determines what information to disclose toenable users of the financial statements to evaluate the nature and financialeffects of the business combination. The scope of SFAS No. 141 (revised2007) is broader than the scope of SFAS No. 141, which it replaces. Theeffective date of SFAS No. 141 (revised 2007) is for all acquisitions inwhich the acquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008. The adoption ofthis statement is not expected to have an immediate material effect on theCompany’s consolidated financial condition or results of operations.

 

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

 

In December, 2007,the FASB issued SFAS No. 160, “Noncontrolling Interests in ConsolidatedFinancial Statements – an amendment of ARB No. 51” (hereinafter “SFASNo. 160”). This statement establishes accounting and reporting standardsthat require a) the ownership interests in subsidiaries held by parties otherthan the parent be clearly identified, labeled and presented in theconsolidated statement of financial position with equity, but separate from theparent’s equity, b) the amount of consolidated net income attributable to theparent and to the noncontrolling interest be clearly identified and presentedon the face of the consolidated statement of income, c) changes in a parent’s ownershipinterest while the parent retains its controlling financial interest in itssubsidiary be accounted for consistently, d) when a subsidiary isdeconsolidated, any retained noncontrolling equity investment in the formersubsidiary be initially measured at fair value and e) entities providesufficient disclosures that clearly identify and distinguish between theinterests of the parent and the interests of the noncontrolling owners. Theeffective date of this standard is for fiscal years and interim periodsbeginning on or after December 15, 2008. The adoption of this statement isnot expected to have an immediate material effect on the Company’s consolidatedfinancial condition or results of operations.

 

*Disclosureabout Derivative Instruments and Hedging Activities*

 

InMarch 2008, the FASB issued SFAS No. 161, *“*Disclosure about Derivative Instruments and HedgingActivities*,”* an amendment of FASBStatement No. 133, (SFAS 161). This statement requires that objectives forusing derivative instruments be disclosed in terms of underlying risk andaccounting designation. The Company is required to adopt SFAS 161 onJanuary 1, 2009. The Company is currently evaluating the potential impactof SFAS No. 161 on the Company’s consolidated financial statements.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

*Determinationof the Useful Life of Intangible Assets*

 

InApril 2008, the FASB issued FSP FAS 142-3, “Determination of the UsefulLife of Intangible Assets,”, which amends the factors that should be consideredin developing renewal or extension assumptions used to determine the usefullife of intangible assets under FASB 142 “Goodwill and Other IntangibleAssets”.  The intent of this FSP is to improve the consistency between theuseful life of a recognized intangible asset under SFAS 142 and the period ofthe expected cash flows used to measure the fair value of the asset under FASB141 (revised 2007) “Business Combinations” and other U.S. generally acceptedaccounting principles.    The Company is currently evaluatingthe potential impact of FSP FAS 142-3 on its consolidated financial statements.

* *

*TheHierarchy of Generally Accepted Accounting Principles*

 

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

 

*Accounting for Convertible Debt Instruments That May Be Settled inCash upon Conversion (Including Partial Cash Settlement)*

 

InMay 2008, the FASB issued FSP Accounting Principles Board (“APB”) OpinionNo. 14-1, “Accounting for Convertible Debt Instruments That May BeSettled in Cash upon Conversion (Including Partial Cash Settlement).” The FSPclarifies the accounting for convertible debt instruments that may be settledin cash (including partial cash settlement) upon conversion.  The FSP requires issuers to accountseparately for the liability and equity components of certain convertible debtinstruments in a manner that reflects the issuer’s nonconvertible debt(unsecured debt) borrowing rate when interest cost is recognized.  The FSP requires bifurcation of a componentof the debt, classification of that component in equity and the accretion ofthe resulting discount on the debt to be recognized as part of interest expensein our consolidated statement of operations. The FSP requires retrospective application to the terms of instrumentsas they existed for all periods presented. The FSP is effective for us as of January 1, 2009 and earlyadoption is not permitted.  The Companyis currently evaluating the potential impact of FSP APB 14-1 upon itsconsolidated financial statements.

 

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

 

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

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

InJune 2008, the FASB issued FSP Emerging Issues Task Force (“EITF”) IssueNo. 03-6-1, “Determining Whether Instruments Granted in Share-BasedPayment Transactions Are Participating Securities.” The FSP addresses whetherinstruments granted in share-based payment transactions are participatingsecurities prior to vesting and, therefore, need to be included in the earningsallocation in computing earnings per share under the two-class method. The FSPaffects entities that accrue dividends on share-based payment awards during theawards’ service period when the dividends do not need to be returned if theemployees forfeit the award. This FSP is effective for fiscal years beginningafter December 15, 2008. The Company is currently assessing the impact ofFSP EITF 03-6-1 on its consolidated financial position and results ofoperations.

 

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

 

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

 

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

 
| ** **                                           | ** ** | **2008** | ** ** | **2007** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| Uncompleted  contract costs                          |       | $        | 8,462,308  |     | $          | 5,011,974 |   |
| Billings and /  or receipts on uncompleted contracts |       | —   |       | —   |       |
| Cost in excess  of billings on uncompleted contracts |       | $        | 8,462,308  |     | $          | 5,011,974 |   |

 

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

 

Accountsreceivable throughout the year may decrease based on payments received, creditsfor change orders, or back charges incurred. At June 30, 2008 andDecember 31, 2007, the Company had $5,491,623 and $6,711,161,respectively, of accounts receivable, of which the Company considers all to befully collectible.

 

There was no baddebt expense recorded for the six months ended June 30, 2008 and 2007.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**3.             COMMITMENTS AND CONTINGENCIES**

 

**Legal Proceedings—**

 

OnJuly 10, 2007, the Company filed a lawsuit against a former subcontractor,Southern California Gold Products d/b/a Gypsy Rack, the subcontractor’sPresident and owner, Glenn Harris, and a designer, James McAvoy in the UnitedStates District Court, Eastern District of New York. Defendants moved to changevenue to the Central District of California based upon insufficient contacts tothe State of New York and on October 12, 2007 the matter was transferredto the United States District Court for the Central District of California,Case Number 07-CV-02779. On February 21, 2008, pursuant to the court’s order,we filed an amended complaint. The amended complaint names only SouthernCalifornia Gold Products and James McAvoy as defendants and asserts six countsas follows: misappropriation of trade secrets and confidential information;breach of contract; unfair competition; conversion; violation of the LanhamAct; and interference with prospective economic advantage. The amendedcomplaint seeks to enjoin the defendants from misappropriating, disclosing, orusing our confidential information and trade secrets, and recall and surrenderall products and trade secrets wrongfully misappropriated or converted by thedefendants. It also seeks compensatory damages in an amount to be establishedat trial together with prejudgment and post judgment interest, exemplary damages,disgorgement, restitution with interest, attorney’s fees and the costs of suit.Defendants filed an answer to the amended complaint on April 16, 2008. Shortlyafter the filing of the amended answer, defendants made a motion for summaryjudgment on, among others, the grounds of collateral estoppel and resjudicata.  The Company filed oppositionto the motion. The motion for summary judgment is scheduled for argument beforethe court on August 25, 2008.

