UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION




Washington,
D.C.  20549





FORM
10-K








x
            ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the fiscal year ended
            December
      31, 2007OR ̈
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934For
      the transition period from
            
            to


Commission
      file Number 0-12965(Exact
      name of registrant as specified in its charter)DELAWARE
            
            13-3163744(State
      of incorporation)
            
            (I.R.S.
      Employer Identification No.)42
      Oriental Street; Providence, Rhode Island
            02908(Address
      of principal executive offices)
            Zip
      Code(401)
      274-5658(Registrant’s
      Telephone Number, Including Area Code)Securities
      registered pursuant to Section 12(b) of the Act:NONESecurities
      registered pursuant to Section 12(g) of the Act:Common
      Stock, $.01 Par Value
              (Title
      of Class)





Indicated
      by check mark if the registrant is a well-known seasoned issuer, as
      defined in Rule 405 of the Securities Act.
            Yes:
             ̈
            No:
            xIndicate
      by check mark if the registrant is not required to file reports pursuant
      to Section 13 or Section 15(d) of the Act.
            Yes:
             ̈
            No:
            xIndicate
      by check mark whether the Registrant (1) has filed all reports required to
      be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
      during the preceding 12 months (or for such shorter period than the
      Registrant was required to file such reports), and (2) has been subject to
      such filingrequirements
      for the past 90 days.
            Yes:
            x
            No:
             ̈Indicate
      by check mark if disclosure of delinquent filers pursuant to Item 405 of
      Regulation S-K is not contained herein, and will not be contained, to the
      best of Registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-K or any
      amendment
      to this Form 10-K.  ̈Indicate
      by check mark whether the Registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting
      company.  See the definitions of “large accelerated filer,”
      “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
      Exchange Act.  (Check
one):


Large
      accelerated filer:
             ̈
            
            Accelerated
      filer:
             ̈
            
            Non-accelerated
      filer:
             ̈
            Smaller
      reporting company:
            x


Indicated
      by check mark whether the registrant is a shell company:
            Yes:
             ̈
            No:
            xThe
      aggregate market value of the 9,683,364 shares of voting stock held by
      non-affiliates of the registrant on June 30, 2007, based on the closing
      price of such stock on June 30, 2007, was $4,067,013.The
      number of shares outstanding of the Registrant’s Common Stock at April 10,
      2008 was 28,954,219.DOCUMENTS
      INCORPORATED BY REFERENCESections
      of Nestor, Inc.’s definitive Proxy Statement for the 2008 Annual Meeting
      of Stockholders are incorporated by reference into Parts II and III of
      this report.


-1-
 Table of Contents


NESTOR,
INC.


ANNUAL
REPORT ON FORM 10-K


FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2007








TABLE OF CONTENTS







PagePART  IItem
      1:
            
            Business
            
            3Item
      1A:
            
            Risk Factors
            
            14Item
      2:
            
            Properties
            
            25Item
      3:
            
            Legal Proceedings
            
            25Item
      4:
            
            Submission of Matters to a Vote of Security
      Holders
            
            26PART
      IIItem
      5:
            
            Market for Registrant’s Common Equity, Related Stockholder
      Matters and Issuer Purchases of Equity Securities
            
            27Item
      6:
            
            Selected Financial Data
            
            28Item
      7:
            
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
            
            30Item
      7A:
            
            Quantitative and Qualitative Disclosures about Market
      Risk
            
            41Item
      8:
            
            Financial Statements
            
            42Item
      9:
            
            Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure
            
            71Item
      9A:
            
            Controls and Procedures
            
            71Item
      9B:
            
            Other Information
            
            72PART
      IIIItem
      10:
            
            Directors, Executive Officers and Corporate
      Governance
            
            73Item
      11:
            
            Executive Compensation
            
            73Item
      12:
            
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
            
            73Item
      13:
            
            Certain Relationships, Related Transactions and Director
      Independence
            
            73Item
      14:
            
            Principal Accountant Fees and Services
            
            73PART
      IVItem
      15:
            
            Exhibits and Financial Statement
    Schedules
            
            74Signatures
            
            75Index of Exhibits
            
            76







-2-
 Table of Contents


PART
I





ITEM
1.                      Business




General




We are a
leading provider of innovative, automated traffic enforcement systems and
services to state and local governments throughout the United States and
Canada.  We are the only provider of both a fully video-based
automated red light enforcement system and a multi-lane, bi-directional scanning
light detection and ranging, or LiDAR, speed enforcement system.  We
also offer a newly developed ViDARTM (Video Detection and Ranging) speed
detection and imaging system as a complement to our other products.
CrossingGuard, our red light enforcement product, uses our patented image
processing technology to predict and record the occurrence of a red light
violation, and manages the process of issuing and processing a
citation.  Poliscanspeed, one
of our speed enforcement products, uses technology developed by Vitronic
GmbH.  ViDARTM uses average speed over distance calculations to detect
and record evidence of speeding vehicles.  Because ViDARTM was
developed by in-house talent, there are no purchase minimums.  By
combining our suite of enforcement products with Citation Composer, our
proprietary citation preparation and processing software, we are able to provide
fully integrated, turnkey red light and speed enforcement
solutions.





