**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


WASHINGTON,
      D.C. 20549




Quarterly
      Report Under Section 13 or 15(d)


of
      the
      Securities Exchange Act of 1934




**FORM
      10-QSB**




**xQuarterly
      Report
      Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934**




**For
      the Quarterly Period Ended September 30, 2007**




**oTransition
      Report
      Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934**




For
      the
      transition period from ____________ to ____________




**Commission
      File Number 0-31136**




**CYBER
      DEFENSE SYSTEMS, INC.**


(Exact
      name of registrant as specified in its charter)





**Florida**
            **45-058387****(State
                or other jurisdiction of**
              **incorporation
                or organization)**
            **(I.R.S.
                Employer Identification
                No.)**







**10901
      ROOSEVELT BOULEVARD, SUITE 100D ST. PETERSBURG, FLORIDA
      33716**


(Address
      of principal executive offices)





**727-577-0878**


Issuer's
      telephone number




Check
      whether the issuer (1) has filed all reports required to be filed by Section
      13
      or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve
      months (or for such shorter period that the registrant was required to file
      such
      reports); and (2) has been subject to such filing requirements for the past
      90
      days. YES xNO
o





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




Indicate
      the number of shares outstanding of each of the issuer's classes of common
      stock, as of the close of the latest practical date.




Title
                  of Class
              
              Number
                  of Shares OutstandingClass
                  A Common Stock(par
                  value $0.001 per share)
              
              
              125,835,202
                  as of November 19, 2007Class
                  B Common Stock(Par
                  Value $0.001 per share)
              
              
              545,455
                  as of November 19, 2007Class
                  C Common StockPar
                  value $0.001 per share)
              
              
              2
                  as of November 19, 2007




Transitional
      Small Business Disclosure Format: Yes o No x









**Page
                Number****PART
                I**ITEM
                1. Condensed Consolidated Financial Statements (unaudited)Balance
                Sheets as of September 30, 2007 and December 31, 2006
            1Statements
                of Operations for the Three and Nine Months EndedSeptember
                30,
                2007 and 2006
            2Statements
                of Cash Flows for the Nine Months EndedSeptember
                30,
                2007 and 2006
            3Notes
                to Condensed Consolidated Financial Statements
            4-21ITEM
                2. Management’s Discussion and Analysis or Plan of
                Operation.
            22ITEM
                3. Controls and Procedures.
            26**PART
                II**ITEM
                2. Unregistered Sales of Equity Securities and Use of
                Proceeds.
            27ITEM
                6. Exhibits.
            27Signatures
            28









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


**CONDENSED
      CONSOLIDATED BALANCE SHEETS**


**(Unaudited)**




**September
                  30,**
              
              **December
                  31,****2007**
              
              **2006****ASSETS****Current
                  assets**Cash
                  and cash equivalents
              
              $
              28,350
              
              $
              86,703Accounts
                  receivable
              
              
              758,892
              
              
              35,870Inventories
              
              
              2,248,222
              
              
              1,170,557Prepaid
                  expenses
              
              
              880
              
              
              60,000**Total
                  current assets**
              
              
              3,036,344
              
              
              1,353,130**Non-current
                  assets**Property
                  and equipment, net of accumulated depreciationof
                  $40,289 and $26,426, respectively
              
              
              55,859
              
              
              66,357Loan
                  costs, net of accumulated amortization of $1,443,672and
                  $940,909, respectively
              
              
              799,210
              
              
              900,683Security
                  deposits
              
              
              7,371
              
              
              7,371Airship
                  manufacturing licenses, net of accumulatedamortization
                  of $300,000 and $75,000, respectively
              
              
              1,800,000
              
              
              2,025,000Intangible
                  assets, net of accumulated amortization of$100,000
                  and $94,449, respectively
              
              
              -
              
              
              5,551**TOTAL
                  ASSETS**
              
              $
              5,698,784
              
              $
              4,358,092**LIABILITIES
                  AND STOCKHOLDERS' DEFICIT****Current
                  liabilities**Accounts
                  payable and accrued liabilities
              
              $
              2,875,411
              
              $
              1,506,139Accrued
                  royalties
              
              
              700,000
              
              
              1,150,000Accrued
                  interest
              
              
              1,505,287
              
              
              912,910Refundable
                  customer deposit
              
              
              -
              
              
              2,760,000Deferred
                  revenue
              
              
              1,781,540
              
              
              416,667Notes
                  payable - related parties
              
              
              1,130,548
              
              
              744,916Notes
                  payable - third parties
              
              
              2,813,237
              
              
              1,572,875Embedded
                  derivative liability
              
              
              27,945,135
              
              
              11,291,671Current
                  portion of long term notes payable, net ofdiscount
                  of $671,692 and $0, respectively
              
              
              2,150,982
              
              
              -**Total
                  current liabilities**
              
              
              40,902,140
              
              
              20,355,178Long-term
                  notes payable - third parties
              
              
              1,502,638
              
              
              -Long
                  term notes payable, net of discounts of $2,174,840and
                  $1,875,863, respectively
              
              
              960,160
              
              
              2,079,398**TOTAL
                  LIABILITIES**
              
              
              43,364,938
              
              
              22,434,576Minority
                  interest in net assets of subsidiary
              
              
              447,746
              
              
              -**Stockholders'
                  deficit:**Class
                  A Preferred stock, $0.001 par value 10,000,000shares
                  authorized, none issued and outstandingClass
                  A, $0.001 par value, 200,000,000 sharesauthorized,
                  125,835,202 and 66,657,316 shares issuedand
                  outstanding, respectively
              
              
              125,835
              
              
              66,657Class
                  B, $0.001 par value, 200,000,000 sharesauthorized,
                  545,455 shares issued and outstanding
              
              
              545
              
              
              545Class
                  C, $0.001 par value, 200,000,000 sharesauthorized,
                  2 shares issued and outstanding
              
              
              -
              
              
              -Additional
                  paid in capital
              
              
              21,660,203
              
              
              20,372,513Accumulated
                  deficit
              
              
              (59,900,483
              )
              
              (38,516,199
              )**TOTAL
                  STOCKHOLDERS' DEFICIT**
              
              
              (38,113,900
              )
              
              (18,076,484
              )**TOTAL
                  LIABILITIES AND STOCKHOLDERS' DEFICIT**
              
              $
              5,698,784
              
              $
              4,358,092




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




1




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


**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


(Unaudited)




**THREE
                  MONTHS ENDED SEPTEMBER 30,**
              
              **NINE
                  MONTHS ENDED SEPTEMBER 30,****2007**
              
              **2006**
              
              **2007**
              
              **2006**Revenues
              
              $
              44,427
              
              $
              136,137
              
              $
              181,465
              
              $
              438,031Cost
                  of revenues
              
              
              12,747
              
              
              58,120
              
              
              92,880
              
              
              202,391Gross
                  profit
              
              
              31,680
              
              
              78,017
              
              
              88,585
              
              
              235,640Expenses:Research
                  and development
              
              
              2,302
              
              
              90,406
              
              
              430,954
              
              
              189,668General
                  and administrative
              
              
              843,553
              
              
              1,630,022
              
              
              2,850,002
              
              
              5,246,277Impairment
                  of license
              
              
              -
              
              
              11,330,674
              
              
              -
              
              
              11,330,674Stock
                  option compensation
              
              
              -
              
              
              1,287,008
              
              
              -
              
              
              2,271,287Total
                  expenses
              
              
              845,855
              
              
              14,338,110
              
              
              3,280,956
              
              
              19,037,906Loss
                  from operations
              
              
              (814,175
              )
              
              (14,260,093
              )
              
              (3,192,371
              )
              
              (18,802,266
              )Other
                  income (expense)Interest
                  expense
              
              
              (906,764
              )
              
              (1,157,741
              )
              
              (2,358,518
              )
              
              (2,543,411
              )Derivative
                  valuation gain (loss)
              
              
              (14,738,189
              )
              
              (485,507
              )
              
              (15,835,649
              )
              
              3,009,193Minority
                  interest in loss of subsidiary
              
              
              -
              
              
              -
              
              
              2,254
              
              
              -Total
                  other income (expense)
              
              
              (15,644,953
              )
              
              (1,643,248
              )
              
              (18,191,913
              )
              
              465,782Net
                  loss before income tax
              
              
              (16,459,128
              )
              
              (15,903,341
              )
              
              (21,384,284
              )
              
              (18,336,484
              )Income
                  tax benefit
              
              
              -
              
              
              -
              
              
              -
              
              
              217,325Net
                  loss
              
              $
              (16,459,128
              )
              $
              (15,903,341
              )
              $
              (21,384,284
              )
              $
              (18,119,159
              )Basic
                  and diluted loss per share
              
              $
              (0.17
              )
              $
              (0.26
              )
              $
              (0.27
              )
              $
              (0.31
              )Weighted
                  average number of Class Acommon
                  shares outstanding
              
              
              96,455,898
              
              
              61,023,924
              
              
              79,125,023
              
              
              58,941,832




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





2




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


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


(Unaudited)




**NINE
                  MONTHS ENDED SEPTEMBER 30,****2007**
              
              **2006****CASH
                FLOWS FROM OPERATING
                ACTIVITIES**Net
                  loss
              
              $
              (21,384,284
              )
              $
              (18,119,159
              )Adjustments
                  to reconcile net loss to netcash
                  from operating activities:Loan
                  discount accretion
              
              
              1,648,687
              
              
              1,966,714Derivative
                  valuation loss (gain)
              
              
              15,835,649
              
              
              (3,009,193
              )Depreciation
                  and amortization
              
              
              747,987
              
              
              1,054,838Gain
                  on settlement of customer refund payable
              
              
              (260,000
              )
              
              -Issuance
                  of stock for services
              
              
              59,599
              
              
              389,793Issuance
                  of equity in subsidiary for loan
              
              
              50,000
              
              
              -Minority
                  interest in loss of subsidiary
              
              
              (2,254
              )
              
              -Issuance
                  of loan for services
              
              
              -
              
              
              351,192Stock
                  option compensation
              
              
              -
              
              
              2,271,687Income
                  tax benefit
              
              
              -
              
              
              (217,325
              )Issuance
                  of warrant for services
              
              
              -
              
              
              419,760Impairment
                  of license
              
              
              -
              
              
              11,330,674Changes
                  in assets and liabilities:Accounts
                  receivable
              
              
              (723,022
              )
              
              209,478Inventories
              
              
              (1,077,665
              )
              
              (554,533
              )Prepaid
                  expenses
              
              
              59,120
              
              
              32,580Accounts
                  payable and accrued liabilities
              
              
              1,444,024
              
              
              506,996Accrued
                  royalty
              
              
              (450,000
              )
              
              -Accrued
                  interest
              
              
              592,377
              
              
              499,891Deferred
                  revenue
              
              
              1,364,873
              
              
              1,383,333**NET
                  CASH FROM OPERATING ACTIVITIES**
              
              
              (2,094,909
              )
              
              (1,483,274
              )**CASH
                  FLOWS FROM INVESTING ACTIVITIES**Purchase
                  of equipment
              
              
              (3,365
              )
              
              (2,636
              )**NET
                  CASH FROM INVESTING ACTIVITIES**
              
              
              (3,365
              )
              
              (2,636
              )**CASH
                  FLOWS FROM FINANCING ACTIVITIES**Proceeds
                  from notes payable, related parties .
              
              
              648,421
              
              
              281,573Proceeds
                  from units sold in subsidiary
              
              
              400,000
              
              
              -Gross
                  proceeds from sale of secured, convertible notes payable
              
              
              1,135,000
              
              
              1,700,000Proceeds
                  from notes payable
              
              
              375,000
              
              
              82,000Issuance
                  of stock for cash
              
              
              60,000
              
              
              -Principal
                  payments on notes payable
              
              
              -
              
              
              (383,139
              )Payments
                  on notes payable - related parties
              
              
              (375,000
              )
              
              (75,000
              )Payments
                  on loan costs
              
              
              (203,500
              )
              
              (120,000
              )**NET
                  CASH FROM FINANCING ACTIVITIES**
              
              
              2,039,921
              
              
              1,485,434Net
                  (decrease) increase in cash
              
              
              (58,353
              )
              
              (476
              )Cash
                  and cash equivalents, beginning
              
              
              86,703
              
              
              476Cash
                  and cash equivalents, ending
              
              $
              28,350
              
              $
              -Supplemental
                  disclosure of cash flow information:Cash
                  paid for interest
              
              
              -
              
              $
              19,235Cash
                  paid for income taxes
              
              
              -
              
              
              -




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




3




**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIAR** **IES**


**NOTES
      TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**


(unaudited)




**NOTE
      1 - ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES**





ORGANIZATION,
      ACQUISITIONS AND MERGERS AND CONTROLLING SHAREHOLDERS -- Cyber Defense Systems,
      Inc. ("the Registrant" or "Cyber Defense" or "the Company") was incorporated
      on
      August 19, 2004 in Florida. E-City Software, Inc. ("E-City") was organized
      in
      Nevada on May 12, 2000. On Alert Systems, Inc. ("On Alert") was incorporated
      on
      March 17, 2003 in Nevada and acquired a control position in E-City in May of
      2003 and in Cyber Aerospace Corp. ("Cyber Aerospace") in March 2004. On Alert
      was merged with and into Cyber Defense on September 1, 2004. On September 1,
      2004 E-City was also merged with and into Cyber Defense following the On Alert
      merger. As a result of the aforementioned, Cyber Defense became the successor
      to
      E-City and its shares of class A common stock began trading on the Over the
      Counter Bulletin Board ("OTC:BB") under the symbol CYDF on September 7, 2004.
      Due to the nature of the mergers, the fiscal year end of the Company was changed
      to December 31 effective for Fiscal 2003 and the historical financial statements
      of the Company are now those of On Alert and include results of operations
      for
      Cyber Aerospace from its date of inception in March 2004, as it was previously
      a
      subsidiary of On Alert, and includes the results of operations of E-City from
      it's date of merger, September 1, 2004. Cyber Aerospace was merged with and
      into
      Cyber Defense effective March 31, 2005 with the acquisition of the 6.19%
      minority interest in Cyber Aerospace for 1,650,000 shares of class A common
      stock and 150,000 shares of class B common stock. In addition, on September
      19,
      2005, the Company acquired its wholly owned subsidiary Techsphere Systems
      International, Inc. ("TSI") for 23,076,923 Class A common shares and 245,455
      Class B common shares. On January 30, 2007, TSI Holdings Co., LLC (“TSI LLC”)
      was reactivated by TSI. In
      2005, Cyber formed Airship Leasing Co., LLC (“ALC”), an Oklahoma limited
      liability company. On July 23, 2007, the board approved all of the interests
      of
      TSI, LLC to be transferred to Airship Leasing Co., LLC in order to raise funds
      to deploy two (2) SA-60 Airships. As a result, the
      4 %
      ownership interest which was not owned by TSI was cancelled and replaced with
      equal ownership interest of ALC which is 96.0% owned by Cyber
      Defense.