 

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

 

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

 

OnMarch 4, 2008, the Company’s former General Counsel, commenced an actionwith the United States Department of Labor, Occupational Safety and Health andSafety Administration, alleging retaliation in contravention of theSarbanes-Oxley Act. The Complaint seeks damages in excess of $3,000,000. TheCompany believe the allegations to be without merit and intend to vigorouslydefend against the action. On March 7, 2008, a second action was commencedagainst the Company for breach of contract and related issues arising from histermination of employment in New York State Supreme Court, Nassau County.  On May 7, 2008, the Company serveda motion to dismiss the complaint, which is fully submitted to the Court. No amounts have been accrued for damages asthe Company believes meritorious defenses to the claims exist. The Companyintends to vigorously defend this action.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**4.             STOCKHOLDERS’ EQUITY**

 

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

 

The following is asummary of stock warrants outstanding at June 30, 2008 andDecember 31, 2007.

 
| ** **                            | ** ** | ** **   | ** ** | **Exercise** | ** ** | **Value**        | ** ** |
|---------------------------------------|------------|--------------|------------|--------------|------------|------------------|------------|
| ** **                            | ** ** | **Warrants** | ** ** | **Price**    | ** ** | **If Exercised** | ** ** |
| Beginning Balance,  December 31, 2007 |       | 808,462      |       | 1.00         |       | 808,462          |       |
|                                  |       |         |       |         |       |             |       |
| Exercised                             |       | (25,630      | )          | 1.00         |       | (25,630          | )          |
|                                  |       |         |       |         |       |             |       |
| Ending Balance,  June 30, 2008        |       | 782,832      |       | 1.00         |       | 782,832          |       |

 

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

 

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

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

 

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

 

**StockOption Plan –** On December 3, 2007, the Company adoptedthe American Defense Systems, Inc. 2007 Incentive Compensation Plan.  Under this plan, stock options may be grantedto employees, officers, consultants or others who provide services to the Company.  On December 14, 2007, 1,645,000 stock optionswere granted to officers and employees of the Company.  An additional 72,500 stock options weregranted to employees of the Company on February 20, 2008.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

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

 

Based on theassumptions noted above, the fair market value of the options issued was valuedat $430,472, of which $54,297 and $0 has been expensed in the Statement ofOperations as of June 30, 2008 and 2007, respectively.

 

**Sharesissued in connection with Asset Purchase Agreement –** InJanuary 2008, the Company acquired the assets of American PhysicalSecurity Group., a manufacturer of crash tested vehicle barricades.   The purchase price for this acquisition isexpected to be $600,000.  Of this amount,$100,000 has been paid in cash and 100,000 shares of stock were issued, valuedat $2 per share.  The Company will payanother $100,000 by the end of 2008.  Theremaining purchase price will be negotiated based on performance.  The Company acquired approximately $120,000in net assets in this acquisition.

 

**5.             ACQUISITION**

 

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

 

The Companyacquired approximately $120,000 in net assets in this acquisition.   As of June 30, 2008, the Company haspaid $300,000 toward the anticipated purchase price.    The remaining balance due of $100,000 underagreement has been accrued as of June 30, 2008.

 

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

** **

**6.             SERIES A CONVERTIBLE PREFERREDSTOCK, INVESTOR WARRANTS AND PLACEMENT WARRANTS**

 

TheCompany entered into a Securities Purchase Agreement (“Purchase Agreement”) onMarch 7, 2008 to sell shares of its Series A Convertible PreferredStock (“Series A Preferred”) and warrants (“Investor Warrants”) topurchase shares of its common stock, and to conditionally sell shares of theCompany’s common stock, to three investors. The investors have agreed topurchase an aggregate of 15,000 shares of Series A Preferred and InvestorWarrants to purchase up to 3,750,000 shares of common stock, and toconditionally purchase 100,000 shares of common stock. The aggregate purchaseprice for the Series A Preferred and Investor Warrants is $15,000,000 andthe aggregate purchase price for the common stock is $500,000.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

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

 

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

 

Series AConvertible Preferred Stock

 

Theprovisions for the Series A Preferred are as follows:

* *

*Dividendson Series A Preferred*

 

The shares of Series A Preferred accrue acumulative dividend at a rate of 9% per annum of the Conversion Amount, asdefined below. Dividends on the Series A Preferred shall be cumulative,shall accrue, whether or not declared, and be payable quarterly in cash or, atthe Company’s option, payable in common stock at 10%.   As of June 30, 2008, the Company hasaccrued $401,252 for dividends payable.

* *

*LiquidationPreference*

 

In the event of the liquidation, dissolution orwinding up of the affairs of the Company, whether voluntary or involuntary (a“Liquidation”), the holders of shares of the Series A Preferred thenoutstanding shall be entitled to receive an amount per Series A Preferredequal to 110% of the Conversion Amount.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

*Voting Rights*

 

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

* *

*Holder’s Right to Convert*

 

At any time the holder of any such shares ofSeries A Preferred may, at such holder’s option, elect to convert all orany portion of their whole number of shares of Series A Preferred held bysuch person into Common stock at the Conversion Rate, which is equal to theConversion Amount divided by the Conversion Price.  The Conversion Amount shall initially beequal to the Stated Value ($1,000 per share) times the number of shares subjectto conversion.  The Conversion Price isthe Initial Conversion Price ($2.00). The conversion Price shall be reduced by (i) 4% of the InitialConversion Price on or after May 30, 2008 if the Company’s common stock isnot listed on an Eligible Market and (ii) a further 1.5% of the InitialConversion Price on each 30th day thereafter until the Company’s commonstock is so listed; provided, however, that all decreases shall in no event bemore than 10% of the Initial Conversion Price. The Conversion Price is also subject to certain standard anti-dilutionadjustment provisions.

* *

*Redemption at Option of Holders*

 

Triggering Event – Upon the occurrence of aTriggering Event, each Holder may, at such Holder’s option, subject to theLimitation on Damages, require the Company to redeem all or a portion of suchHolder’s Series A Stock shares at a price per Preferred Share equal to thegreater of (i) 110% of the Conversion Amount (or, in the case of theTriggering Events set forth in Sections 3(a)(v) and 3(a)(vi), 100% of theConversion Amount) and (ii) the product of (A) the Conversion Rate ineffect at such time and (B) the Closing Sale Price of the Company’s commonstock on the trading day immediately preceding such Triggering Event (the“Triggering Event Redemption Price”).

 

Failure to Satisfy Equity Condition - If theEquity Conditions are not satisfied as of December 31, 2008, then on anydate thereafter that any Equity Condition (as defined in the Series APreferred Certificate) is not satisfied the Holders shall have the right, inits sole discretion, to require that the Company redeem all of or any portionof such Holder’s Series A Preferred shares in case at a price equal to100% of the Conversion Amount.

* *

*Redemptionby Company*

 

Mandatory redemption – If any Series APreferred shares remain outstanding on the Maturity Date, which isDecember 31, 2010, the Company shall redeem all such Series A Preferredshares on the Maturity Date for an amount in cash per Preferred Share equal tothe Conversion Amount.