CrossingGuard
is an automated, video-based monitoring system that predicts and records the
occurrence of a red light violation.  The system includes our patented
collision avoidance technology that anticipates expected violations and can be
used to extend the red light phase for cross traffic, preventing collisions
between violators and vehicles in the cross traffic.  CrossingGuard
simultaneously records multiple views of the violation sequence, including
close-ups of the vehicle and the license plate, and transmits video evidence
electronically to the police department, which reviews the violation and
approves the issuance of a citation.  Our technology captures over 300
images of each red light violation, which combined with our patented
synchronized playback capability, enables us to provide a superior evidence
package, resulting in a system-wide court challenge rate of 3% and a court
dismissal rate of less than 1%.





Poliscanspeed is a
fully automated system for photo speed detection and
recording.  Poliscanspeed is
capable of simultaneously capturing multiple vehicles in multiple lanes in
bi-directional traffic, a distinct advantage over traditional radar or LiDAR
systems limited to one lane, one direction or one car at a time.  This
laser-based system scans a 45-degree arc 100 times per second, recording the
speed, vehicle classification, and distance between vehicles, to create a
three-dimensional image of all vehicles in the coverage area.  The
system uses high-resolution digital cameras for documenting the speeding
violation, including pictures of the license plate and an overview picture
specifically identifying the speeding vehicle.





ViDARTM is
an internally developed, fully automated system for video-based speed detection
and recording. ViDARTM uses distance over time calculations in combination with
video detection and tracking technology to measure and record the scene and
license plate from speeding vehicles. ViDARTM technology simultaneously tracks
multiple vehicles bi-directionally in multiple lanes.  ViDARTM
incorporates current digital camera technology and secures evidence of
violations in real-time with a 1/100 of a second time-stamp.  Also,
because the system is based on video tracking, it is undetectable by radar/laser
detectors.  A unique feature of the ViDARTM speed system is its
evidence package.  In addition to producing digital close-up still
images, it is capable of storing and replaying time-stamped, full motion video
of the violation.





We
provide back office citation processing services for CrossingGuard,
Poliscanspeed and
ViDARTM systems using our proprietary software solution called Citation Composer.
These processing services include obtaining data from the roadside systems,
reviewing the data, preparing the citations and evidence packages and tracking
final resolution of the citations.  One of Citation Composer’s many
unique features is its ability to simultaneously replay synchronized videos of a
red light violation, allowing for a more complete evidence
package.


-3-
 Table of Contents





We
generate recurring revenue through contracts with government entities that
provide for equipment lease and services on a fixed monthly and/or per citation
fee basis.  As of December 31, 2007, we were generating revenue from
302 installed CrossingGuard-equipped approaches in 25 municipalities in 6 states
and 2 Canadian provinces, and 8 speed units in 3
municipalities.  As of that date, our active contracts with state and
local governments authorized the installation of CrossingGuard at up to an
additional 176 approaches and 11 speed units.





Our
Market





Status
of the CrossingGuard Market





The
market for automated red light enforcement is experiencing significant
growth.  Based on the Federal Highway Administration’s (FHWA) 2007
assessment that there are approximately 270,000 signalized intersections in the
United States, and we estimate that there are over 1 million approaches to
signalized intersections in the United States.  With over 250
communities with red-light cameras and assuming an average of 10 enforced
approaches per community, there are approximately 2,500 or 0.025% of signalized
approaches enforced with red light cameras.





Recent
studies have shown that automated red-light enforcement systems are effective in
reducing red-light running at enforced intersections.  The Insurance
Institute for Highway Safety (IIHS) reported that red-light cameras were
generally successful, leading to significant decreases in intersection crashes
and violations – a 25-30% reduction in intersection injury
crashes.  Our customer in Germantown, Tennessee reported more than a
20% reduction in crashes since the system began and more than a 30% reduction
since before the system was put in place.  The City of Germantown’s
Automated Enforcement System began issuing citations on September 6,
2002.





First-generation
red-light camera systems generally relied on in-ground vehicle sensing loops and
still photography.  This technology is outdated.  The
preferred technology uses all digital video detection and either all high
resolution digital still cameras or a combination of digital still and digital
video technology.