The
      controlling shareholders of the Company are Proxity, Inc. ("Proxity"), a
      publicly traded company ("PRXT") and Cherokee Raiders, a partnership,
      ("Cherokee") owning approximately 12.2% and 7.8% of the Class A common shares
      of
      the Company, respectively at September 30, 2007. In addition, the former
      shareholders of TSI also own 21,219,111 shares or 16.9% of the Class A common
      stock and 245,455 or 45%, of the issued and outstanding shares of Class B common
      stock as of March 31, 2007. Cherokee owns 300,000 or 55% of such class B shares
      which allow for 1,000 votes per share and as a result, Cherokee is the
      controlling shareholder of the Company. Cherokee and Proxity each own one share
      of the two shares of Class C common stock issued and outstanding which have
      certain liquidation preference rights. The Chief Executive Officer of Proxity
      and the General Partner of Cherokee is Mr. Robinson, the Chief Executive Officer
      of the Company.





CONSOLIDATION
      - The accompanying unaudited condensed consolidated financial statements include
      the accounts and transactions of Cyber Defense Systems, Inc. for all periods
      presented and the accounts and transactions of Cyber Defense and TSI, its wholly
      owned subsidiary from its date of acquisition on September 19, 2005. On January
      30, 2007, TSI Holdings Co., LLC (“TSI LLC”) was reactivated by TSI, which at
      September 30, 2007 owns a 99.5% interest in TSI, LLC. During the quarter ended
      September 30, 2007, Cyber Defense reactivated Airship Leasing (collectively
      the
      "Company"). Intercompany accounts and transactions have been eliminated in
      consolidation.




Basis
      of
      Presentation -- The unaudited financial statements included in this Form 10-QSB
      have been prepared in accordance with generally accepted accounting principles
      for interim financial information and with the instructions to Form 10-QSB
      and
      Item 310(b) of Regulation SB of the Securities and Exchange Act of 1934, as
      amended. The financial information furnished herein reflects all adjustments,
      which, in the opinion of management, are necessary for a fair presentation
      of
      the Company's financial position, the results of operations and cash flows
      for
      the periods presented.




Certain
      information and footnote disclosures normally contained in financial statements
      prepared in accordance with generally accepted accounting principles have been
      omitted, pursuant to such rules and regulations.




4




Condensed
      Interim Financial Statements -- The accompanying unaudited condensed
      consolidated financial statements include the accounts of Cyber Defense Systems,
      Inc. and its subsidiaries, collectively ("Cyber" or the "Company"). These
      financial statements are condensed and, therefore, do not include all
      disclosures normally required by accounting principles generally accepted in
      the
      United States of America. In the opinion of management, all adjustments
      necessary for a fair presentation have been included in the accompanying
      condensed consolidated financial statements and consist of only normal recurring
      adjustments. The results of operations presented in the accompanying condensed
      consolidated financial statements are not necessarily indicative of the results
      that may be expected for the full year ending December 31, 2007 and such
      financial statements should be read in conjunction with the Company's Form
      10-KSB for the year ended December 31, 2006 and other filings made with the
      Securities and Exchange Commission.




Use
      of
      Estimates - The preparation of financial statements in conformity with
      accounting principles generally accepted in the United States of America
      requires management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities, disclosure of contingent assets and
      liabilities and the reported amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates.




Management's
      Intentions - The accompanying financial statements have been prepared on a
      going
      concern basis, which contemplates the realization of assets and the satisfaction
      of liabilities in the normal course of business. For the nine months ended
      September 30, 2007 the Company recorded revenues of $181,465 and incurred a
      net
      loss of $21,384,284. For the year ended December 31, 2006, the Company recorded
      revenues of $494,220 and incurred a net loss of $22,039,817. As of September
      30,
      2007 and December 31, 2006 the net working capital deficit was $37,865,796
      and
      $19,002,048, respectively. The lack of sufficient revenues and the loss from
      operations raise substantial doubt about the Company's ability to continue
      as a
      going concern for a reasonable period of time. The financial statements do
      not
      include any adjustments relating to the recoverability and classification of
      recorded assets or the amount and classification of liabilities which might
      be
      necessary should the Company be unable to continue as a going concern. The
      Company's continuation as a going concern is dependent upon its ability to
      generate sufficient cash flows to meet its obligations on a timely basis, to
      obtain additional financing as further discussed in Note 4, 5 and 9 as may
      be
      required, and ultimately to attain successful operations.




Cash
      and
      Cash Equivalents - Cash equivalents include highly liquid short-term investments
      with original maturities of three months or less, readily convertible to known
      amounts of cash. At September 30, 2007 and December 31, 2006 the Company had
      no
      cash in excess of federally insured limits.




Inventory
      - At September 30, 2007 and December 31, 2006, inventory of $2,248,222 and
      $1,170,557, respectively primarily consists of parts for the Unmanned Aerial
      Vehicles ("UAV's") and airships that the Company sells and
      services.




Property
      and Equipment - Property and equipment is recorded at cost. Depreciation is
      computed using the straight-line method over the estimated useful lives of
      the
      assets ranging from 3 to 5 years. Expenditures for maintenance, repairs, and
      renewals are charged to expense as incurred. Expenditures for major renewals
      and
      betterments that extend the useful lives of existing equipment are capitalized
      and depreciated. On retirement or disposition of property and equipment, the
      cost and accumulated depreciation are removed and any resulting gain or loss
      is
      recognized in the statement of operations.




Long-lived
      assets are reviewed for impairment when events or changes in circumstances
      indicate that the carrying amount may not be recoverable. Recoverability of
      assets to be held and used is measured by comparison of the carrying amount
      of
      an asset to future net cash flows expected to be generated by the asset. If
      such
      assets are considered to be impaired, the impairment to be recognized is
      measured by the amount that the carrying amount of the assets exceeds the fair
      value of the assets. Assets to be disposed of are reported at the lower of
      the
      carrying amount or fair value less costs to sell. For the quarter ended
      September 30, 2007, management has determined that no impairment of its long
      lived assets was required.




Manufacturing
      License -- The Company acquired an exclusive manufacturing license for the
      manufacture and sale of its airships with the acquisition of TSI in September,
      2005. Amortization expense relating to the license was $225,000 and $593,982
      for
      the nine months ended September 30, 2007 and 2006, respectively. The Company
      evaluated the carrying value of the license to determine if the carrying amount
      warranted revision or may not be recoverable. In management's opinion, an
      adjustment is not required at September 30, 2007.




Fair
      Values of Financial Instruments -- The carrying amounts reported in the balance
      sheet for notes payable approximate their fair values because the interest
      rates
      approximate current interest rates to be charged on similar
      borrowings.




5




Revenue
      Recognition - The Company recognizes service revenues when the services, as
      specified by the customer and agreed to by the Company, have been performed
      and
      the customer accepts the services, and the services are billed. Airship and
      UAV
      sales are recognized when contract specifications are met, the price is
      determined, title passes to the customer and the customer is billed.
      Reasonableness of collectibility of all revenue transactions is a key element
      before the transactions are recorded.





Share
      Based Payments - The
      Company accounts for stock-based compensation expense in accordance with
      Statement of Financial Accounting Standards (SFAS) No. 123(R),
“Share-Based Payment” (SFAS 123R). Under SFAS 123R, stock-based compensation
      expense reflects the fair value of stock-based awards measured at the grant
      date, is recognized over the requisite service period, and is adjusted each
      period for anticipated forfeitures. The Company estimates the fair value of
      each
      stock-based award on the date of grant using the Black-Scholes option valuation
      model. The Black-Scholes option valuation model incorporates assumptions as
      to
      stock price volatility, the expected life of options, a risk-free interest
      rate
      and dividend yield. There were no stock options issued under the Company’s 2005
      option plan during the nine months ended September 30, 2007.




Derivative
      Instruments - The Company does not hold or issue derivative instruments for
      trading purposes. However, the Company has convertible notes payable that
      contain embedded derivatives that require separate valuation from the
      convertible notes under Emerging Issues Task Force Abstract (EITF) 00-19,
      "Accounting for Derivative Financial Instruments Indexed to, and Potentially
      Settled in, a Company's Own Stock". The Company recognizes these derivatives
      as
      liabilities in the accompanying balance sheet and measures them at estimated
      fair value each quarter, and recognizes changes in estimated fair value in
      the
      statement of operations in the respective period. The Company has estimated
      the
      fair value of these embedded derivatives using the Black-Scholes
      model.




Income
      Taxes -- No income taxes have been paid or accrued because the Company has
      had
      no net taxable income since inception. The Company recognizes the amount of
      income taxes payable or refundable for the current year and recognizes deferred
      tax assets and liabilities for the future tax consequences attributable to
      differences between the financial statement amounts of certain assets and
      liabilities and their respective tax bases. Deferred tax assets and deferred
      liabilities are measured using enacted tax rates expected to apply to taxable
      income in the years those temporary differences are expected to be recovered
      or
      settled. Deferred tax assets are reduced by a valuation allowance to the extent
      that uncertainty exists as to whether the deferred tax assets will ultimately
      be
      realized.





Earnings
      (Loss) Per Share --Basic earnings (loss) per share is calculated by dividing
      earnings (loss) available to Class A common shareholders by the weighted-average
      number of Class A common shares outstanding during each period. Fully diluted
      income (loss) per share for the three and nine months ended September 30, 2007
      and 2006 is the same as basic due to losses sustained by the Company for those
      periods.




The
      following potentially dilutive common shares are excluded from the computation
      of diluted net loss per share for all periods presented because the effect
      is
      anti-dilutive:





**September
                  30,****2007**
              
              **2006**Shares
                  underlying warrants
              
              
              40,200,000
              
              
              6,870,000Shares
                  underlying options
              
              
              6,512,812
              
              
              9,106,838Shares
                  underlying convertible debt
              
              
              2,319,362,130
              
              
              50,699,342Shares
                  underlying convertible debt - related parties
              
              
              5,478,544
              
              
              2,887,735Total
                  potentially dilutive securities
              
              
              2,371,553,486
              
              
              69,563,915


Recent
      Accounting Pronouncements - In September 2006, the FASB issued SFAS No. 157,
      "Fair Value Measures" ("SFAS 157"). SFAS 157 defines fair value, establishes
      a
      framework for measuring fair value, and expands disclosures about fair value
      measurements. This statement applies under other accounting pronouncements
      that
      require or permit fair value measurements. However, it does not apply to SFAS
      123(R). This statement shall be effective for financial statements issued for
      fiscal years beginning after November 15, 2007, and interim periods within
      those
      fiscal years. Earlier application is encouraged, provided that the reporting
      entity has not issued financial statements for that fiscal year, including
      any
      financial statements for an interim period within that fiscal year. The
      provisions of this statement should be applied prospectively as of the beginning
      of the fiscal year in which this Statement is initially applied, except in
      some
      circumstances where the statement shall be applied retrospectively. The Company
      is currently evaluating the effect, if any, of SFAS 157 on its financial
      statements.




6




In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities”, including an amendment of FASB
      Statement No. 115 (“SFAS 159”). This pronouncement permits entities to choose to
      measure many financial instruments and certain other items at fair value that
      are not currently required to be measured at fair value and to recognize the
      resulting gains and losses in the results of operations. SFAS 159 is effective
      as of the beginning of an entity’s first fiscal year that begins after November
      15, 2007. The impact of adopting SFAS 159 on the Company’s consolidated
      financial statements, if any, has not yet been determined.





In
      June
      2007, the Emerging Issues Task Force of the FASB issued EITF Issue No. 07-3,
      “Accounting for Nonrefundable Advance Payments for Goods or Services to be Used
      in Future Research and Development Activities”, (“EITF 07-3”) which is effective
      for fiscal years beginning after December 15, 2007. EITF 07-3 requires that
      nonrefundable advance payments for future research and development activities
      be
      deferred and capitalized. Such amounts will be recognized as an expense as
      the
      goods are delivered or the related services are performed. The Company does
      not
      expect the adoption of EITF 07-3 to have a material impact on the financial
      results of the Company.




**NOTE
      2 - RELATED PARTY TRANSACTIONS**




Cyber
      Aerospace - Prior to March 31, 2005, Cyber Aerospace ("Aerospace") had
      previously been consolidated with the Company as it was a 93.8% owned
      subsidiary. All transactions and account balances between the Company and
      Aerospace were eliminated during consolidation. On March 31, 2005, the Company
      purchased the minority interest so that Aerospace became a wholly owned
      subsidiary and was then merged with and into the Company.




Cherokee
      Raiders - Cherokee's general partner is William C. Robinson. Cherokee also
      owns
      300,000 Class B common shares, each of which entitles the holder to 1,000 votes.
      As a result, Cherokee is the controlling shareholder of the
      Company.




William
      C. Robinson - Mr. Robinson is President, CEO and Chairman of the Company and
      has
      ownership and control in Proxity and Cherokee Raiders.




During
      the nine months ended September 30, 2007, Mr. Robinson made net advances of
      $214,926 to the Company.




See
      Note
      5 - Related Party Notes for additional related party disclosure.