 

Optional redemption – At any time on or after the(i) 2nd anniversary of the Public Company Date (the date onwhich the Company’s securities are initially registered under the ExchangeAct), (A) the median price of the Weighted Average Price of the Company’scommon stock over any consecutive 30 Trading Day period is greater than $3.00per share, (B) the median trading 

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

volume for such period is greater than 75,000 sharesand (C) there shall not have been any Equity Conditions Failure or(ii) 6-month anniversary of a Qualified Public Offering and there shallnot have been any Equity Conditions Failure, the Company shall have the rightto redeem any or all of the Series A Preferred shares to cash in an amountequal to 100% of the Conversion Amount.

* *

*Accountingfor the Series A Preferred*

 

The Company accounted for the transaction inaccordance with SFAS 150 “Accounting for Certain Financial Instrument withCharacteristics of both Liabilities and Equity”.  SFAS 150 provides guidance on how financialinstruments should be classified and measured when characteristics of bothliabilities and equity exist and requires that an entity classify a financialinstrument that is within its scope as a liability because the financialinstrument embodies an obligation of the issuer.  The mandatory redemption provisionincorporated into the Series A Preferred causes the stock to fall withinthe scope of SFAS 150 since the Company must redeem the stock byDecember 31, 2010 by transferring cash to the Holders.

 

The proceeds from the issuance of theSeries A Preferred and accompanying common stock warrants, net of directcosts including the fair value of warrants issued to placement agent in connectionwith the transaction, must be allocated to the instruments based upon relativefair value upon issuance.  In addition,under SFAS 150, paragraph 20, “mandatorily redeemable instruments must bemeasured initially at fair value”.  Therefore, after the initial recording of the Series A Stock basedupon net proceeds received, the carrying value of the Series A Preferredmust be adjusted to the fair value at the date of issuance, with the differencerecorded as a loss.    The initialvaluation of the Series A Preferred is as follows:

 
| **Security**  | ** ** | **Face Value** | ** ** | **Fair Value** | ** ** | **Allocation of  proceeds** | ** ** | **Proceeds in excess  of fair value** | ** ** |
|---------------|------------|---------------------|------------|---------------------|------------|----------------------------------|------------|-----------------------------------------------------------|------------|
| Series A |       | $                   | 15,000,000 |                | $          | 12,437,584                       |       | $                                                         | 13,459,474 |   | $ | 1,021,890 |   |
| Preferred     |       |                |       |                |       |                             |       |                                                      |       |
| Warrants      |       | —              |       | 265,604             |       | 1,540,526                        |       | 1,274,922                                                 |       |
|          |       | $                   | 15,000,000 |                | $          | 12,703,188                       |       | $                                                         | 15,000,000 |   | $ | 2,296,812 |   |

 

The Series A Preferred has been included as anoncurrent liability until December 31, 2009, at which time it will beincluded as a current liability.

 

For the three months ended June 30, 2008, theCompany has recorded a net gain on adjustment of fair value of theirSeries A Preferred of $2,605,159. The total net gain on adjustment as of June 30, 2008 is $1,176,494.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

Investor Warrants

 

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

 

Theterms of the investor warrants provide the following:

 

(a)                                 Exercise price of $2.40 per share.  If not listed on an eligible market on orbefore May 30, 2008, the exercise price shall be reduced $.10 and shall befurther decreased by $.04 on each 30th day thereafter until suchlisting occurs, subject to a maximum of $.24

 

(b)                                 The investor warrants are immediatelyexercisable upon issuance through the date that is 36 months after the PublicCompany date.

 

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

 

(d)                                 In the event of a Fundamental Transaction,the Holders may request that the Company repurchase the Warrant from theHolders by paying a cash amount equal to the Black-Scholes Value of theremaining unexercised portion on the date of the Fundamental Transaction.   Fundamental Transactions are defined withinthe terms of the Investor Warrant Agreement.

 

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

 

TheInvestor Warrants were accounted for as follows:

 

(a)   The warrants meet thecriteria under SFAS 133 “Accounting for Derivative Instruments and HedgingActivities”.  Under SFAS 133, thewarrants are recorded at fair value upon the date of issuance, with changes inthe value fair value recognized as a gain or loss as they occur.   At the initial date of issuance, the Companyrecorded a derivative liability of $1,142,503, which represents the fair valueof the Investor Warrants and a loss on Investor Warrants of $146,510.  Upon the second closing, the Company recordeda derivative liability of an additional $398,023 and a loss on InvestorWarrants of $51,836.  This liability wassubsequently adjusted to fair value as of June 30, 2008 and acorresponding fair value adjustment of $1,473,268 reduced the derivativeliability.   The total net gain onInvestor Warrants as of June 30, 2008 was $1,313,843.

 

(b)   The warrants meet thecriteria under EITF 01-6 “The Meaning of Indexed to a Company’s Own Stock”,which provides guidance as to whether a contract is indexed to a Company’s ownstock.    However, since the warrants donot meet the criteria for reporting as an equity instruments under EITF 00-19“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock”, the fair value of the Investor Warrants isincluded as a noncurrent liability.

 

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**AMERICANDEFENSE SYSTEMS, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

In valuing the Investor Warrants associated with the Series APreferred Stock the Company used the Black-Scholes option pricing model withthe following range of assumptions:

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

 

The resulting values per warrant for the March 7, 2008 and theApril 4, 2008 issuances were $.47 and $.07, respectively.  The resulting fair value associated with the3,750,000 Investor Warrants as of June 30, 2008 was $265,604.

 

Placement Agent Warrants

 

Inconnection with the sale of the Series A Preferred and Investor Warrants,the placement agent was entitled to receive warrants (Placement Agent Warrants)to purchase a total of 6% of the number of common stock issued in the financingor 675,000 shares.   The Placement AgentWarrants were accounted for as a transaction cost associated with the issuanceof the Series A Preferred.  ThePlacement Agent Warrants recorded at fair value at the date of issuance.  Under EITF 00-19 “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock”, the Company satisfies the criteria for classification of the PlacementAgent Warrants as equity.   The Companyhas recorded the corresponding amount recorded as a Deferred Financing Cost.  Since the Series A Preferred andInvestor Warrants are classified as liabilities, the carrying value of thePlacement Agent Warrants has been recorded as an other asset and is amortizedas additional financing costs over the term of the Series A Preferredusing the interest method.  At the dateof each issuance, the Company recorded $1,033,433 and $418,559 in deferredfinancing costs and amortized $147,747 as interest expense as of June 30,2008.

 

In valuing the Placement Agent Warrants associated with the Series APreferred the Company used the Black-Scholes option pricing model with thefollowing range of assumptions:

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

 

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

 

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

 

*The following discussion andanalysis of our financial condition and results of operations should be read inconjunction with our consolidated financial statements and related notes thatappear elsewhere in this repor**t and in our registration statement on Form 10 (SECNo. 0-53092) filed with the SEC on April 22, 2008.*

 

*Except for statements of historical fact, certaininformation described in this report contains “forward-looking statements” thatinvolve substantial risks and uncertainties. You can identify these statementsby forward-looking words such as “anticipate,” “believe,” “could,” “estimate,”“expect,” “intend,” “may,” “should,” “will,” “would” or similar words. Thestatements that contain these or similar words should be read carefully becausethese statements discuss our future expectations, contain projections of ourfuture results of operations or of our financial position, or state other“forward-looking” information. We believe that it is important to communicateour future expectations to our investors. However, there may be events in thefuture that we are not able accurately to predict or control. Further, we urgeyou to be cautious of the forward-looking statements which are contained inthis report because they involve risks, uncertainties and other factorsaffecting our operations, market growth, service and products. The factorslisted in the section captioned “Risk Factors” within Item 1A, “Description ofBusiness,” in our Form 10 Registration Statement filed with the SEC onApril 22, 2008, as well as other cautionary language in suchForm 10,  describe such risks,uncertainties and events that may cause our actual results and achievements,whether expressed or implied, to differ materially from the expectations wedescribe in our forward-looking statements. The occurrence of any of the eventsdescribed as risk factors could have a material adverse effect on our business,results of operations and financial position.*

 

**Overview**

 

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

 

We also sell physicalsecurity products consisting primarily of vehicle anti-ram barriers such asbollards, steel gates and steel wedges that deploy out of the ground.  In addition, we sell tactical products such asbody armor, nylon holsters, vests and packs, weapons, ammunition, weapons partsand accessories through a retail outlet.

 

In May 2008, we launchedour new live-fire interactive T2 Tactical Training System and have begun activemarketing of the system.  T2 provides lawenforcement officers, SWAT team members, tactical specialists and militaryoperators with the opportunity to hone their firearms and combat skills, withtheir own weapons and ammunition, in conjunction with realistic video scenariosbroadcast on a large screen, incorporating environmental factors such as heat,cold, sound and light effects.  Inaddition to installation fees for T2 systems, we anticipate additional revenueopportunities for service and support of T2 facilities once installed.

 

Our technical expertise is inthe development of lightweight composite ballistic, blast and bullet mitigatingmaterials used to fortify and enhance capabilities of existing and in-serviceequipment and structures. We serve primarily the defense market and our saleare highly concentrated within the U.S. government. Our customers includevarious branches of the U.S. military through the U.S. Department of Defense(or DoD) and to a much lesser extent other government, law enforcement andcorrectional agencies as well as private sector customers.

 

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We have experiencedsignificant growth, with revenues of $4.8 million, $25.3 million and $36.5million in 2005, 2006 and 2007, respectively, and $18.6 million for the sixmonths ended June 30, 2008. The principal factor contributing to ourrecent growth has been increased demand by the U.S. military for lightweightballistic and blast resistant transparent and opaque armor that protectssoldiers, sailors and marines.

 

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

 

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

 

· form strategic partnershipswith original equipment manufacturers (OEMs);

 

· develop strategic alliances;

 

· capitalize on increasedhomeland security requirements and non-military platforms; and

 

· focus on an advancedresearch and development program to capitalize on increased demand for newarmor materials.

 

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

 

**Sources of Revenues**

 

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

 

Our contract backlog as ofJune 30, 2008 and 2007 was $45 million and $32 million,respectively.  Of our $45 million contract backlog at June 30, 2008,we estimate that $30 million, $10 million and $5 million will be filled duringthe remainder of 2008 and in 2009 and 2010, respectively. Accordingly, in orderto maintain our current growth rate or even our current revenue levels, we willneed to win more contracts with the U.S. government and other commercialentities, achieve significant penetration into critical infrastructure andpublic safety protection markets, and successfully further develop ourrelationships with OEM’s and strategic partners. Notwithstanding the possiblesignificant troop reductions in Afghanistan and Iraq, we expect that demand inthose countries for armored military construction vehicles will continue inorder to repair significant war damage and for nation-building purposes. Inaddition, we are exploring interest in armored construction equipment in othercountries with mine-infested regions.

 

We continue to aggressivelybid on projects and are in preliminary talks with a number of internationalfirms to pursue long-term government and commercial contracts, including withrespect to Homeland Security. While no assurances can be given that we willobtain a sufficient number of contracts or that any contracts we do obtain willbe of significant value or duration, we are confident that we will continue tohave the opportunity to bid and win contracts as we have in 2006 and 2007.

 

**Cost of Revenues and Operating Expenses**

 

*Cost of Revenues.* Cost of revenues consists of parts, direct labor andoverhead expense incurred for the fulfillment of orders under contract. Thesecosts are charged to expense upon completion and acceptance of an 

 

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order. Costs of revenue also includes the costs of protypingand engineering, which are expensed upon completion of an order as well. Thesecosts are included as costs of revenue because they are incurred to modifyproducts based upon government specifications and are reimbursable costs withinthe contract. These costs for the production of goods under contract areexpensed when they are complete. We allocate overhead expenses such as employeebenefits, computer supplies, depreciation for computer equipment and officesupplies based on personnel assigned to the job. As a result, indirect overheadexpenses are included in cost of revenues and each operating expense category.

 

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

 

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

 

*Research and Development.* Research and development expenses are incurred as weperform ongoing evaluations of materials and processes for existing products,as well as the development of new products and processes. Such expensestypically include compensation and employee benefits of engineering and testingpersonnel, materials, travel and costs associated with design and requiredtesting procedures associated with our product line. We expect that in the remainderof 2008, research and development expenses will increase in absolute dollars aswe upgrade and extend our service offerings and develop new protectionsproducts, but will remain relatively consistent or decrease slightly as apercentage of revenues. Research and development costs are charged to expenseas incurred.

 

*General and Administrative.* General and administrative expenses consist of compensationand related expenses for executive, finance, accounting, administrative, legal,professional fees, other corporate expenses and allocated overhead. We expectthat in the remainder of 2008, general and administrative expenses willincrease in absolute dollars but decrease as a percentage of revenues.

 

**Critical Accounting Policies**

 

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

 

We believe that of oursignificant accounting policies, which are described in Note 1 to theconsolidated financial statements, the following accounting policies involve agreater degree of judgment and complexity. Accordingly, these are the policies webelieve are the most critical to aid in fully understanding and evaluating ourconsolidated financial condition and results of operations.

 

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

 

We recognize revenue andreport profits from purchases orders filled under master contracts under thecompleted contract method. Purchase orders received under master contracts mayextend for periods in excess of one year. Contract costs are accumulated asdeferred assets and billings and/or cash received are charged to a deferredrevenue account during the periods of construction. However, no revenues, costsor profits are recognized in operations until the period upon completion of theorder. An order is considered complete when all costs, except 

 

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insignificant items, have been incurred, installation isoperating according to specification or the shipment has been accepted by thecustomer. Provisions for estimated contract losses are made in the period thatsuch losses are determined. As of June 30, 2008 and December 31,2007, there were no such provisions made.

 

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

 

All billings associated withuncompleted purchase orders under contract are recorded on the balance sheet asa deferred liability called “Billings in Excess of Costs on UncompletedContracts”. Upon completion of a purchase order, all such associated billingswould be reclassified from the balance sheet to the statement of operations asrevenues. Due to the structure of our contracts, billing is not done until thepurchase order is complete, therefore there are no amounts recorded as deferredliabilities as of June 30, 2008 or December 31, 2007.