**NOTE
      3- INTANGIBLE ASSETS AND MANUFACTURING LICENSE**




With
      the
      acquisition of TSI in September, 2005 the Company acquired an exclusive,
      worldwide license with 21st Century Airships, Inc. for the manufacture of its
      airships. The license agreement stipulates royalty payments relating to the
      sales of airships ranging from $450,000 for a low altitude airship, $600,000
      for
      a medium altitude airship, 10% of the gross sales price of a high altitude
      airship and $400,000 for the manufacture of a low altitude airship used for
      commercial advertising purposes. Payments are to be made on any royalties due
      upon receipt of payment from the customer on a proportionate basis as defined
      in
      the agreement and in full within 120 days of completion of the manufacturing
      process.





The
      license agreement calls for a minimum annual royalty payment of $1,000,000
      for
      the period of January 17, 2005 through January 16, 2006 and each annual period
      thereafter ending January 16. TSI has paid an aggregate of $1,000,000 through
      November 13, 2007. On July 23, 2007, 21 st Century
      Airships notified the Company that it had not made an agreed to payment in
      the
      amount of $676,225 and if said payment was not received by August 23, 2007,
      21 st Century
      Airships intends to terminate the agreement immediately. Said payment was made
      on August 22, 2007. . On October 12, 2007 21 st Century
      notified the Company of past due interest in the amount of $92,618 this was
      in
      excess of the amount 21 st Century
      stated was required to bring the TSI current and would be considered a condition
      of default. The Company is negotiating with 21 st Century
      to settle the amount due. Should TSI fail to make future royalty payments or
      any
      other payments due under the license agreement, this would have the effect
      of
      TSI being unable to manufacture and sell its airships.




7




In
      2004,
      the Company purchased designs and plans for unmanned air vehicles (UAV's) which
      have a useful life of 3 years. The cost was $100,000 and the monthly
      amortization is $2,778. Amortization expense was $5,551 and $25,002 for the
      nine
      months ended September 30, 2007 and 2006, respectively.




**NOTE
      4- NOTES PAYABLE**





On
      August
      22, 2007 the Company received $800,000 pursuant to a Securities Purchase
      Agreement dated August 22, 2007 with AJW in exchange for 8% Callable Secured
      Convertible Notes and issued seven year warrants to purchase 11,000,000 shares
      of common stock at an exercise price of $0.01 per share valued at $220,000
      on
      the date of issuance which was recorded as a derivative liability. An aggregate
      of $20,000 was recognized as loan costs and $200,000 was recognized as a
      derivative valuation loss on issuance of the warrants. The beneficial conversion
      feature was valued at $4,355,556 and was recorded as a derivative liability.
      An
      aggregate of $800,000 was allocated to discounts on the individual notes,
      representing 100% of the face value of the notes which will accrete over the
      three year life of the notes, with the remaining $3,555,556 recognized as a
      derivative valuation loss. The Company incurred loan costs totaling $90,000
      which consists of fees of $70,000 payable in cash, and a seven year warrant
      to
      purchase 1,000,000 shares of common stock with an exercise price of $0.01 valued
      at $20,000 using the Black Scholes method on the date of issuance which will
      be
      amortized over the three year term of the notes. The conversion price per the
      agreement was 30% of the average of the lowest three intra-day trading prices
      for the Company's common stock during the 20 trading days immediately preceding
      the conversion date.





On
      May 8,
      2007, the Company received $335,000 pursuant to a Securities Purchase Agreement
      dated May 8, 2007 with AJW in exchange for 6% Callable Secured Convertible
      Notes
      and issued five year warrants to purchase 22,000,000 shares of common stock
      at
      an exercise price of $0.07 valued at $1,964,600 on the date of issuance which
      was recorded as a derivative liability. An aggregate of $178,600 was recognized
      as loan costs and $1,786,000 was recognized as a derivative valuation loss
      on
      issuance of the warrants. The beneficial conversion feature was valued at
      $687,873 and was recorded as a derivative liability. An aggregate of $335,000
      was allocated to discounts on the individual notes, representing 100% of the
      face value of the notes which will accrete over the three year life of the
      notes, with the remaining $387,873 recognized as a derivative valuation loss.
      The Company incurred loan costs totaling $71,492 which consists of fees of
      $68,500 paid in cash, and a five year warrant to purchase 2,000,000 shares
      of
      common stock with an exercise price of $0.07 valued at $178,600 using the Black
      Scholes method on the date of issuance which will be amortized over the three
      year term of the notes. The conversion price per the agreement was 40% of the
      average of the lowest three intra-day trading prices for the Company's common
      stock during the 20 trading days immediately preceding the conversion date.
      On
      August 22, 2007, the Company and AJW amended the conversion price to 30% of
      the
      average of the lowest three intra-day trading prices for the Company's common
      stock during the 20 trading days immediately preceding the conversion date
      as
      discussed below.





An
      analysis of the issuance under the August 22 and May 8, 2007 Securities Purchase
      Agreement with AJW and the significant assumptions used to value the warrants
      and beneficial conversion feature are contained in the following table:




8


Issue
                  date
              
              5/8/2007
              
              8/22/2007Aggregate
                  note amounts
              
              $
              335,000
              
              $
              800,000Conversion
                  price on issue dates
              
              $
              0.02
              
              $
              0.0036Term
                  of notes at issuance
              
              
              3
                  years
              
              
              3
                  yearsShares
                  issuable upon conversion
              
              
              15,320,122
              
              
              222,222,222Warrants
                  issued
              
              
              22,000,000
              
              
              11,000,000Exercise
                  price of warrants
              
              $
              0.07
              
              $
              0.01Term
                  of warrants at issuance
              
              
              5
                  years
              
              
              7
                  yearsMarket
                  Price on issue dates
              
              $
              0.047
              
              $
              0.020Risk
                  free interest rate on issuance date
              
              
              4.54
              %
              
              4.20
              %Volatility
                  on date of issuance
              
              
              231.77
              %
              
              243.11
              %Fair
                  value per share of conversion shares
              
              
              0.0449
              
              
              0.0196Beneficial
                  conversion feature fair value
              
              $
              687,873
              
              $
              4,355,556Note
                  discount amount
              
              $
              335,000
              
              $
              800,000Warrant
                  fair value per share at issuance
              
              $
              0.0893
              
              $
              0.0200Fair
                  values of warrants at issuance dates
              
              $
              1,964,600
              
              $
              220,000Value
                  of warrants allocable to loan costs
              
              $
              178,600
              
              $
              20,000Fair
                  value of derivative related to warrants
              
              $
              1,786,000
              
              $
              200,000Fair
                  value of derivative allocated to benficialconversion
                  fearure
              
              $
              352,873
              
              $
              3,555,556Aggregate
                  fair value allocated to derivative instruments
              
              $
              2,317,473
              
              $
              3,775,556


On
      August
      1, 2007 the Company entered into an amendment agreement with AJW which would
      subordinate their security interest in the Company's assets to certain future
      lenders in the event that ALC obtains funding from other sources. In addition,
      AJW waived any event of default that existed at the time of the agreement and
      any default that continues to exist until such time as a management plan and
      funding is put in place. In exchange for the waiver and subordination, AJW
      received an additional discount in the method that the conversion price is
      calculated. The conversion price of the Notes issued in conjunction with the
      April 1, 2005 agreement was 60% of the average of the lowest three intra-day
      trading prices for the Company's common stock during the 20 trading days
      immediately preceding the conversion date. The conversion price of the March
      14,
      2006 agreement was 55% of the average of the lowest three intra-day trading
      prices for the Company's common stock during the 20 trading days immediately
      preceding the conversion date. These conversion prices were all adjusted to
      41.5% of the average of the lowest three intra-day trading prices for the
      Company's common stock during the 20 trading days immediately preceding the
      conversion date. As a result of this change in the conversion price for these
      Notes, the Company recognized a loss in the aggregate amount of $3,673,127
      based
      upon the difference in fair value of the beneficial conversion feature
      associated with these notes immediately before and after the agreement to change
      to the conversion prices.





An
      analysis of the valuation of the beneficial conversion feature related to the
      Notes issued in conjunction with the April 1, 2005 and March 14, 2006 AJW Notes
      and the significant assumptions used to value the beneficial conversion feature
      used to compute the derivative valuation loss are contained in the following
      table:




April
                  1, 2005 Agreement
              
              March
                  14, 2006 AgreementTranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  4Valuation
                  date
              
              8/1/2007
              
              8/1/2007
              
              8/1/2007
              
              8/1/2007
              
              8/1/2007
              
              8/1/2007
              
              8/1/2007
              
              TotalAggregate
                  note amounts
              
              $
              459,162
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000
              
              $
              4,959,162Conversion
                  price prior to Agreement
              
              $
              0.0074
              
              $
              0.0074
              
              $
              0.0074
              
              $
              0.0068
              
              $
              0.0068
              
              $
              0.0068
              
              $
              0.0068Conversion
                  price subsequent to Agreement
              
              $
              0.0051
              
              $
              0.0051
              
              $
              0.0051
              
              $
              0.0051
              
              $
              0.0051
              
              $
              0.0051
              
              $
              0.0051Term
                  of notes at August 1, 2007
              
              
              0.67
                  years
              
              
              0.81
                  years
              
              
              1.01
                  years
              
              
              1.66
                  years
              
              
              1.96
                  years
              
              
              2.16
                  years
              
              
              2.26
                  yearsShares
                  issuable upon conversion - prior to agreement
              
              
              63,042,859
              
              
              197,126,351
              
              
              179,388,378
              
              
              159,658,084
              
              
              78,447,715
              
              
              31,054,349
              
              
              46,835,971
              
              
              755,553,707Shares
                  issuable upon conversion - subsequent to agreement
              
              
              91,146,303
              
              
              285,001,954
              
              
              259,356,692
              
              
              211,595,050
              
              
              103,966,851
              
              
              41,156,366
              
              
              62,071,768
              
              
              1,054,294,984Market
                  Price on August 1, 2007
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130Risk
                  free interest rate at August 1, 2007
              
              
              4.65
              %
              
              4.65
              %
              
              4.65
              %
              
              4.65
              %
              
              4.65
              %
              
              4.65
              %
              
              4.65
              %Volatility
                  at August 1, 2007
              
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %Fair
                  value per share of conversion shares - prior to agreeement
              
              $
              0.0100
              
              $
              0.0104
              
              $
              0.0109
              
              $
              0.0119
              
              $
              0.0122
              
              $
              0.0123
              
              $
              0.0124Fair
                  value per share of conversion shares - subsequent to
                  agreeement
              
              $
              0.0106
              
              $
              0.0109
              
              $
              0.0113
              
              $
              0.0121
              
              $
              0.0123
              
              $
              0.0124
              
              $
              0.0125Beneficial
                  conversion feature fair value - prior to agreement
              
              $
              630,429
              
              $
              2,050,114
              
              $
              1,955,333
              
              $
              1,899,931
              
              $
              957,062
              
              $
              381,968
              
              $
              580,766
              
              $
              8,455,604Beneficial
                  conversion feature fair value - subsequent to agreement
              
              $
              966,151
              
              $
              3,106,521
              
              $
              2,930,731
              
              $
              2,560,300
              
              $
              1,278,792
              
              $
              510,339
              
              $
              775,897
              
              $
              12,128,731Loss
                  on repricing
              
              $
              (335,722
              )
              $
              (1,056,407
              )
              $
              (975,397
              )
              $
              (660,369
              )
              $
              (321,730
              )
              $
              (128,370
              )
              $
              (195,131
              )
              $
              (3,673,127
              )




9




On
      August
      22, 2007, in conjunction with the $800,000 Securities Purchase Agreement
      discussed above, the Company and AJW entered into a letter agreement that
      further reduced the conversion price of the Notes issued in conjunction with
      the
      April 1, 2005 agreement the March 14, 2006 agreement from 41.5% of the average
      of the lowest three intra-day trading prices for the Company's common stock
      during the 20 trading days immediately preceding the conversion date. These
      conversion prices were adjusted to 30.0% of the average of the lowest three
      intra-day trading prices for the Company's common stock during the 20 trading
      days immediately preceding the conversion date. In addition, the Company agreed
      to reduce the conversion price of the May 8, 2007 agreement from 40% to 30%
      of
      the average of the lowest three intra-day trading prices for the Company's
      common stock during the 20 trading days immediately preceding the conversion
      date. As a result of this change in the conversion price for these Notes, the
      Company recognized a loss in the aggregate amount of $8,381,479 based upon
      the
      difference in fair value of the beneficial conversion feature associated with
      these notes immediately before and after the agreement to change to the
      conversion prices.





An
      analysis of the valuation of the beneficial conversion feature related to the
      Notes issued in conjunction with the April 1, 2005, March 14, 2006 and May
      8,
      2007 AJW Notes and the significant assumptions used to value the beneficial
      conversion feature used to compute the derivative valuation loss are contained
      in the following table:




April
                  1, 2005 Agreement
              
              March
                  14, 2006 AgreementTranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  4
              
              May
                  8, 2007 AgreementValuation
                  date
              
              8/22/2007
              
              8/22/2007
              
              8/22/2007
              
              8/22/2007
              
              8/22/2007
              
              8/22/2007
              
              8/22/2007
              
              8/22/2007
              
              TotalAggregate
                  note amounts
              
              $
              459,162
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000
              
              $
              335,000
              
              $
              5,294,162Conversion
                  price prior to Agreement
              
              $
              0.0050
              
              $
              0.0050
              
              $
              0.0050
              
              $
              0.0050
              
              $
              0.0050
              
              $
              0.0050
              
              $
              0.0050
              
              $
              0.0049Conversion
                  price subsequent to Agreement
              
              $
              0.0036
              
              $
              0.0036
              
              $
              0.0036
              
              $
              0.0036
              
              $
              0.0036
              
              $
              0.0036
              
              $
              0.0036
              
              $
              0.0036Term
                  of notes at August 22, 2007
              
              
              0.61
                  years
              
              
              0.76
                  years
              
              
              0.96
                  years
              
              
              1.61
                  years
              
              
              1.91
                  years
              
              
              2.11years
              
              
              2.21
                  years
              
              
              2.71
                  yearsShares
                  issuable upon conversion - prior to agreement
              
              
              92,992,761
              
              
              290,888,170
              
              
              264,728,703
              
              
              215,768,387
              
              
              106,023,372
              
              
              41,971,893
              
              
              63,300,622
              
              
              70,227,457
              
              
              1,145,901,365Shares
                  issuable upon conversion - subsequent to agreement
              
              
              128,639,986
              
              
              402,395,302
              
              
              366,208,038
              
              
              298,479,602
              
              
              146,665,665
              
              
              58,061,118
              
              
              87,565,860
              
              
              93,636,610
              
              
              1,581,652,181Market
                  Price on August 22, 2007
              
              $
              0.0200
              
              $
              0.0200
              
              $
              0.0200
              
              $
              0.0200
              
              $
              0.0200
              
              $
              0.0200
              
              $
              0.0200
              
              $
              0.0200Risk
                  free interest rate at August 22, 2007
              
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %Volatility
                  at August 22, 2007
              
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %
              
              242.24
              %Fair
                  value per share of conversion shares - prior to agreeement
              
              $
              0.0170
              
              $
              0.0175
              
              $
              0.0179
              
              $
              0.0188
              
              $
              0.0191
              
              $
              0.0193
              
              $
              0.0193
              
              $
              0.0196Fair
                  value per share of conversion shares - subsequent to
                  agreeement
              
              $
              0.0177
              
              $
              0.0177
              
              $
              0.0183
              
              $
              0.0190
              
              $
              0.0193
              
              $
              0.0194
              
              $
              0.0195
              
              $
              0.0197Beneficial
                  conversion feature fair value - prior to agreement
              
              $
              1,580,877
              
              $
              5,090,543
              
              $
              4,738,644
              
              $
              4,056,446
              
              $
              2,025,046
              
              $
              810,058
              
              $
              1,221,702
              
              $
              1,376,458
              
              $
              20,899,773Beneficial
                  conversion feature fair value - subsequent to agreement
              
              $
              2,276,928
              
              $
              7,122,397
              
              $
              6,701,607
              
              $
              5,671,112
              
              $
              2,830,647
              
              $
              1,126,386
              
              $
              1,707,534
              
              $
              1,844,641
              
              $
              29,281,253Loss
                  on repricing
              
              $
              (696,051
              )
              $
              (2,031,854
              )
              $
              (1,962,963
              )
              $
              (1,614,667
              )
              $
              (805,601
              )
              $
              (316,328
              )
              $
              (485,832
              )
              $
              (468,183
              )
              $
              (8,381,479
              )




The
      Company has outstanding a series of Convertible Notes and warrants issued to
      AJW
      under Securities Purchase Agreements dated April 1, 2005, March 14, 2006, May
      8,
      2007 and August 22, 2007. The conversion price of the Notes issued in
      conjunction with these agreements as of September 30, 2007 is 30% of the average
      of the lowest three intra-day trading prices for the Company's common stock
      during the 20 trading days immediately preceding the conversion date. The Notes
      are secured by all of the Company's assets, except for its accounts receivable
      and proceeds of inventory. AJW has subordinated certain of its interest in
      the
      assets of ALC to Ayuda Funding Corp. The Notes contain embedded derivatives
      in
      the form of the Warrants and the beneficial conversion feature. The Company
      revalues the embedded derivatives and the beneficial conversion feature and
      recognizes a gain or loss based on the changes in the fair values between
      reporting dates. As of September 30, 2007, the derivative instruments had a
      fair
      value of $27,944,906. The carrying value of the AJW notes issued under these
      Securities Purchase Agreements as of September 30, 2007 and December 31, 2006
      was $3,111,142 and $2,079,398 net of discount, respectively. The carrying value
      will be increased each quarter over the respective three year lives of the
      notes
      as the accretion of the discount related to the embedded derivatives is recorded
      until the carrying value equals the face value of the notes.





An
      analysis of the valuation of the individual tranches issued under the above
      mentioned notes and warrants as of September 30, 2007 and the significant
      assumptions used to value the warrants and the beneficial conversion features
      are contained in the following table:




10




April
                  1, 2005 Agreement
              
              March
                  14, 2006 AgreementTranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  4
              
              May
                  8, 2007 Agreement
              
              August
                  22, 2007 AgreementValuation
                  date
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              9/30/2007
              
              
              TotalAggregate
                  note amounts
              
              $
              322,674
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000
              
              $
              335,000
              
              $
              800,000
              
              $
              5,957,674Conversion
                  price at September 30, 2007
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029
              
              $
              0.0029Term
                  of notes at September 30, 2007
              
              
              0.50
                  years
              
              
              0.65
                  years
              
              
              0.85
                  years
              
              
              1.45
                  years
              
              
              1.75
                  years
              
              
              1.95
                  years
              
              
              2.05
                  years
              
              
              2.70
                  years
              
              
              2.90
                  yearsShares
                  issuable upon conversion
              
              
              145,821,081
              
              
              517,835,439
              
              
              471,317,544
              
              
              383,465,614
              
              
              188,444,912
              
              
              74,605,263
              
              
              112,513,333
              
              
              120,345,589
              
              
              283,101,179
              
              
              2,297,449,954Warrants
                  outstanding
              
              
              1,650,000
              
              
              1,430,000
              
              
              1,320,000
              
              
              1,100,000
              
              
              550,000
              
              
              220,000
              
              
              330,000
              
              
              22,000,000
              
              
              11,000,000
              
              
              39,600,000Exercise
                  price of warrants
              
              $
              0.45
              
              $
              0.45
              
              $
              0.45
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25
              
              $
              0.07
              
              $
              0.01Term
                  of warrants at September 30, 2007
              
              
              4.50
                  years
              
              
              4.65
                  years
              
              
              4.85
                  years
              
              
              3.45
                  years
              
              
              3.75
                  years
              
              
              3.95
                  years
              
              
              4.05
                  years
              
              
              4.60
                  years
              
              
              6.90
                  yearsMarket
                  Price on September 30, 2007
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130
              
              $
              0.0130Risk
                  free interest rate at September 30, 2007
              
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %
              
              4.10
              %Volatility
                  at September 30, 2007
              
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %
              
              245.06
              %Fair
                  value per share of conversion shares
              
              $
              0.0110
              
              $
              0.0113
              
              $
              0.0116
              
              $
              0.0122
              
              $
              0.0124
              
              $
              0.0125
              
              $
              0.0126
              
              $
              0.0127
              
              $
              0.0128Beneficial
                  conversion feature fair value
              
              $
              1,604,032
              
              $
              5,851,540
              
              $
              5,467,284
              
              $
              4,678,280
              
              $
              2,336,717
              
              $
              932,566
              
              $
              1,417,668
              
              $
              1,528,389
              
              $
              3,623,695
              
              $
              27,440,171Warrant
                  fair value per share
              
              $
              0.0125
              
              $
              0.0125
              
              $
              0.0126
              
              $
              0.0111
              
              $
              0.0115
              
              $
              0.0117
              
              $
              0.0118
              
              $
              0.0128
              
              $
              0.0130Fair
                  value of derivative related to warrants
              
              $
              20,625
              
              $
              17,875
              
              $
              16,632
              
              $
              12,210
              
              $
              6,325
              
              $
              2,574
              
              $
              3,894
              
              $
              281,600
              
              $
              143,000
              
              $
              504,735Fair
                  value of derivative related tobeneficial
                  conversion feature
              
              $
              1,604,032
              
              $
              5,851,540
              
              $
              5,467,284
              
              $
              4,678,280
              
              $
              2,336,717
              
              $
              932,566
              
              $
              1,417,668
              
              $
              1,528,389
              
              $
              3,623,695
              
              $
              27,440,018Aggregate
                  fair value of derivative instruments
              
              $
              1,624,657
              
              $
              5,869,415
              
              $
              5,483,916
              
              $
              4,690,490
              
              $
              2,343,042
              
              $
              935,140
              
              $
              1,421,562
              
              $
              1,809,989
              
              $
              3,766,695
              
              $
              27,944,906




The
      derivative liability is comprised of the following as of September 30, 2007
      and
      December 31, 2006:





September
                  30, 2007
              
              December
                  31, 2006AJW
                  Notes
              
              $
              27,440,171
              
              $
              10,142,448AJW
                  Warrants
              
              
              504,735
              
              
              1,004,608William
                  Robinson Note
              
              
              229
              
              
              144,615Total
                  derivative liability
              
              $
              27,945,135
              
              $
              11,291,671




As
      of
      December 31, 2006, the derivative instruments had a fair value of $11,147,056.
      An analysis of the valuation of the individual tranches as of December 31,
      2006
      and the significant assumptions used to value the warrants and the beneficial
      conversion feature are contained in the following table:




April
                  1, 2005 Agreement
              
              March
                  14, 2006 AgreementTranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  4
              
              TotalValuation
                  date
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006Aggregate
                  note amounts
              
              $
              739,780
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000
              
              $
              5,239,780Conversion
                  price at December 31, 2006
              
              $
              0.0800
              
              $
              0.0800
              
              $
              0.0800
              
              $
              0.0733
              
              $
              0.0733
              
              $
              0.0733
              
              $
              0.0733Term
                  of notes at December 31, 2006
              
              
              1.25
                  years
              
              
              1.40
                  years
              
              
              1.60
                  years
              
              
              2.2
                  years
              
              
              2.50
                  years
              
              
              2.70
                  years
              
              
              2.80
                  yearsShares
                  issuable upon conversion
              
              
              9,987,192
              
              
              17,475,562
              
              
              15,893,151
              
              
              14,290,909
              
              
              7,017,684
              
              
              2,777,036
              
              
              4,140,000Warrants
                  outstanding
              
              
              1,650,000
              
              
              1,430,000
              
              
              1,320,000
              
              
              1,100,000
              
              
              550,000
              
              
              220,000
              
              
              330,000
              
              
              6,600,000Exercise
                  price of warrants
              
              $
              0.45
              
              $
              0.45
              
              $
              0.45
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25Term
                  of warrants at December 31, 2006
              
              
              5.25
                  years
              
              
              5.4
                  years
              
              
              5.6
                  years
              
              
              4.2
                  years
              
              
              4.5
                  years
              
              
              4.7
                  years
              
              
              4.5
                  yearsMarket
                  Price on December 31, 2006
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155Risk
                  free interest rate at December 31, 2006
              
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %Volatility
                  at year end
              
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %Fair
                  value per share of conversion shares
              
              $
              0.1347
              
              $
              0.1373
              
              $
              0.1401
              
              $
              0.1463
              
              $
              0.1487
              
              $
              0.1496
              
              $
              0.1501Beneficial
                  conversion feature fair value
              
              $
              1,345,275
              
              $
              2,399,395
              
              $
              2,226,630
              
              $
              2,090,760
              
              $
              1,043,530
              
              $
              415,445
              
              $
              621,414
              
              $
              10,142,448Warrant
                  fair value per share at year end
              
              $
              0.1533
              
              $
              0.1535
              
              $
              0.1537
              
              $
              0.1488
              
              $
              0.1501
              
              $
              0.1508
              
              $
              0.1511Fair
                  value of derivative related to warrants
              
              $
              252,945
              
              $
              219,505
              
              $
              202,884
              
              $
              163,680
              
              $
              82,555
              
              $
              33,176
              
              $
              49,863
              
              $
              1,004,608Fair
                  value of derivative related tobeneficial
                  conversion feature
              
              $
              1,345,275
              
              $
              2,399,395
              
              $
              2,226,630
              
              $
              2,090,760
              
              $
              1,043,530
              
              $
              415,445
              
              $
              621,414
              
              $
              10,142,448Aggregate
                  fair value of derivative instruments
              
              $
              1,598,220
              
              $
              2,618,900
              
              $
              2,429,514
              
              $
              2,254,440
              
              $
              1,126,085
              
              $
              448,621
              
              $
              671,277
              
              $
              11,147,056




The
      derivative valuation gain (loss) reported in the accompanying condensed
      consolidated statements of operations results from the issuance, revaluation
      to
      fair value of the beneficial conversion feature and attached warrants associated
      with the above referenced notes to AJW and the derivative valuation loss related
      to the change in valuation of the beneficial conversion features related to
      notes issued to James Gardiner, William Robinson and Frank Lively and changes
      in
      value recognized upon conversion of the notes. As the fair value of the
      derivatives change, a gain or a loss is recognized. The components of the
      derivative valuation gain (loss) for the three and nine months ended September
      30, 2007 and 2006 consists of the following:




11




Three
                  months September 30,
              
              Nine
                  months ended September 30,2007
              
              2006
              
              2007
              
              2006Derivative
                  valuation gain (loss) - beneficial conversion revaluation -
                  AJW
              
              $
              363,639
              
              $
              165,202
              
              $
              (926,208
              )
              $
              4,225,140Derivative
                  valuation gain (loss) - warrant revaluation AJW
              
              
              655,678
              
              
              (9,779
              )
              
              2,679,818
              
              
              1,164,955Derivative
                  valuation loss - August 1, 2007 repricing
              
              
              (3,673,127
              )
              
              -
              
              
              (3,673,127
              )
              
              -Derivative
                  valuation loss - August 22, 2007 repricing
              
              
              (8,381,479
              )
              
              -
              
              
              (8,381,479
              )
              
              -Derivative
                  valuation gain - beneficial conversion revaluation -
                  Robinson
              
              
              14,321
              
              
              24,960
              
              
              232,012
              
              
              767,572Derivative
                  valuation (loss) on issuance of notes - AJW
              
              
              (3,555,556
              )
              
              (527,648
              )
              
              (3,908,429
              )
              
              (2,127,303
              )Derivative
                  valuation (loss) on issuance of warrants -AJW
              
              
              (197,008
              )
              
              (117,140
              )
              
              (1,986,000
              )
              
              (610,040
              )Derivative
                  valuation gain (loss) on conversion of notes -AJW
              
              
              35,343
              
              
              (45,305
              )
              
              127,764
              
              
              (58,489
              )Derivative
                  valuation gain on conversion of notes - Robinson
              
              
              -
              
              
              20,010
              
              
              -
              
              
              20,010Derivative
                  valuation gain on conversion of notes - Lively
              
              
              -
              
              
              -
              
              
              -
              
              
              4,193Derivative
                  valuation gain on conversion of notes - Gardiner
              
              
              -
              
              
              -
              
              
              -
              
              
              840Derivative
                  valuation (loss) on issuance of note - Gardiner
              
              
              -
              
              
              -
              
              
              -
              
              
              (37,050
              )Derivative
                  valuation (loss) on issuance of note- Robinson
              
              
              -
              
              
              -
              
              
              -
              
              
              (368,608
              )Derivative
                  valuation (loss) on issuance of notes - Lively
              
              
              -
              
              
              4,193
              
              
              -
              
              
              (58,306
              )Derivative
                  valuation gain - beneficial conversion revaluation -
                  Lively
              
              
              -
              
              
              -
              
              
              -
              
              
              106,799Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Gardiner
              
              
              -
              
              
              
              
              
              -
              
              
              (20,520
              )Total
                  Derivative valuation gain (loss)
              
              $
              (14,738,189
              )
              $
              (485,507
              )
              $
              (15,835,649
              )
              $
              3,009,193




In
      a
      series of transactions from April 11, 2007 to July 23, 2007, AJW converted
      an
      aggregate of $361,462 of the Notes for 22,162,821 Shares of Class A common
      stock
      of the Company. The conversions were made at a 40% discount to market pursuant
      to the terms of the Secured Convertible Note agreements. As a result of the
      conversion, $432,436 of the derivative liability was reclassified to additional
      paid-in capital.