 

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

 

In December 2007, we adoptedour 2007 Incentive Compensation Plan pursuant to which we have issued and intendto 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 suchcompensation in the form of stock options is as follows:

 

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

 

Because we have only recentlybecome a public entity, we will have a limited trading history. The expectedterm of an award is based on the “simplified” method allowed by SABNo. 107, whereby the expected term is equal to the midpoint between thevesting date and the end of the contractual term of the award. The risk-freeinterest rate will be based on the rate on U.S. Treasury zero coupon issueswith maturities consistent with the estimated expected term of the awards. Wehave not paid and do not anticipate paying a dividend in the foreseeable futureand accordingly, use an expected dividend yield of zero. Changes in theseassumptions can affect the estimated fair value of options granted and therelated compensation expense which may significantly impact our results ofoperations in future periods.

 

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

 

We recognized $54,297 and$6,800 in stock compensation expense as of June 30, 2008 andDecember 31, 2007, respectively.

 

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

 

*Series A Preferred Stock*.  We accounted for our Series A ConvertiblePreferred Stock (or Series A Preferred) in accordance with SFAS 150“Accounting for Certain Financial Instrument with Characteristics of bothLiabilities and Equity”.  SFAS 150 provides guidance on how financialinstruments should be classified and measured when characteristics of bothliabilities and equity exist and requires that an entity classify a financialinstrument that is within its scope as a liability because the financialinstrument embodies an obligation of the issuer.  The mandatory redemptionprovision incorporated into the Series A Preferred causes the stock tofall within 

 

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the scope of SFAS 150 since we must redeem the stock byDecember 31, 2010 by transferring cash to the holders of the Series APreferred.

 

The proceeds from theissuance of the Series A Preferred and accompanying common stock warrants,net of direct costs including the fair value of warrants issued to thePlacement Agent in connection with the transaction, must be allocated to theinstruments based upon relative fair value upon issuance.  In addition,under SFAS 150, paragraph 20, “mandatorily redeemable instruments must bemeasured initially at fair value”.   Therefore, after the initialrecording of the Series A Preferred based upon net proceeds received, thecarrying value of the Series A Preferred must be adjusted to the fairvalue at the date of issuance, with the difference recorded as a loss.

 

*Investor Warrants.*  The warrants issued with the Series A Preferred(or Investor Warrants) meet the criteria under SFAS 133 “Accounting forDerivative Instruments and Hedging Activities”.  Under SFAS 133, thewarrants are recorded at fair value upon the date of issuance, with changes inthe value fair value recognized as a gain or loss as they occur.  On March 7,2007, the date of initial issuance, we recorded a derivative liability of$1,142,503.  On April 4, 2008, thedate of the second issuance, we recorded a derivative liablity of$398,023.  These liabilities weresubsequently adjusted to fair value as of June 30, 2008, which resulted ina net gain of $1,313,843.  As ofJune 30, 2008, the Investor Warrant liability was $265,604.

 

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

 

*Placement Agent Warrants.*  The warrants issued to the Placement Agent withrespect to the sale of the Series A Preferred and Investor Warrants (or PlacementAgent Warrants) were accounted for as a transaction cost associated with theissuance of the Series A Preferred.  The Placement Agent Warrants arerecorded at fair value at the date of issuance.  Under EITF 00-19“Accounting for Derivative Financial Instruments Indexed to, and PotentiallySettled in, a Company’s Own Stock”, we satisfy the criteria for classificationof the Placement Agent Warrants as equity.   We have recorded thecorresponding amount recorded as a Deferred Financing Cost.  Since theSeries A Preferred and Investor Warrants are classified as liabilities,the carrying value of the Placement Agent Warrants has been recorded as another asset and is amortized as additional financing costs over the term of theSeries A Preferred using the interest method.  At the date of each issuance,we recorded $1,033,433 and $418,559 in deferred financing costs and amortized$147,747 as interest expense as of June 30, 2008.

 

***Comparison of the Three Months EndedJune 30, 2008 versus June 30, 2007***

 

*Revenues.*  Revenues for the three months endedJune 30, 2008 were approximately $9.1 million, a decrease of approximately$1.3 million, or 12.5%, over revenues of approximately $10.4 million in thecomparable period in 2007.  This decrease was due primarily to a highervolume of orders completed under our U.S. Marine Corp. sole source contract(no. M6785407D5023) during the second quarter of 2007 versus the same quarterin 2008.

 

*Cost ofRevenues.* Costof revenues for the three months ended June 30, 2008 and June 30,2007 were approximately $6.3 million for each period.   As a percentage of revenue, the cost ofrevenue was 69% for the three months ended June 30, 2008 versus 61% forthe three months ended June 30, 2007. This increase was due primarily to additional costs of sales includedfrom the tactical application retail outlet and physical security productbusiness, both of which were not in existence in 2007.  In addition, the increase was related to ourincreased production costs under the Marine Corp. sales contract mentionedabove.  Cost of sales for the three months ended June 30, 2007 alsoincluded costs related to orders filled for spare parts, which have a muchlower cost.

 

*Grossprofit margin*.  The gross profit margin for the three months ended June 30, 2008 andJune 30, 2007 was approximately $2.8 million and $4.1 million,respectively.  The gross profit margin percentage was 31% and 39% for thethree months ended June 30, 2008 and June 30, 2007,respectively.  The decrease in gross profit margin percentage was dueto higher costs associated with production associated with the MarineCorp. sales contract and lower gross profit margins associated with ourtactical application retail outlet and our physical security product 

 

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business.  Gross profit marginfor the three months ended June 30, 2007 also includes sales related toorders filled for spare parts, which have higher gross profit margins.

 

*Sales andMarketing Expenses.*  Salesand marketing expenses for the three months ended June 30, 2008 andJune 30, 2007 were approximately $727,000 and $609,000, respectively,representing an increase of $118,000, or 19%.  We increased our sales andmarketing department from 7 employees as of June 30, 2007 to 15 employeesas of June 30, 2008.   This increasein personnel resulted in approximately $120,000 in additional salaries andemployee benefits expense.

 

*Research andDevelopment Expenses.*  Researchand development expenses for the three months ended June 30, 2008 andJune 30, 2007 were approximately $204,000 and $98,000, respectively. The increase of $106,000 or 108% from 2007 to 2008 was the result of additionaltesting and improvements of existing products.

 

*Generaland Administrative Expenses.*  General and administrative expenses for the three monthsended June 30, 2008 and June 30, 2007 were approximately $728,000 and$828,000, respectively.  The decrease of $100,000, or 12%, was primarilydue primarily to expansion expenses incurred during the three months endedJune 30, 2007 that were not incurred during the three months endedJune 30, 2008.

 

 *Generaland Administrative Salaries Expense .*  General andadministrative salaries expense for the three months ended June 30, 2008and June 30, 2007 were approximately $1.1 million and $747,000,respectively.  The increase of $353,000, or 47%, was primarily due to theincrease in personnel associated with our expansion and our acquisition of theour tactical application retail outlet and our physical security productbusiness.  As of June 30, 2008,there were 41 employees that were classified as general and administrativepersonnel, versus 27 employees as of June 30, 2007.