An
      analysis of these conversions of the AJW Notes and the significant assumptions
      used to value the beneficial conversion feature recognized upon conversion
      are
      contained in the following table:




Conversion
                  date
              
              4/11/2007
              
              5/18/2007
              
              6/12/2007
              
              6/26/2007
              
              7/18/2007
              
              7/20/2007
              
              7/23/2007Original
                  proceeds from note
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000Note
                  amount converted
              
              
              156,437
              
              
              47,038
              
              
              32,071
              
              
              45,071
              
              
              43,223
              
              
              20,000
              
              
              17,621Principal
                  remaining after conversion
              
              $
              583,343
              
              $
              536,305
              
              $
              504,234
              
              $
              459,162
              
              $
              415,939
              
              $
              395,939
              
              $
              378,318Conversion
                  price
              
              $
              0.044
              
              $
              0.0132
              
              $
              0.009
              
              $
              0.012
              
              $
              0.0115
              
              $
              0.0098
              
              $
              0.0098Term
                  of notes at conversion
              
              
              1
                  year
              
              
              0.87
                  year
              
              
              0.80
                  year
              
              
              0.76
                  year
              
              
              0.70
                  year
              
              
              0.69
                  year
              
              
              0.69
                  yearShares
                  issued on conversion
              
              
              3,563,483
              
              
              3,563,483
              
              
              3,563,483
              
              
              3,755,941
              
              
              3,758,553
              
              
              2,000,000
              
              
              1,957,878Potential
                  remaining conversion shares
              
              
              13,760,051
              
              
              37,144,991
              
              
              43,516,573
              
              
              40,225,958
              
              
              36,444,933
              
              
              49,225,669
              
              
              47,431,279Common
                  Stock Price on conversion date
              
              $
              0.055
              
              $
              0.025
              
              $
              0.022
              
              $
              0.024
              
              $
              0.015
              
              $
              0.0140
              
              $
              0.0140Risk
                  free interest rate at conversion date
              
              
              4.97
              %
              
              4.92
              %
              
              5.01
              %
              
              4.97
              %
              
              4.98
              %
              
              5.00
              %
              
              5.00
              %Volatility
                  on conversion dates
              
              
              228.21
              %
              
              232.70
              %
              
              236.88
              %
              
              238.44
              %
              
              240.16
              %
              
              242.36
              %
              
              242.36
              %Fair
                  value per share of conversion shares
              
              
              0.0420
              
              
              0.0195
              
              
              0.0172
              
              
              0.0189
              
              
              0.0106
              
              
              0.0104
              
              
              0.0104Fair
                  value of derivative
              
              $
              577,922
              
              $
              724,327
              
              $
              748,485
              
              $
              760,271
              
              $
              386,316
              
              $
              511,947
              
              $
              493,285Derivative
                  liability reclassified to additionalpaid-in
                  capital upon conversion
              
              $
              149,666
              
              $
              69,488
              
              $
              61,292
              
              $
              70,987
              
              $
              39,841
              
              $
              20,800
              
              $
              20,362Derivative
                  valuation gain (loss)recognized
                  on conversion
              
              $
              115,381
              
              $
              (14,097
              )
              $
              (3,187
              )
              $
              (5,676
              )
              $
              41,344
              
              $
              (5,819
              )
              $
              -




From
      August 27 to September 28, 2007 AJW converted an aggregate of $55,644 of the
      Notes for 18,391,434 Shares of Class A common stock of the Company. The
      conversions were made at a 70% discount to market pursuant to the terms of
      the
      Secured Convertible Note agreements. As a result of the conversion, $170,975
      of
      the derivative liability was reclassified to additional paid-in
      capital.




An
      analysis of these conversions of the AJW Notes and the significant assumptions
      used to value the beneficial conversion feature recognized upon conversion
      are
      contained in the following table:




12


Conversion
                  date
              
              8/27/2007
              
              8/31/2007
              
              9/6/2007
              
              9/19/2007
              
              9/28/2007Original
                  proceeds from note
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000Note
                  amount converted
              
              
              7,154
              
              
              7,353
              
              
              14,897
              
              
              13,936
              
              
              12,303Principal
                  remaining after conversion
              
              $
              371,164
              
              $
              363,811
              
              $
              348,914
              
              $
              334,977
              
              $
              322,674Conversion
                  price
              
              $
              0.0036
              
              $
              0.0037
              
              $
              0.0031
              
              $
              0.0290
              
              $
              0.0026Term
                  of notes at conversion
              
              
              0.59
                  year
              
              
              0.58
                  year
              
              
              0.57
                  year
              
              
              0.53
                  year
              
              
              0.51
                  yearShares
                  issued on conversion
              
              
              1,987,272
              
              
              1,987,272
              
              
              4,805,630
              
              
              4,805,630
              
              
              4,805,630Potential
                  remaining conversion shares
              
              
              123,394,275
              
              
              112,491,411
              
              
              125,726,746
              
              
              122,376,983
              
              
              145,771,761Common
                  Stock Price on conversion date
              
              $
              0.0130
              
              $
              0.0120
              
              $
              0.0095
              
              $
              0.0130
              
              $
              0.0130Risk
                  free interest rate at conversion date
              
              
              4.20
              %
              
              4.20
              %
              
              4.20
              %
              
              4.10
              %
              
              4.10
              %Volatility
                  on conversion dates
              
              
              242.74
              %
              
              242.67
              %
              
              242.33
              %
              
              243.51
              %
              
              245.06
              %Fair
                  value per share of conversion shares
              
              
              0.0078
              
              
              0.0098
              
              
              0.0098
              
              
              0.0075
              
              
              0.0110Fair
                  value of derivative
              
              $
              962,475
              
              $
              1,102,416
              
              $
              1,232,122
              
              $
              917,827
              
              $
              1,603,489Derivative
                  liability reclassified to additionalpaid-in
                  capital upon conversion
              
              $
              15,501
              
              $
              19,475
              
              $
              47,095
              
              $
              36,042
              
              $
              52,862Derivative
                  valuation gain (loss)recognized
                  on conversion
              
              $
              19,868
              
              $
              (2,501
              )
              $
              (5,575
              )
              $
              9,073
              
              $
              (21,046
              )




The
      Company has granted certain registration rights with respect to the Securities
      Purchase Agreements with AJW dated April 1, 2005, March 14, 2006, May 8, and
      August 22, 2007. These registration rights agreements call for penalties for
      failure to have an effective registration statement covering the securities
      under these agreements of 2.0% per month of the outstanding principal balance
      of
      the notes under said agreements. As part of the August 1, 2007 Agreement
      discussed above, AJW cured any deficiencies or defaults in the above mentioned
      Securities Purchase Agreements dated April 1, 2005, March 14, 2006 and May
      8,
      2007 including the penalties for failure to have the registration statement
      declared effective. If AJW chooses to assess these penalties, the Company would
      have a liability for said penalty as of September 30, 2007 of approximately
      $1,300,000. No amount has been accrued for these penalties as of September
      30,
      2007.





On
      August 24, 2007, ALC and TSI LLC jointly issued a convertible promissory note
      to
      Ayuda Funding Corp. (“Ayuda”) in the amount of $375,000 which note replaces a
      note issued by the Company’s CEO, William Robinson in the same amount. Mr.
      Robinson used the funds to make a loan to the Company in order to enable it
      to
      pay its licensing fee owed to 21 st Century
      Airships. In connection with such loan, ALC and TSI LLC entered into a Pledge
      and Security Agreement with Ayuda. The Note is guaranteed by Mr. Robinson,
      personally and by Proxity, Inc. The note is convertible at any time at the
      closing market price of the Company’s common stock on the date of conversion. On
      September 20, 2007 Ayuda converted $132,000 of the note at a price of $0.012
      per
      share, representing the closing market price as of that date. The Company
      accordingly issued 11,000,000 shares of its Class A common stock to
      Ayuda.




The
      following table details the Notes payable - third parties, Current portion
      of
      long term notes payable and Long term notes payable outstanding as of September
      30, 2007 and December 31, 2006.




13


**September
                  30,**
              
              **December
                  31,****2007**
              
              **2006****Current
                  - Unrelated parties**Convertible
                  Notes payable C.M.G. Tech., interest accrues at 10% perannum
                  due February 25, 2007 currently in default
              
              $
              822,094
              
              $
              822,094Note
                  payable Charles McClure, secured by an airship, interest
                  accruesat
                  25.0% per annum and is due December 31, 2005, currently in
                  default
              
              
              250,000
              
              
              250,000Demand
                  Notes to Vendors - unsecured, interest accrues at 12% perannum
                  currently in default
              
              
              781
              
              
              781Note
                  payable - Sierra Nevada Corporation - non interest bearing secured
                  bycertain
                  inventory due August 25, 2006, currently in default
              
              
              500,000
              
              
              500,000Note
                  payable - Microsoft Corporation - bearing interest at 7.0%
                  toJune
                  14, 2008, 9.0% to June 14, 2009, and 11.0% thereafterequal
                  monthly installments of $166.227 commencing April 1, 2008due
                  August 1, 2010
              
              
              2,500,000
              
              
              -Convertible
                  note payable - Ayuda Funding Corp. - bearing interest at
                  15%secured
                  by certain assets of TSI LLC and ALC, due February 21,
                  2008
              
              
              243,000
              
              
              -$
              4,315,875
              
              $
              1,572,875Less
                  current portion
              
              
              (2,813,237
              )
              
              (1,572,875
              )Total
                  long term notes payable - Unrelated parties
              
              $
              1,502,638
              
              $
              -**Current
                  Portion of Long Term Notes Payable**Notes
                  payable - AJW Partners, LLP and affiliates, callable
                  securedconvertible
                  notes bearing interest at 8% per annum, $459,162due
                  April 4, 2008; $1,300,000 due May 25, 2008 , $1,200,000August
                  4, 2008 less total discount of $671,692 and $0,
                  respectively
              
              $
              2,150,982
              
              $
              -**Long
                  Term Notes Payable**Notes
                  payable - AJW Partners, LLP and affiliates, callable
                  securedconvertible
                  notes bearing interest at 8% per annum, $739,779due
                  April 4, 2008; $1,300,000 due May 25, 2008 and$1,200,000
                  due August 4, 2008 less total discount of$0
                  and $1,549,058, respectively
              
              $
              -
              
              $
              1,690,721Notes
                  payable - AJW Partners, LLP and affiliates, callable
                  securedconvertible
                  notes bearing interest at 6% per annum, $1,000,000due
                  April 14, 2009; $500,000 due July 5, 2009, 200,000 due$200,000
                  due September 11, 2009, $300,000 due October19,
                  2006 and $335,000 due May 10, 2009 less total discountof
                  $1,403,333 and $1,611,323, respectively
              
              
              931,667
              
              
              388,677Notes
                  payable - AJW Partners, LLP and affiliates, callable
                  securedconvertible
                  notes bearing interest at 8% per annum, $800,000due
                  August 21, 2010; less total discount of $771,507 and $0,
                  respectively
              
              
              28,493
              
              
              -Total
                  long term notes payable
              
              $
              960,160
              
              $
              2,079,398




14




**NOTE
      5 - NOTES PAYABLE - RELATED PARTIES**




On
      April
      19th, 2006, the Board approved a $1,000,000 line of credit with Mr. Robinson.
      On
      April 19, 2006 pursuant to the line of Credit, the Company entered into a
      convertible variable promissory note in the principal amount as of March 31,
      2006 of $565,188 including all related accrued interest. The note bears interest
      at the rate of 12% per annum, is unsecured and is convertible into Class A
      common stock at $0.30 per share. The note is due on December 31, 2007. The
      note
      contains a beneficial conversion due to the conversion price of $0.30 being
      lower than the market price of $0.53 on the date of issuance. The carrying
      value
      of the note in the accompanying balance sheet as of September 30, 2007 and
      December 31, 2006 was $508,198 and $181,061, net of discount, respectively
      and
      is recorded in Notes Payable - related parties.