 

*Depreciationexpense.* Depreciation expense was approximately $148,000 and $91,000 for the threemonths ended June 30, 2008 and June 30, 2007, respectively.  Theincrease of $57,000, or 63%, resulted from the expansion of our headquartersduring 2008, which resulted in higher depreciation expense.  For the threemonths ended June 30, 2008, we acquired additional property and equipmentassociated with our tactical application retail outlet and our physicalsecurity product business and, as a result, incurred higher depreciationcosts.   No such property or equipmentwas acquired during the three months ended June 30, 2007.

 

*Other (income) and expense.*  We experienced a gain on adjustment offair value with respect to our Series A Convertible Preferred Stock, whichwas classified as a liability, of approximately $2.6 million and a gain on therelated investor warrants of approximately $1.4 million for the three monthsended June 30, 2008.  These securities were not outstanding duringthe three months ended June 30, 2007 and accordingly there was no suchgain or loss recorded.   As a result of our agreement to sell ourSeries A Convertible Preferred Stock and warrants to purchase commonstock, we incurred gains which occurred upon the valuation of the stock.  Suchvaluation took into account the features, rights and obligations of theconvertible preferred stock, which ultimately resulted in a lower fair valuethan the proceeds received.   Since the Series A ConvertiblePreferred Stock and related Investor Warrants are required to be recorded atfair value, we recorded a gain on such securities.    Interest expense for the three months endedJune 30, 2008 and June 30, 2007 was $243,000 and $3,700, respectively.  The increase of $239,300 or 6467% for thethree months ended June 30, 2008 was the result of interest expenseassociated with the amortization of the deferred financing costs and relateddiscounts on the Series A preferred stock of approximately $240,000.  We had no such interest expense associatedwith amortization of deferred financing costs for the three months endedJune 30, 2007.

 

***Comparison of the Six Months EndedJune 30, 2008 versus June 30, 2007***

 

*Revenues.*  Revenues for the six months endedJune 30, 2008 was approximately $18.6 million, an increase ofapproximately $2 million, or 12%, over revenues of approximately $16.6 millionin the comparable period in 2007.  This increase was due primarily to ahigher volume of orders completed under the Marine Corp. sole source contractmentioned above for the six months ended June 30, 2008 versusJune 30, 2007.  In addition, we recordedapproximately $1 million dollars in sales relating to the tactical applicationretail outlet and physical 

 

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security product business for the six months ended June 30,2008.  No such revenue was recorded forthe six months ended June 30, 2007.

 

*Cost ofRevenues.* Costof revenues for the six months ended June 30, 2008 and June 30, 2007was approximately $11.8 million and $9.6 million, respectively.  This resulted in an increase of approximately$2.2 million or 23%.  This increase wasdue to additional costs of revenue associated with the tactical applicationretail outlet and physical security product business, both of which were not inexistence in 2007.  In addition, theincrease was related to our increased production costs under the Marine Corp.sales contract mentioned above.  Cost of sales for the six months endedJune 30, 2007 also included costs related to orders filled for spareparts, which have a much lower cost.

 

*Grossprofit margin*.  The gross profit margin for the six months ended June 30, 2008 andJune 30, 2007 was approximately $6.8 million and $7.0 million,respectively.  The gross profit margin percentage was 37% and 42% for thesix months ended June 30, 2008 and June 30, 2007, respectively. The decrease in gross profit margin percentage was due to higher costs associatedwith production associated with the Marine Corp. sales contract and lower grossprofit margins associated with our tactical application retail outlet and ourphysical security product business. Gross profit margin for the six months ended June 30, 2007 alsoinclude sales related to orders filled for spare parts, which have higher grossprofit margins.

 

*Sales and Marketing Expenses.*  Salesand marketing expenses for the six months ended June 30, 2008 andJune 30, 2007 were approximately $1.36 million and $1.28 million,respectively, representing an increase of $80,000, or 6%.  We increased oursales and marketing department from 7 employees as of June 30, 2007 to 15employees as of June 30, 2008.  This increase in personnel resulted in approximately $120,000 inadditional salaries and employee benefits expense for the six months endedJune 30, 2008.  For the six monthsended June 30, 2007, we incurred an additional $40,000 in travel expensesrelated to tradeshows and commissions, over the corresponding six months endedJune 30, 2008.

 

*Researchand Development Expenses.*  Research and development expenses for the six months endedJune 30, 2008 and June 30, 2007 were approximately $370,000 and$236,000, respectively.  The increase of $134,000 or 57% from 2007 to 2008was the result of additional testing and improvements of existing products.

 

*Generaland Administrative Expenses.*  General and administrative expenses for the six monthsended June 30, 2008 and June 30, 2007 were approximately $2.7 millionand $1.4 million, respectively.  The increase of $1.3 million, or 93%, wasprimarily due to expansion expenses incurred during the six months endedJune 30, 2008, primarily during the first three months of 2008.  Due to our expansion, we also incurredincreases in other expenses, such as general and liability insurance, rent andgeneral supplies, which approximated $420,000.  We also incurredadditional general and administrative expenses associated with the facilitiesfor our tactical application retail outlet and our physical security productbusiness of approximately $600,000.  We also incurred significant legal,merger and acquisition, and accounting costs associated with the registrationof our common stock with the SEC under the Securities Exchange Act of 1934 andour asset acquisition during the first quarter of 2008, which wereapproximately $200,000.

 

 *Generaland Administrative Salaries Expense.*  General andadministrative salaries expense for the six months ended June 30, 2008 andJune 30, 2007 were approximately $2.3 million and $1.5 million,respectively.  The increase of $800,000, or 53%, was due to the increasein personnel associated with our expansion and our acquisition of our tacticalapplication retail outlet and our physical security product business.  As of June 30, 2008, there were 41employees that were classified as general and administrative personnel, versus27 employees as of June 30, 2007.

 

*Depreciationexpense.* Depreciation expense was approximately $282,000 and $175,000 for the six monthsended June 30, 2008 and June 30, 2007, respectively.  Theincrease of $107,000, or 61%, was the result the expansion of our headquartersduring 2008, which resulted in higher depreciation expense.  For the sixmonths ended June 30, 2008, we acquired additional property and equipmentassociated with our tactical application retail outlet and our physicalsecurity product business and, as a result, incurred higher depreciationcosts.  No such property or equipment wasacquired as of June 30, 2007.

 

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*Other (income) and expense.*  We experienced a gain on adjustment offair value with respect to our Series A Convertible Preferred Stock, whichwas classified as a liability, of approximately $1.2 million and a gain on therelated investor warrants of approximately $1.3 million for the six monthsended June 30, 2008.  These securities were not outstanding as ofJune 30, 2007 and accordingly there was no such gain or loss recorded forthe six months then ended.   As a result of our agreement to sell ourSeries A Convertible Preferred Stock and warrants to purchase commonstock, we incurred gains which occurred upon the valuation of the stock. Such valuation took into account the features, rights and obligations of theconvertible preferred stock, which ultimately resulted in a lower fair valuethan the proceeds received.   Since the Series A ConvertiblePreferred Stock and related Investor Warrants are required to be recorded atfair value, we recorded a gain on such securities.    Interest expense for the six months endedJune 30, 2008 and June 30, 2007 was $310,000 versus $3,700.  The increase of $306,300 or 8278% for the sixmonths ended June 30, 2008 was the result of interest expense associatedwith the amortization of the deferred financing costs and related discounts onthe Series A preferred stock of approximately $303,000.  There was no such interest expense associatedwith amortization of deferred financing costs for the six months endedJune 30, 2007.

 

**Liquidity and Capital Resources**

 

As June 30, 2008, our principal sources of liquidity were cash andcash equivalents totaling approximately $6.6 million, net accounts receivableof approximately $5.5 million and costs in excess of billings of approximately$8.5 million.  The primary sources of our liquidity during 2008 have comefrom operations and proceeds received from the sale of our shares ofSeries A Convertible Preferred Stock and warrants to purchase our commonstock.

 

On March 7, 2008, we entered into an agreement to sell shares ofour Series A Convertible Preferred Stock and warrants to purchase ourcommon stock, and to conditionally sell shares of our common stock, to threeinvestors. The aggregate purchase price of the preferred stock and warrants was$15.0 million and the aggregate purchase price of the common stock was$0.5 million.  An initial closing on the sale of the preferred stockand warrants was held on March 7, 2008 in which we received gross proceedsof $10,975,000. A second closing took place on April 4, 2008 in which wereceived gross proceeds of $4,025,000. The conditional closing of the $500,000 common stock sale was not, andwill not be, completed.

 

In May 2007, we entered into a loan agreementwith Commerce Bank, N.A. pursuant to which we have access to a $12.0 millionrevolving credit facility, and had access to a term loan of up to $3.0 millionthrough October 2007.  As of the end of June 30, 2008,approximately $143,000 was outstanding under the term loan.   There wereno other draws upon the term loan.  The credit facility is secured by allof our assets, and bears interest at a variable rate equal to LIBOR plus amargin of between 1.75% and 2.45%.  We have not yet drawn on any funds availableunder the revolving credit facility.

 

As of June 30, 2007, our principalsources of liquidity were cash and cash equivalents totaling approximately$2.7 million, net accounts receivable of approximately $6.4 millionand costs in excess of billings of approximately $3.2 million.  Theprimary source of our liquidity and capital resources during the first sixmonths of 2007 came from operations.

 

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

 

It is possible, however, that implementationof our growth strategy could result in additional business requiring us toexpand our operations, including our operating facilities, equipment andemployees. These facility and resource requirements could necessitateadditional funding beyond our operating cash flow and available credit. We are exploring a number of capital raising alternatives to plan for this 

 

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possibility.  There can be no assurances that any outside fundingwill be available to us or, if available, on reasonably acceptable terms.

 

*Cash Flowsfrom Operating Activities.*Net cash used in operating activities was approximately $6.7 millionfor the six months ended June 30, 2008 compared to net cash used inoperating activities of approximately $2.2 million as of June 30,2007.  Net cash used in operating activities in 2008 consisted primarilyof  changes in our operating assets and liabilities of approximately $(2.7)million, including changes in accounts receivable, cost in excess of billing,prepaid expense, accounts payable and accrued liabilities.  The changes inaccounts receivable and costs in excess of billing of $1.2 million and $(3.5)million, respectively, reflects the increased payments received from ourcustomers and increases in projects in process as of June 30,2008.   Our prepaid expenses increased approximately $1.5 million dueto amounts paid in advance in connection with our intent to enter the public marketand obtain outside financing.  In addition, the changes in accountspayable and accrued liabilities reflect the related increase in expensesincurred, with no funds paid out.  Netcash used in operating activities for the six months ended June 30, 2007consisted primarily of changes in operating assets and liabilities ofapproximately $(4.3) million, including changes in accounts receivable, cost inexcess of billing, accounts payable and accrued liabilities.  Thesechanges in accounts receivable and cost in excess of billing resulted from theincrease in projects completed and invoices issued to customers.

 

As of June 30, 2008, we had netoperating loss carryforwards of approximately $5.0 million available toreduce future taxable income. In the future, we may utilize our net operatingloss carryforwards and would begin making cash tax payments at that time. Inaddition, the limitations on utilizing net operating loss carryforwards andother minimum taxes may also increase our overall tax obligations. We expectthat if we generate taxable income and/or we are not allowed to use netoperating loss carryforwards, our cash generated from operations will beadequate to meet our income tax obligations.

 

*Net CashUsed In Investing**Activities.*  Net cash used ininvesting activities for the six months ended June 30, 2008 and 2007 wasapproximately $2.3 million and $436,000, respectively.  Net cash used ininvesting activities during these periods consisted primarily of cash paid forthe acquisition of equipment,  leaseholdimprovements  related to the expansion ofthe office and cash paid out for the acquisition of assets in excess of cashreceived.

 

*Net CashProvided by Financing**Activities.*  Net cashprovided by financing for the six months ended June 30, 2008 and 2007 wasapproximately $14 million and $389,000 respectively. Net cash provided byfinancing activities during 2008 consisted primarily of proceeds of $13.9million received from the sale of  Series A Preferred Stock, $194,000received from the sale of our common stock and approximately $65,000 receivedfrom the term loan, offset by repayments of short term financing ofapproximately $13,000.  Net cash used in financing activities during 2007consisted of proceeds from the sale of our common stock of $260,000 and proceedsfrom short term financing of $141,000, which were offset by repayments of shortterm financing of approximately $12,000.

 

**Item 4.    Controls and Procedure**

 

**Evaluation of Disclosure Controls and Procedures**

 

Our management carried out anevaluation required by Rule  13a-15 under the Securities Exchange Act of1934, as amended (the “Exchange Act”), under the supervision and with theparticipation of our President and Chief Executive Officer (“CEO”) and ChiefFinancial Officer (“CFO”), of the effectiveness of our disclosure controls andprocedures as defined in Rule  13a-15 and 15d-15 under the Exchange Act(“Disclosure Controls”). Based on the evaluation, our CEO and CFO concludedthat, subject to the limitations noted herein, as of June 30, 2008, ourDisclosure Controls are effective in timely alerting them to materialinformation required to be included in our reports filed with the SEC.

 

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

 

This quarterly report does not include a report of management’s assessmentregarding internal controls over financial reporting or an attestation reportof our registered independent public accounting firm due to a transition periodestablished by rules of the Securities and Exchange Commission for newlyformed public companies.