Mr.
      Robinson advanced certain amounts from time to time to the Company under the
      line of credit during the nine months ended September 30, 2007 resulting in
      the
      recognition of additional discounts upon issuance. The derivative analysis
      of
      the valuation upon issuance and the revaluation as of September 30, 2007 and
      December 31, 2006 of the beneficial conversion feature related to Mr. Robinson's
      note and the significant assumptions used are contained in the following
      table:




Issuances
              
              IssuancesReport
                  date
              
              from
                  January 1 to
              
              from
                  April 1 to
              
              Report
                  dateDecember
                  31, 2006
              
              March
                  31, 2007
              
              June
                  30, 2007
              
              September
                  30, 2007Aggregate
                  note amounts
              
              $
              362,412
              
              $
              430,163
              
              $
              66,504
              
              $
              577,338Conversion
                  price
              
              $
              0.30
              
              $
              0.30
              
              $
              0.30
              
              $
              0.30Term
                  of notes
              
              
              1.0
                  year
              
              
              .80
                  - .95 years
              
              
              ..65
                  - .80 years
              
              
              0.25
                  yearShares
                  issuable upon conversion
              
              
              1,375,974
              
              
              1,433,876
              
              
              1,433,876
              
              
              2,287,960Market
                  Price
              
              $
              $0.16
              
              
              $0.085
                  - $0.135
              
              
              $0.038
                  - $0.065
              
              $
              $0.0130Risk
                  free interest rate
              
              
              5.00
              %
              
              4.93%
                  - 5.07
              %
              
              4.87%
                  - 5.07
              %
              
              4.10
              %Volatility
              
              
              233.53
              %
              
              231.76%
                  - 233.53
              %
              
              228.81%
                  - 237.36
              %
              
              245.06
              %Fair
                  value per share of conversion shares
              
              $
              0.1051
              
              
              $0.042
                  - $0.083
              
              
              $0.0086
                  - $0.0256
              
              $
              0.0001Beneficial
                  conversion feature fair value
              
              $
              144,615
              
              $
              78,843
              
              $
              2,783
              
              $
              229Note
                  discount amount
              
              
              
              
              $
              78,843
              
              $
              2,783Fair
                  value of derivative related tobeneficial
                  conversion feature
              
              $
              144,615
              
              $
              -
              
              $
              -
              
              $
              229




The
      following table details the Notes payable - related parties outstanding as
      of
      September 30, 2007 and December 31, 2006.




15




**September
                  30,**
              
              **December
                  31,****2007**
              
              **2006**Convertible
                  Promissory Note - Cherokee Raiders, interest at 12%per
                  annum, due December 31, 2007, unsecured
              
              $
              262,255
              
              $
              262,255Convertible
                  Promissory Note - Proxity Inc., interest at 12% per annum,due
                  July 31, 2007, unsecured
              
              
              301,600
              
              
              301,600Convertible
                  Promissory Note - Billy Robinson, interest at 12%per
                  annum, due December 31, 2007, unsecured, net of discount
                  of$69,140
                  and $181,350, respectively
              
              
              508,198
              
              
              181,061Related
                  Party Promissory Notes, interest at 12% per annumdue
                  on demand.
              
              
              58,495
              
              
              -$
              1,130,548
              
              $
              744,916




On
      July
      16, 2007 the Company executed new notes whereby each of the balances of the
      notes due to Proxity, Cherokee and Mr. Robinson plus the respective accrued
      interest on each note was refinanced into a new note on exactly the same terms
      as the previous notes.




**NOTE
      6- STOCKHOLDERS' DEFICIT**




COMMON
      STOCK - At September 30, 2007 and December 31, 2006 the Company had 125,835,202
      and 66,657,316 shares of Class A Common Stock outstanding, respectively, 545,455
      shares of Class B Common Stock, and 2 shares of Class C Common Stock issued
      and
      outstanding with 200,000,000 shares of Class A and Class B Common Stock
      authorized, par value $.001, and 200,000,000 shares of Class C Common Stock
      authorized, par value $.001. In addition, the Company had 100,000,000 shares
      of
      Class A Preferred Stock authorized, par value $.001, with no shares issued
      and
      outstanding. Class B Common Stock allows for 1,000 votes per share. Class C
      Common Stock allows for one vote per share and entitles the holder to receive
      the net assets of the Company upon dissolution. Additional paid in capital
      at
      September 30, 2007 and December 31, 2006 was $21,660,203 and $20,372,513,
      respectively. The accumulated deficit at September 30, 2007 and December 31,
      2006 was $59,900,483 and $38,516,199 respectively.




The
      Company issued the following shares of Class A Common Stock during the nine
      months ended September 30, 2007.




On
      January 19, 2007 the Company issued a total of 5,114 shares valued at $0.13
      per
      share to a vendor for services based on the closing market price as of that
      date. The Company recorded an expense of $665 as general and administrative
      expenses in the accompanying statement of operations for the nine months ended
      September 30, 2007.




On
      January 19, 2007 the Company issued a total of 357,059 shares valued at $0.13
      per share to a vendor for services rendered in partial settlement of accounts
      payable based on the closing market price as of that date. The Company recorded
      a reduction of accounts payable of $46,418 in the accompanying balance sheet
      as
      of that date.




On
      February 12, 2007 the Company issued 360,000 shares valued at $0.12 per share
      to
      a vendor for services based on the closing market price as of that date. The
      Company recorded an expense of $43,200 as general and administrative expenses
      in
      the accompanying statement of operations for the nine months ended September
      30,
      2007.




On
      February 28, 2007 the Company issued a total of 251,538 shares valued at $0.11
      per share to a vendor for services rendered in settlement of accounts payable
      based on the closing market price as of that date. The Company recorded a
      reduction of accounts payable of $27,669 in the accompanying balance sheet
      as of
      the date of issuance and a reduction of general and administrative expenses
      of
      $8,541 for the nine months ended September 30, 2007.




16




On
      April
      11, 2007 the Company issued 3,563,483 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $156,438
      at
      a price of $0.044 per share.





On
      April
      17, 2007 the Company issued 100,000 shares of Class A Common Stock to a vendor
      for services valued at $0.065 per share based on the closing market price as
      of
      that date. The Company recorded a general and administrative expense of $6,500
      relative to this stock issuance for nine months ended September 30,
      2007.





On
      May
      18, 2007 the Company issued 3,563,483 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $47,038
      at
      a price of $0.0132 per share.





On
      June
      12, 2007 the Company issued 3,563,483 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $32,071
      at
      a price of $0.009 per share.





On
      June
      26, 2007 the Company issued 3,755,941 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $45,071
      at
      a price of $0.012 per share.





On
      July
      18, 2007 the Company issued 3,758,553 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $43,223
      at
      a price of $0.015 per share.





On
      July
      20, 2007 the Company issued 2,000,000 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $20,000
      at
      a price of $0.0098 per share.





On
      July
      23, 2007 the Company issued 1,957,880 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $17,621
      at
      a price of $0.010 per share.





On
      August
      7, 2007, the Company issued 6,000,000 shares to two accredited investors for
      cash at a price of $0.01 per share for aggregate proceeds to the Company of
      $60,000.





On
      August
      13, 2007 the Company issued 250,000 shares valued at $0.018 per share to Launch
      Funding Network, Inc. for services based on the closing market price as of
      that
      date. The Company recorded an expense of $4,500 as general and administrative
      expenses in the accompanying statement of operations for the nine months ended
      September 30, 2007.





On
      August
      27, 2007 the Company issued 1,987,272 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $7,154 at a
      price of $0.0036 per share.





On
      August
      31, 2007 the Company issued 1,987,272 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $7,353
      at a
      price of $0.0037 per share.





On
      September 6, 2007 the Company issued 4,805,630 shares of Class A Common Stock
      to
      AJW et al upon the conversion of notes in the aggregate principal amount of
      $14,897 at a price of $0.0031 per share.





On
      September 12, 2007 the Company issued 300,000 shares valued at $0.018 per share
      to The Technology Communications Group, Inc. for services based on the closing
      market price as of that date. The Company recorded an expense of $5,400 as
      general and administrative expenses in the accompanying statement of operations
      for the nine months ended September 30, 2007.





On
      September 19, 2007 the Company issued 4,805,630 shares of Class A Common Stock
      to AJW et al upon the conversion of notes in the aggregate principal amount
      of
      $13,936 at a price of $0.0029 per share.





On
      September 20, 2007 the Company issued 11,000,000 shares of Class A Common Stock
      to Ayuda Funding upon the conversion of notes in the aggregate principal amount
      of $132,000 at a price of $0.012 per share representing the closing market
      price
      as of that date.





On
      September 28, 2007 the Company issued 4,805,630 shares of Class A Common Stock
      to AJW et al upon the conversion of notes in the aggregate principal amount
      of
      $12,303 at a price of $0.00256 per share.




17




The
      Company no longer has enough authorized Class A Common stock to satisfy the
      outstanding convertible debt, warrants, and options outstanding due to the
      reduction in the price of its common stock and the conversion pricing of the
      AJW
      debt.




**NOTE
      7- INCOME TAXES**




The
      Company has paid no federal or state income taxes since its incorporation.
      As of
      September 30, 2007 and December 31, 2006, the Company had net operating loss
      carry forwards for federal income tax reporting purposes of approximately
      $19,000,000 and $15,019,484 respectively, which if unused, will expire through
      2027. Deferred tax assets are reduced by a valuation allowance to the extent
      that uncertainty exists as to whether the deferred tax assets will ultimately
      be
      realized.




**NOTE
      8- COMMITMENTS AND CONTINGENCIES**




On
      January 1, 2006 we entered into a new employment agreement with Mr. Robinson,
      the CEO, Chairman and President of the Company. The term of this agreement
      is
      for a period of one year subject to renewal for successive one year periods,
      unless 14 days prior written notice is provided by either party. Mr. Robinson
      will receive an annual salary of not less than $250,000. The agreement provides
      for standard benefits, vacation and participation in the Company's bonus pool
      as
      defined in the agreement. In addition, the Company shall issue to Employee
      options to purchase shares of Company stock (Shares) in accordance with the
      Company's Stock Option Plan. The agreement may be terminated for due cause,
      upon
      death, upon disability, voluntary termination by him, or us, without due cause
      by providing 14 days prior written notice. Mr. Robinson is subject to a
      non-compete and non-solicitation provision during the employment term and during
      a specified Post-Employment Period (as defined in the employment
      agreement).




On
      April
      1, 2006, TSI entered into a new employment agreement with John Youngbeck as
      Executive Vice President. The term of this agreement is one year, subject to
      renewal for successive one year periods, unless 14 days prior written notice
      is
      provided by either party. Mr. Youngbeck will receive an annual salary of not
      less than $100,000. The agreement provides for standard benefits, vacation
      and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or us without due cause by providing 14 days
      prior
      written notice. Mr. Youngbeck is subject to a non-compete and non-solicitation
      provision during the employment term and during a specified Post-Employment
      Period.




On
      April
      1, 2006, TSI entered into a new employment agreement with Michael Lawson as
      Corporate Marketing Officer. The term of this agreement is one year, subject
      to
      renewal for successive one year periods, unless 14 days prior written notice
      is
      provided by either party. Mr. Lawson will receive an annual salary of not less
      than $100,000. The agreement provides for standard benefits, commissions of
      2%
      of all gross sales less costs registered by the employee, vacation and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or us without due cause by providing 14 days
      prior
      written notice. Mr. Lawson is subject to a non-compete and non-solicitation
      provision during the employment term and during a specified Post-Employment
      Period.





On
      January 1, 2006, the Company entered into an hourly consulting agreement for
      with Steve Johnson. Fees due under the consulting agreement are convertible
      into
      Class A common shares of the Company by Mr. Johnson at the lesser of $0.30
      per
      share or the closing price on the date of conversion.




On
      May 3,
      2007 the Company entered in an agreement, as amended with Affiliated Business
      Services, Inc. (“Affiliated”) to assist the Company with introducing the Company
      to potential sources of debt or equity financing. As part of the agreement,
      Affiliated agreed to settle the remaining balance owed by the Company to
      Affiliated related to its fees due under the financings related to AJW of
      $40,882 for a cash payment of $20,000. In addition, the agreement calls for
      the
      payment of cash of 10% of the gross proceeds as a result of any investment
      transaction resulting from Affiliated having made such introduction as well
      a
      grant of 10% of any warrants granted to any investor in any successful
      transaction. The Company issued five year warrants to purchase 2,000,000 of
      the
      Company’s Class A common stock at an exercise price of $0.07 per share in
      conjunction with the May 8, 2007 AJW transaction and warrants to purchase
      1,000,000 of the Company’s Class A common stock at an exercise price of $0.01
      per share in conjunction with the August 22, 2007 AJW transaction.




18




On
      April
      27, 2006 the Company entered into an Agreement, (the "Agreement") dated as
      of
      April 25, 2006, by and among the Company, Sierra Nevada Corporation "Sierra"
      and
      TSI. The Agreement is intended to clarify the relationship and obligations
      of
      the parties, which arise from three prior agreements (the Exclusive Agreement
      to
      Provide Integration Services, dated June 30, 2004, the Memorandum of Agreement
      dated November 4, 2004 and the Subcontract Agreement dated May 11, 2005) which
      were entered into prior to TSI becoming a wholly-owned subsidiary of the
      Company. The Agreement provides that SNC will serve as the prime contractor
      to
      Government End-Users for all Techsphere Airships and provided that Sierra will
      give Techsphere the right of first refusal to lease or sell other non-Techsphere
      manufactured airships to Sierra on competitive terms. The Agreement also is
      intended to arrive at an understanding with respect to amounts claimed by Sierra
      as owed, which arose from certain expenditures made by Sierra for which they
      are
      seeking reimbursement. The Agreement provides that if all other conditions
      of
      the Agreement are fulfilled that (i) Sierra will reduce its claim from $780,000
      to $500,000; (ii) the Company will within 90 days deliver four MAA-90 airship
      pods to Techsphere free and clear of any liens and encumbrances and (iii) if
      a
      delivery order is awarded and Techsphere delivers the completed MAA-90 airship
      to Sierra, Sierra will set-off the $500,000 payment due from the Company. The
      Company has delivered the four MAA-90 airship pods and has received the delivery
      order from Sierra in February, 2007 in excess of $1,000,000 calling for the
      completion of the MAA-90 airship as well as certain additional operating
      features and accessories. Final terms include a $500,000 credit against the
      note
      provided that a completed airship is delivered upon a mutually agreed upon
      milestone schedule. During September, 2007 SNC cancelled the delivery order
      for
      the completion of the MAA-90 Airship. On
      September 26, 2007 the Company received a cancelation of PO number 55814 for
      the
      completion of the SA 90 Airship under contract. The Company was also informed
      that it still owes the $500,000 agreed to in the aforementioned settlement.
      There are receivables currently outstanding from SNC and the company believes
      that there can be an amicable settlement with SNC. The current IDIQ is still
      in
      effect and the company has requested a meeting with SNC to negotiate their
      working relationship going forward. As of the date of this filing no meeting
      has
      been set.