 

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**Limitations on the Effectiveness of Controls**

 

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

 

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

 

**PART II**

 

**Item 1.  Legal Proceedings**

 

On July 10, 2007, we filed a lawsuit against aformer subcontractor, Southern California Gold Products d/b/a Gypsy Rack, thesubcontractor’s President and owner, Glenn Harris, and a designer, James McAvoyin the United States District Court, Eastern District of New York. Defendantsmoved to change venue to the Central District of California based uponinsufficient contacts to the State of New York and on October 12, 2007 thematter was transferred to the United States District Court for the CentralDistrict of California, Case Number 07-CV-02779. On February 21, 2008,pursuant to the court’s order, we filed an amended complaint. The amendedcomplaint names only Southern California Gold Products and James McAvoy asdefendants and asserts six counts as follows: misappropriation of trade secretsand confidential information; breach of contract; unfair competition;conversion; violation of the Lanham Act; and interference with prospectiveeconomic advantage. The amended complaint seeks to enjoin the defendants frommisappropriating, disclosing, or using our confidential information and tradesecrets, and recall and surrender all products and trade secrets wrongfullymisappropriated or converted by the defendants. It also seeks compensatorydamages in an amount to be established at trial together with prejudgment andpost judgment interest, exemplary damages, disgorgement, restitution withinterest, attorney’s fees and the costs of suit. Defendants filed an answer tothe amended complaint on April 16, 2008. Shortly after the filing of theamended answer, defendants made a motion for summary judgment on, among others,the grounds of collateral estoppel and res judicata.  We filed opposition to the motion. The motionfor summary judgment is scheduled for argument before the court on August 25,2008.

 

OnDecember 6, 2006,  Stephen Lassak, our former Chief Financial Officercommenced an action for breach of contract arising from his termination ofemployment, which was in the United States District Court, Eastern District ofNew York.  The parties have reached asettlement in this matter.

 

OnFebruary 29, 2008, Roy Elfers, a former employee commenced an actionagainst us for breach of contract arising from his termination of employment inthe Supreme Court of the State of New York, Nassau County. The Complaint seeksdamages of approximately $87,000. We filed an answer to the complaint and willbe commencing discovery.  Meritorious defenses to the claims exist and weintend to vigorously defend this action.

 

OnMarch 4, 2008, Thomas Cusack, our former General Counsel, commenced anaction with the United States Department of Labor, Occupational Safety andHealth and Safety Administration, alleging retaliation in contravention of theSarbanes-Oxley Act. Mr. Cusack seeks damages in excess of $3,000,000.  On April 2, 2008, we filed a response tothe charges.  We believe the allegationsto be without merit and intend to vigorously defend against the action.  On March 7, 2008, Mr. Cusack alsocommenced a second action against the Company for breach of contract andrelated issues arising from his termination of employment in New York StateSupreme Court, Nassau County.  OnMay 7, 2008, we served a motion to dismiss the complaint, which is fullysubmitted before the Court.  Meritoriousdefenses to the claims exist and we intend to vigorously defend this action.

 

**Item 2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

 

On March 7, 2008, we entered into anagreement to sell shares of our Series A Convertible Preferred Stock(“Series A Preferred”) and warrants (“Investor Warrants”) to purchase ourcommon stock, and to conditionally sell shares of our common stock, to threeinvestors.  The investors agreed topurchase an aggregate of 15,000 shares of Series A Preferred and InvestorWarrants to purchase up to 3,750,000 shares of common stock, and toconditionally purchase 100,000 shares of common stock.  The aggregate purchase price of the preferredstock and warrants is $15.0 million and the aggregate purchase price ofthe common stock is $0.5 million.

 

Each share of Series A Preferred is initially convertible into 500shares of common stock at a conversion price of $2.00 per share (“ConversionPrice”).

 

The holders of Investor Warrants may purchaseshares of our common stock at an exercise price of $2.40 per share until thedate that is 36 months after the date we become a reporting company under the1934 Act.  We have the right to require holders of the warrants toexercise such warrants at any time after the 2nd anniversary of the date we become a publicreporting company under the 1934 Act if the trading price and volume of ourcommon 

 

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stock achieves certain benchmarks or at any time after the six monthanniversary of a qualified public offering, in each case provided certain otherconditions are satisfied.

 

An initial closing on the sale of the preferredstock and warrants was held on March 7, 2008 in which we received grossproceeds of $10,975,000.  A subsequentclosing took place on April 4, 2008 in which we received gross proceeds of$4,025,000.  In addition, the threeinvestors in our Series A Preferred were obligated to purchase 100,000shares of our common stock for an aggregate purchase price of $500,000 if wesuccessfully listed our common stock on an eligible market on or prior toJune 30, 2008.  We have agreed withthe investors that the conditional purchase would not be consummated.

 

In connection with the foregoing financing, wealso paid a portion of the related placement agent fees in the form of warrantsto purchase 675,000 shares of our common stock. The warrants issued to the placement agent are exercisable for 5years from the date of issue at an exercise price of $2.00 per share.

 

With respect to the sales of our securities described above, we relied on the exemption provided bySection 4(2) of the Securities Act and Regulation D promulgatedthereunder.  The purchasers of securities are accredited investors andacquired securities for their own account for investment purposes only and notfor resale unless registered under the Securities Act or pursuant an exemptionfrom such registration.

 

**Item 5.  Other Information**

 

None.

 

**Item 6.    Exhibits**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                               |
|-------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                      |
| 10.1                    |       | Consent and Agreement of Series A Convertible  Preferred Stockholders, dated May 23, 2008 (1)                                                                                                   |
| 10.2                    |       | Form of Voting Agreement for Anthony Piscitelli, Gary  Sidorsky and Curtis Taufman (1)                                                                                                               |
| 10.3                    |       | Letter  Agreement, dated May 29, 2008, between American Defense Systems, Inc. and  West Coast Opportunity Fund, LLC (2)                                                                              |
| 10.4                    |       | Letter Agreement, dated May 29, 2008, between American  Defense Systems, Inc.and Centaur  Value Fund, LP and United Centaur Master Fund (2)                                                          |
| 10.5                    |       | Amendment No.1 to Independent Consulting Agreement, effective  July 23, 2008, between Richard Torykian and American Defense  Systems, Inc.(3)                                                   |
| 31.1*                   |       | Certification of  Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended.*                |
| 31.2*                   |       | Certification of  Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Act of 1934, as amended.*                                       |
| 32.1*                   |       | Certification of  Chairman and Chief Executive Officer and Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.* |

 

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*      Filed herewith.

 

(1)   Incorporated by reference to an exhibit tothe Registrant’s current report on Form 8-K filed with the SEC onMay 27, 2008.

(2)   Incorporated by reference to an exhibit tothe Registrant’s current report on Form 8-K filed with the SEC onMay 30, 2008.

(3)   Incorporated by reference toExhibit 99.1 to the Registrant’s current report on Form 8-K filedwith the SEC on August 8, 2008.

 

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**SIGNATURES**

 

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

 
|                        | AMERICAN DEFENSE  SYSTEMS, INC. |
|-----------------------------|---------------------------------|
|                        |                            |
|                        |                            |   |
| Date:  August 14, 2008 | By:                             | /s/ Gary  Sidorsky |
|                        |                            | Chief Financial  Officer |
|                             |                                 |  |  |

 

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**Index to Exhibits**

 
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                              |
|-------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                     |
| 31.1                    |       | Certification of  Chairman and Chief Executive Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended.                |
| 31.2                    |       | Certification of  Chief Financial Officer pursuant to Rule 13a-14(a) and  Rule 15d-14(a), promulgated under the Securities Act of 1934, as  amended.                                      |
| 32.1                    |       | Certification of  Chairman and Chief Executive Officer and Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

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