During
      the year ended December 31, 2006, the Company executed an Airship Advertising
      Agreement with Microsoft Corporation (“Microsoft”) for the lease and operation
      of two of its SA-60 spherical airships. The Company received an aggregate of
      $2,760,000 under the terms of the contract as amended for the construction
      of
      the airship. The construction process was halted and the Airship Advertising
      Agreement was cancelled in the first quarter of 2007.





Effective
      June 15, 2007 TSI executed a promissory note in the amount of $2,500,000 on
      terms to settle its current contract and payables issues for funds advanced
      for
      the construction of two SA 60 airships. The note bears interest accruing at
      a
      rate of 7.0% percent per annum for the first twelve months, 9.0% per annum
      for
      the second twelve months, and 11.0% for the remaining term of the note. TSI
      was
      eligible to receive a discount of $1,000,000 if it makes payments of $875,000
      on
      or before August 25, 2007, $50,000 on or before November 25, 2007 and $575,000
      on or before January 25, 2008. On
      September 10, 2007, TSI entered into an amendment with Microsoft Corporation
      which extended the due date of the $875,000 to October 26, 2007 the $50,000
      to
      January 25, 2008 and the final $575,000 to March 24, 2008. TSI has not made
      the
      October 26, 2007 payment on a timely basis and, as a result is liable for the
      full principal sum of $2,500,000 and all accrued interest under the Note payable
      in equal monthly installments commencing on April 1, 2008 and due by August
      1,
      2010. If
      the
      Company should not make the required monthly installments, upon receipt of
      a
      notice of demand, the note will bear interest at 12% per annum and the entire
      balance will be deemed due immediately.





On
      December 10, 2006, the Company entered into a Licensing and Technical Assistance
      Agreement with Global Skyship Industries, Inc. (“Global”) for the use of certain
      patented technology and know how in the manufacture of TSI’s airships. The
      license agreement called for a term of 6 years ending December 10, 2012 and
      minimum royalty payments under the agreement of $240,000 for 2007 and 2008,
      $300,000 for 2009 and 2010 and $360,000 for 2011 and 2012. The payment for
      the
      quarter ending September 30, 2007 has not been made.




In
      February, 2007 the Company’s Columbus, GA lease expired and the facility is
      presently being leased on a month to month basis. The Company allowed Mr.
      Robinson’s lease for his apartment to expire at the end of its term on May 31,
      2007.





On
      April
      16, 2007 the Company entered into a non-exclusive agreement with John Nathan
      Youngbeck to perform strategic and financial consulting for the Company. The
      agreement calls for payment of 7.0% of the value of the sale of any assets
      of
      the Company and 3.0% of the value of any product of the Company sold by his
      efforts. The contract has a term of 12 months. No transactions have occurred
      under the contract. On October 23, 2007 this agreement was
      canceled.




19




On
      July
      2, 2007, the Company entered into an agreement with Royce Kelly, an individual
      assisting the Company with raising funds. Mr. Kelly will receive compensation
      in
      the amount of 5% of the value of any investment transaction which closes by
      his
      efforts. No transactions have closed under this agreement.





On
      August
      6 th ,
      2007
      James Alman the Vice President of Engineering resigned.





On
      August
      13 th ,
      2007
      the Company executed an agreement with Launch Funding Network, Inc. to assist
      the Company in raising funds. The agreement provides for payment of $11,500
      in
      cash by October 5, 2007, the issuance of 250,000 shares of stock, expenses
      to a
      maximum of $75,000 and 3% of any financing raised through their efforts. The
      Company recorded the value of the stock of $4,500 based on the August 13, 2007
      closing market price for the Company’s common stock. Under the terms of the
      agreement, the Company will pay no more than 3.5% of amounts raised through
      their efforts.





On
      August the 16 th The Company cancelled its Cyber Bug Sales Agreement with National Security
      Associates, Inc. (“NSA”) which provided that NSA would act as the exclusive
      sales agent for the Cyber Bug.





On
      September 6 th ,
      2007, the Company announced that it will pay a dividend of its shares of
      Techsphere. The record date for this dividend is September 17, 2007. NASDAQ
      will
      set the ex-dividend date. For every four shares of the Company owned the holder
      will receive one share of Techsphere.





On
      September 12 th ,
      2007
      the Company entered into an agreement with The Technology Communications Group,
      Inc. (“TTC”) to assist the Company with corporate communications and in raising
      funds. Under the terms of the agreement, the Company issued 300,000 shares
      valued at $0.018 per share to The Technology Communications Group, Inc. for
      services based on the closing market price as of that date. The Company recorded
      an expense of $5,400 as general and administrative expenses in the accompanying
      statement of operations for the nine months ended September 30, 2007. Under
      the
      terms of the agreement, the Company will pay TTC 1% of any funds raised through
      their efforts.





October
      16 th the
      Company and JADA Consulting agreed to mutually cancel the global agreement
      entered into to market the Company’s CyberBug products.




On
      October the 31 st the
      lease on the current facility in St. Petersburg Florida expired. The company
      is
      negotiating with the landlord for a new facility in the same complex and is
      currently on a month to moth lease.





The
      Company received notice that a lawsuit has been filed by Georgia Tech Applied
      Research Corporation (“Georgia Tech”) against TSI. TSI is in negotiations to
      settle the matter and engage Georgia Tech for further research and engineering
      studies in the future. The lawsuit brought in the State Court of Fulton County,
      State of Georgia and seeks immediate payment of the outstanding balance of
      $229,649. The Company has signed a consent judgment for the balance plus
      interest of $49,938 through September 30, 2007. The consent judgment calls
      provides for total payments of $158,100 in two installments, the first of which
      in the amount of $11,842 was due November 15, 2007 and has not been paid and
      is
      presently in default. The remaining balance of $146,258 is due December 15,
      2007
      plus additional accrued interest. The agreement states that the full,
      undiscounted amount shall be due and immediately payable should the Company
      fail
      to make the required payments. The Company is in discussions with Georgia Tech
      regarding an extension to the due date of the payment, but there can be no
      assurances that these discussions will be successful. The entire, undiscounted
      amount plus related accrued interest has been recorded in the accompanying
      balance sheet as of September 30, 2007.





Certain
      trade vendors in the ordinary course of business have not been paid. Certain
      vendors have obtained judgments for unpaid services. The amounts owed have
      been
      accrued in the accompanying financial statements as of September 30,
      2007.




**NOTE
      9 - TSI HOLDINGS CO. LLC**





In
      2005,
      TSI formed TSI Holdings Co., LLC ("TSI, LLC") a Georgia limited liability
      company. On January 30, 2007, TSI reactivated TSI, LLC, in order to raise
      funds in order deploy two (2) SA-60 Airships. The Company’s intent is to sell an
      aggregate of twenty-five (25%) percent membership interest in TSI, LLC. During
      the quarter ending March 31, 2007 the Company sold units representing 4.5%
      of TSI, LLC for $100,000 per unit for aggregate proceeds of $450,000. In
      2005, Cyber formed ALC and on July 23, 2007, the board approved all of the
      interests of TSI, LLC to be transferred to Airship Leasing Co., LLC in order
      to
      raise funds to deploy two (2) SA-60 Airships. As a result, the
      4.0%
      ownership interest which was not owned by TSI was cancelled and replaced with
      equal ownership interest of ALC which is 96.0% owned by Cyber
      Defense.




20




The
      aggregate amount of the value of the membership units issued has been recorded
      as “Minority interest in consolidated subsidiary” in the accompanying condensed
      consolidated statement of operations as of September 30, 2007, net of the 4.0%
      proportionate share of the losses of TSI LLC applicable to the
      minority interest. Cyber Defense Systems, Inc has an aggregate
      membership interest of 96.0% in TSI, LLC at September 30,
      2007.





The
      minority interest investors have certain rights to be entitled to twenty-five
      percent (25%) of future available net income for distribution of TSI, LLC as
      defined in the agreements relative to their investment.




**NOTE
      10- SUBSEQUENT EVENTS**





On
      November 19, 2007, David M. Barnes, our chief financial officer, resigned his
      position with the Company.




21




**ITEM
      2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND LIQUIDITY
      AND CAPITAL RESOURCES**




**GENERAL**




The
      following discussion and analysis should be read in conjunction with the
      Condensed Consolidated Financial Statements and Notes thereto appearing
      elsewhere in this Form 10-QSB.




This
      management's discussion and analysis of financial conditions and results of
      operations contains certain "forward-looking statements" as defined in the
      Private Securities Litigation Reform Act of 1995. Such statements relating
      to
      future events and financial performance are forward-looking statements that
      involve risks and uncertainties, detailed from time to time in the Company's
      various SEC filings. No assurance can be given that any such matters will be
      realized.




**RESULTS
      OF OPERATIONS**




The
      Three
      Months Ended September 30, 2007 Compared to the Three Months Ended September
      30,
      2006




Revenues
      for the quarter ended September 30, 2007 were $44,427 as compared to $136,137
      for the quarter ended September 30, 2006, a decrease of $91,710. The decrease
      is
      primarily due to lower sales of TSI.




Research
      and development costs relative to the development of our airships and UAV's
      totaled $2,302 for the quarter ended September 30, 2007, a decrease of $88,104
      from the quarter ended September 30, 2006 amount of $90,406. The decrease is
      primarily due to decreased research and development efforts related to TSI’s
      airships in the quarter ended September 30, 2007.




General
      and administrative expenses totaled $843,553 for the quarter ended September
      30,
      2007 as compared to $1,630,022 for the quarter ended September 30, 2006, a
      net
      decrease of $786,469. The decrease is primarily due to decreased salaries and
      overheads due to reduced levels of operations as well as decreased amortization
      expense of approximately $123,000 in the quarter ended September 30,
      2007.





The
      impairment loss of $11,330,674 for the quarter ended September 30, 2006 is
      related to the exclusive manufacturing license from 21st Century Airships.
      We
      determined that the asset was impaired due to the reduced expected revenues
      and
      cash flows for the license, creating the impairment. There is no comparable
      current year period expense.





Stock
      option compensation expense for the quarter ended September 30, 2006 totaled
      $1,287,008 relating to the fair value of stock options that vested during the
      period. There is no comparable current year period expense.





Other
      income (expense) for the quarter ended September 30, 2007 and 2006 was comprised
      of interest expense and derivative valuation gains or losses. Interest expense
      for the quarter ended September 30, 2007 was $906,764, of which $563,037
      represents amortization of discounts on notes to AJW and Mr. Robinson. Interest
      expense for the quarter ended September 30, 2006 was $1,157,741 of which
      $922,336 represents amortization of discounts on notes to AJW, Mr. Robinson,
      Mr.
      Lively and James Gardiner and $57,125 represents the beneficial conversion
      feature related to the conversion of a note by Mayo Hadden. The decrease of
      interest expense is primarily due to the decrease in amortization of discount
      and beneficial conversion features for the quarter ended September 30, 2007
      offset by higher borrowing levels.




The
      derivative valuation loss for the quarter ended September 30, 2007 in the amount
      of $14,738,189 which relates to the issuance, conversion, and revaluation of
      Notes and Warrants to AJW and Mr. Robinson treated as derivative securities.
      In
      addition, the underlying conversion price of the AJW notes were reduced during
      the quarter ended September 30, 2007 on two occasions. The derivative valuation
      loss for the quarter ended September 30, 2006 in the amount of $485,507 relates
      to the issuance, conversion and revaluation of Notes and Warrants to AJW, Mr.
      Robinson, Mr. Lively and James Gardiner treated as derivative securities.





22




The
      components of the derivative valuation (losses) gains for the quarter ended
      September 30, 2007 and 2006 are presented in the following table:





Three
                  months September 30,2007
              
              2006Derivative
                  valuation gain (loss) - beneficial conversion revaluation -
                  AJW
              
              $
              363,639
              
              $
              165,202Derivative
                  valuation gain (loss) - warrant revaluation AJW
              
              
              655,678
              
              
              (9,779
              )Derivative
                  valuation loss - August 1, 2007 repricing
              
              
              (3,673,127
              )
              
              -Derivative
                  valuation loss - August 22, 2007 repricing
              
              
              (8,381,479
              )
              
              -Derivative
                  valuation gain - beneficial conversion revaluation -
                  Robinson
              
              
              14,321
              
              
              24,960Derivative
                  valuation (loss) on issuance of notes - AJW
              
              
              (3,555,556
              )
              
              (527,648
              )Derivative
                  valuation (loss) on issuance of warrants -AJW
              
              
              (197,008
              )
              
              (117,140
              )Derivative
                  valuation gain (loss) on conversion of notes -AJW
              
              
              35,343
              
              
              (45,305
              )Derivative
                  valuation gain on conversion of notes - Robinson
              
              
              -
              
              
              20,010Derivative
                  valuation (loss) on issuance of notes - Lively
              
              
              -
              
              
              4,193Total
                  Derivative valuation gain (loss)
              
              $
              (14,738,189
              )
              $
              (485,507
              )


We
      use
      the Black Scholes method to value the derivatives contained in the
      securities we have issued. The assumptions used in the valuation of
      the derivatives have been detailed in Notes 4 and 5 of the condensed
      consolidated financial statements. The most significant valuation assumption
      components in the valuation calculations are the closing stock price on the
      date
      of the valuation and the number of shares issuable upon conversion, which is
      based upon a discount applied to the average of the lowest three intra-day
      trading prices for our common stock during the 20 trading days immediately
      preceding the valuation date.





The
      increase of the loss is primarily due to the $12,054,606 recognized upon the
      reduction of the conversion prices of the AJW notes and the loss on issuance
      of
      the notes and warrants somewhat offset by increases in the derivative valuation
      gains from the notes and the warrants for the quarter ended September 30, 2007
      when compared to the quarter ended September 30, 2006.




The
      Nine
      Months Ended September 30, 2007 Compared to the Nine Months Ended September
      30,
      2006




Revenues
      for the nine months ended September 30, 2007 were $181,465 as compared to
      $438,031 for the nine months ended September 30, 2006, a decrease of $256,566.
      The decrease is primarily due to lower sales at TSI and Cyber for the nine
      months ended September 30, 2007 when compared to the comparable prior year
      period.





Research
      and development expense totaled $430,954 for the nine months ending September
      30, 2007 as compared to $189,668 for the nine months ended September 30, 2006,
      a
      net increase of $241,286. The expense for the nine months ended September 30,
      2007 is primarily due to increases in the development efforts for TSI’s airships
      while the expense for the nine months ended September 30, 2006 period pertains
      primarily to development of the Cyber UAV's.





General
      and administrative expenses totaled $2,850,002 for the nine months ended
      September 30, 2007 as compared to $5,246,277 for the nine months ended September
      30, 2006, a net decrease of $2,396,275. The decrease is primarily due to share
      based compensation expense relative to warrants of $419,760, decreased
      amortization expense of approximately $369,000 and a decrease in salaries,
      professional fees and general corporate overheads due to lower levels of
      operations.





Other
      income (expense) for the nine months ended September 30, 2007 and 2006 was
      comprised of interest expense, derivative valuation gains or losses and the
      minority interest in loss of subsidiary. Interest expense for the nine months
      ended September 30, 2007 was $2,358,518, of which $1,648,687 represents
      amortization of discounts on notes to AJW and Mr. Robinson. Interest expense
      for
      the nine months ended September 30, 2006 was $2,543,411, of which $1,649,390
      represents amortization of discounts on notes to AJW, Mr. Robinson, Mr. Lively
      and James Gardiner. The decrease of interest expense is primarily due to the
      decrease in Notes payable - related party for the nine months ended September
      30, 2007 when compared to the comparable prior year period.




23




The
      impairment loss of $11,330,674 for the nine months ended September 30, 2006
      is
      related to the exclusive manufacturing license from 21st Century Airships.
      We
      determined that the asset was impaired due to the reduced expected revenues
      and
      cash flows for the license, creating the impairment. There is no comparable
      current year period expense.





Stock
      option compensation expense for the nine months ended September 30, 2006 totaled
      $2,271,287 relating to the fair value of stock options that vested during the
      period. There is no comparable current year period expense.





The
      components of the derivative valuation (losses) gains for the nine months ended
      September 30, 2007 and 2006 are presented in the following table:




Nine
                  months ended September 30,2007
              
              2006Derivative
                  valuation gain (loss) - beneficial conversion revaluation -
                  AJW
              
              $
              (926,208
              )
              $
              4,225,140Derivative
                  valuation gain (loss) - warrant revaluation AJW
              
              
              2,679,818
              
              
              1,164,955Derivative
                  valuation loss - August 1, 2007 repricing
              
              
              (3,673,127
              )
              
              -Derivative
                  valuation loss - August 22, 2007 repricing
              
              
              (8,381,479
              )
              
              -Derivative
                  valuation gain - beneficial conversion revaluation -
                  Robinson
              
              
              232,012
              
              
              767,572Derivative
                  valuation (loss) on issuance of notes - AJW
              
              
              (3,908,429
              )
              
              (2,127,303
              )Derivative
                  valuation (loss) on issuance of warrants -AJW
              
              
              (1,986,000
              )
              
              (610,040
              )Derivative
                  valuation gain (loss) on conversion of notes -AJW
              
              
              127,764
              
              
              (58,489
              )Derivative
                  valuation gain on conversion of notes - Robinson
              
              
              -
              
              
              20,010Derivative
                  valuation gain on conversion of notes - Lively
              
              
              -
              
              
              4,193Derivative
                  valuation gain on conversion of notes - Gardiner
              
              
              -
              
              
              840Derivative
                  valuation (loss) on issuance of note - Gardiner
              
              
              -
              
              
              (37,050
              )Derivative
                  valuation (loss) on issuance of note- Robinson
              
              
              -
              
              
              (368,608
              )Derivative
                  valuation (loss) on issuance of notes - Lively
              
              
              -
              
              
              (58,306
              )Derivative
                  valuation gain - beneficial conversion revaluation -
                  Lively
              
              
              -
              
              
              106,799Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Gardiner
              
              
              -
              
              
              (20,520
              )Total
                  Derivative valuation gain (loss)
              
              $
              (15,835,649
              )
              $
              3,009,193




The
      increase of the loss is primarily due to the $12,054,606 recognized upon the
      reduction of the conversion prices of the AJW notes and the loss on issuance
      of
      the notes and warrants somewhat offset by increases in the derivative valuation
      gains from the notes and the warrants for the quarter ended September 30, 2007
      when compared to the quarter ended September 30, 2006.




The
      derivative gain for the nine months ended September 30, 2006 relates primarily
      to the decrease in the value of the common stock for the nine months ended
      September 30, 2006. The stock price was $0.40 as of December 31, 2005 as
      compared to $0.165 as of September 30, 2006. As a result of the decrease of
      the
      stock price, the valuation of the underlying derivatives decreased
      significantly.





**LIQUIDITY
      AND CAPITAL RESOURCES**





Our
      primary needs for liquidity and capital resources are the funding of salaries,
      and other administrative expenses related to the management of the Company
      as
      well as for payment of the cost of products sold and inventory.




Our
      cash
      and cash equivalents of $28,350 as of September 30, 2007 are not sufficient
      to
      support current levels of operations for the next twelve months and it will
      be
      necessary for us to seek additional financing.





24





We
      are in
      negotiations with potential lending and investment sources, but there can be
      no
      assurance that these negotiations will be successful or that the Company will
      obtain sufficient financing or that financing will be structured on agreeable
      terms.





Subject
      to the realization of certain financings as described above we should be in
      a
      position to fund the anticipated level of operations for at least one year.
      However, there can be no assurances that this will be the case. If we are unable
      to obtain sufficient financing, we will be forced to severely curtail or even
      cease operations.




**Critical
      Accounting Policies**




Our
      discussion and analysis of its financial condition and results of operations
      are
      based upon Cyber Defense's financial statements, which have been prepared in
      accordance with accounting principles generally accepted in the United States.
      The preparation of these financial statements requires the use of estimates
      that
      affect the reported amounts of assets, liabilities and expenses. We evaluate
      our
      estimates on an ongoing basis, including estimates for income tax assets and
      liabilities and the impairment of the value of investments. We base our
      estimates on historical experience and on actual information and assumptions
      that are believed to be reasonable under the circumstances at that time. Actual
      results may differ from these estimates under different assumptions or
      conditions. We believe that the following critical accounting policies affect
      its more significant estimates used in the preparation of its financial
      statements.




**Accounting
      for Income Taxes**




No
      income
      taxes have been paid or accrued because we have had no net income since
      inception. We recognize the amount of income taxes payable or refundable for
      the
      current year and recognizes deferred tax assets and liabilities for the future
      tax consequences attributable to differences between the financial statement
      amounts of certain assets and liabilities and their respective tax bases.
      Deferred tax assets and deferred tax liabilities are measured using enacted
      tax
      rates expected to apply to taxable income in the years those temporary
      differences are expected to be recovered or settled. Deferred tax assets are
      reduced by a valuation allowance to the extent that uncertainty exists as to
      whether the deferred tax assets will ultimately be realized.




**Impairment
      of Investments**




Long-lived
      assets are reviewed for impairment quarterly or when events or changes in
      circumstances indicate that the carrying amount may not be recoverable.
      Recoverability of assets to be held and used is measured by comparison of the
      carrying amount of an asset to future net cash flows expected to be generated
      by
      the asset. If such assets are considered to be impaired, the impairment to
      be
      recognized is measured by the amount that the carrying amount of the assets
      exceeds the fair value of the assets.




**Derivative
      Securities**




We
      do not
      hold or issue derivative instruments for trading purposes. However, we have
      convertible notes payable that contain embedded derivatives that require
      separate valuation from the convertible notes under Emerging Issues Task Force
      Abstract (EITF) 00-19, “Accounting for Derivative Financial Instruments Indexed
      to, and Potentially Settled in, a Company's Own Stock.” We recognize these
      derivatives as liabilities in the accompanying balance sheet and measure them
      at
      estimated fair value each quarter, and recognize changes in estimated fair
      value
      in the statement of operations in the respective period. We have estimated
      the
      fair value of these embedded derivatives using the Black-Scholes
      model.





**Recent
      Accounting Pronouncements**





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measures" ("SFAS
      157"). SFAS 157 defines fair value, establishes a framework for measuring fair
      value, and expands disclosures about fair value measurements. This statement
      applies under other accounting pronouncements that require or permit fair value
      measurements. However, it does not apply to SFAS 123(R). This statement shall
      be
      effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not issued
      financial statements for that fiscal year, including any financial statements
      for an interim period within that fiscal year. The provisions of this statement
      should be applied prospectively as of the beginning of the fiscal year in which
      this Statement is initially applied, except in some circumstances where the
      statement shall be applied retrospectively. The Company is currently evaluating
      the effect, if any, of SFAS 157 on its financial statements.




25




In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities”, including an amendment of FASB
      Statement No. 115 (“SFAS 159”). This pronouncement permits entities to choose to
      measure many financial instruments and certain other items at fair value that
      are not currently required to be measured at fair value and to recognize the
      resulting gains and losses in the results of operations. SFAS 159 is effective
      as of the beginning of an entity’s first fiscal year that begins after November
      15, 2007. The impact of adopting SFAS 159 on our consolidated financial
      statements, if any, has not yet been determined.





In
      June
      2007, the Emerging Issues Task Force of the FASB issued EITF Issue No. 07-3,
      “Accounting for Nonrefundable Advance Payments for Goods or Services to be Used
      in Future Research and Development Activities”, (“EITF 07-3”) which is effective
      for fiscal years beginning after December 15, 2007. EITF 07-3 requires that
      nonrefundable advance payments for future research and development activities
      be
      deferred and capitalized. Such amounts will be recognized as an expense as
      the
      goods are delivered or the related services are performed. We do not expect
      the
      adoption of EITF 07-3 to have a material impact on the financial results of
      the
      Company.




**OFF-BALANCE
      SHEET ARRANGEMENTS**




We
      have
      no off-balance sheet arrangements.




**ITEM
      3. CONTROLS AND PROCEDURES**




As
      required by Rule 13a-15 under the Exchange Act, as of the end of the fiscal
      period covered by this report, we have carried out an evaluation of the
      effectiveness of the design and operation of our disclosure controls and
      procedures. This evaluation was carried out under the supervision and with
      the
      participation of our company's management, including our chief executive officer
      and chief financial officer. Based upon that evaluation, our chief executive
      officer and chief financial officer concluded that our disclosure controls
      and
      procedures are effective at September 30, 2007. There have been no changes
      in
      our internal controls over financial reporting in connection with this
      evaluation that occurred during the third quarter of fiscal 2007 that has
      materially affected, or is reasonably likely to materially affect, our internal
      control over financial reporting.





Disclosure
      controls and procedures are controls and other procedures that are designed
      to
      ensure that information required to be disclosed in our reports filed or
      submitted under the Exchange Act (a) is recorded, processed, summarized and
      reported, within the time periods specified in the Securities and Exchange
      Commission's rules and forms and (b) is accumulated and communicated to
      management, including our chief executive officer and chief financial officer,
      as appropriate, to allow timely decisions regarding required
      disclosure.




26




**PART
      II OTHER INFORMATION**




**ITEM
      2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF
      PROCEEDS**





On
      July
      18, 2007 we issued 3,758,553 shares of Class A Common Stock to AJW et al upon
      the conversion of notes in the aggregate principal amount of $43,223 at a price
      of $0.012 per share.





On
      July
      20, 2007 we issued 2,000,000 shares of Class A Common Stock to AJW et al upon
      the conversion of notes in the aggregate principal amount of $20,000 at a price
      of $0.0098 per share.





On
      July
      23, 2007 we issued 1,957,880 shares of Class A Common Stock to AJW et al upon
      the conversion of notes in the aggregate principal amount of $17,621 at a price
      of $0.010 per share.





On
      August
      7, 2007, we issued 6,000,000 shares to two accredited investors for cash at
      a
      price of $0.01 per share for aggregate proceeds to us of $60,000.





On
      August
      13, 2007 we issued 250,000 shares valued at $0.018 per share to Launch Funding
      Network, Inc. for services based on the closing market price as of that date.
      We
      recorded an expense of $4,500 as general and administrative expenses in the
      accompanying statement of operations for the nine months ended September 30,
      2007.





On
      August
      27, 2007 we issued 1,987,272 shares of Class A Common Stock to AJW et al upon
      the conversion of notes in the aggregate principal amount of $7,154 at a price
      of $0.0036 per share.





On
      August
      31, 2007 we issued 1,987,272 shares of Class A Common Stock to AJW et al upon
      the conversion of notes in the aggregate principal amount of $7,353 at a price
      of $0.0037 per share.





On
      September 6, 2007 we issued 4,805,630 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $14,897
      at
      a price of $0.0031 per share.





On
      September 12, 2007 we issued 300,000 shares valued at $0.018 per share to The
      Technology Communications Group, Inc. for services based on the closing market
      price as of that date. We recorded an expense of $5,400 as general and
      administrative expenses in the accompanying statement of operations for the
      nine
      months ended September 30, 2007.





On
      September 19, 2007 we issued 4,805,630 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $13,936
      at
      a price of $0.0029 per share.





On
      September 20, 2007 we issued 11,000,000 shares of Class A Common Stock to Ayuda
      Funding upon the conversion of notes in the aggregate principal amount of
      $132,000 at a price of $0.012 per share representing the closing market price
      as
      of that date.





On
      September 28, 2007 we issued 4,805,630 shares of Class A Common Stock to AJW
      et
      al upon the conversion of notes in the aggregate principal amount of $12,303
      at
      a price of $0.00256 per share.




**ITEM
      6. EXHIBITS**




31.1
      Certification of the Chief Executive Officer and Chief Financial Officer
      pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.




32.1
      Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section
      906 of the Sarbanes-Oxley Act of 2002.




27




**SIGNATURES**




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




**CYBER
                DEFENSE SYSTEMS, INC.**November 19, 2007By:
            /s/ William C. RobinsonWilliam
                C. Robinson
              Chief
                Executive Officer,
              President
                and Chairman




28