The use
of automated traffic systems to enforce red light running violations requires
specific authority at the state or local government level, either through state
enabling or home rule statutes.  Attorney General and/or court rulings
also affect a state’s ability to allow red light
enforcement.  Twenty-five states and the District of Columbia
currently allow the use of automated traffic light systems such as
CrossingGuard; several more are expected to enter the automated red light market
later this year.  Four Canadian provinces allow the use of automated
traffic light systems; the province of Manitoba permits automated red light
enforcement only in the City of Winnipeg.




U.S.
jurisdictions allowing red light enforcement include:





Arizona
              Arkansas
              California
              Colorado
              Delaware
              Florida
              Georgia
              Illinois
            Indiana
              Louisiana
              Maryland
              New
      Jersey
              New
      Mexico
              New
      York
              North
      Carolina
              Ohio
            Oregon
              Pennsylvania
              Rhode
      Island
              Tennessee
              Texas
              Utah
              Virginia
              Washington
              Washington,
      D.C.





Canadian
jurisdictions allowing red light enforcement include:





AlbertaBritish
      ColumbiaManitobaOntarioSaskatchewan





-4-
 Table of Contents


There
remains some opposition to these systems, largely based upon concerns regarding
compliance with existing state law, individual privacy and due process
rights.  For example, in Minneapolis, Minnesota last year, a
Hennepin County district judge and later the state’s Court of Appeals
struck down the city ordinance allowing automated enforcement suggesting the
city’s ordinance overstepped state law.  Many states and communities
have or are considering authorization of automated traffic enforcement but need
to address these concerns first.





Status
of the Speed Market





The
automated speed enforcement market is potentially more significant than the
automated red light enforcement market.  While already well
established in Europe, Asia and Australia, the automated speed enforcement
market in the U.S. is positioned to grow significantly as a result of the
enormous costs associated with speeding-related crashes. The FHWA reports an
average of 117 traffic fatalities each day, 30% of which are caused by drivers
under the age of 25.  The FHWA further reports that daily financial
losses from such accidents is $630 million.





The need
for automated speed enforcement is well documented.  The IIHS released
information in July 2006 linking high rates of speed to the likelihood of a
crash resulting in a serious injury.  The report cited “one problem is
that speed increases the distance it takes to stop in an emergency, so crash
likelihood increases.  When a crash does occur, speed worsens its
severity by increasing the energy of impact.” The IIHS further reported the
number of drivers and the miles traveled have increased faster than the
availability of officers to routinely enforce traffic laws.  Plus it
is hard on congested roads to pull over speeding drivers without creating a
hazard.  So while police do pay attention to speeders, they cannot
keep up.





Similar
to automated red light enforcement, the use of automated traffic systems to
enforce speed limits requires specific authority at the state or local
government level, either through state enabling or home rule
statutes.  Judicial opinions and rulings have also determined state
progress.  Currently, eleven states, the District of Columbia and two
Canadian provinces, with Manitoba limited to just the City of Winnipeg, allow
automated speed enforcement.  They are:





UNITED
      STATES
            
            CANADAArizona
            Maryland
            Tennessee
            
            AlbertaCalifornia
            North
      Carolina
            Utah
            
            ManitobaColorado
            Ohio
            WashingtonIllinois
            Oregon
            Washington,
      D.C.





In
addition, many states are moving forward with speed enforcement technology to
deliver traditional uniform traffic tickets (UTT) under existing state
statute.  The UTT market depends upon the interpretation of state law
for personal delivery of the citation and witnessing the
violation.  The active UTT market includes Texas and
Massachusetts.





Our
Response to the Market





Our
automated traffic solutions respond to the traffic enforcement market by
creating a strong overall value proposition for our customers.  Our
response to the UTT speed enforcement market in particular has broadened our
appeal.  Our ability to capture a full evidence package, including the
driver image, and deliver tickets via the postal service has allowed us to
become the first company to use speed enforcement technology for delivering
traditional uniform traffic tickets (UTT).





We offer
complete turnkey solutions for automated traffic enforcement programs. We
generally retain ownership of the equipment and bear all of the up-front costs
for purchase, installation and maintenance of our systems. We provide the
software, data warehousing, processing, printing, mailing, collection,
maintenance, and community awareness support for a program.  Customers
generally provide program management and oversight, approve all citations for
issuance, prosecute citations, establish operating and enforcement criteria, and
select enforcement locations and times.  Our systems increase safety
by reducing the number of crashes while enhancing police officer safety and
efficiency.  Our systems also reduce the demand for emergency
resources without significantly increasing our customer’s administrative
costs.


-5-
 Table of Contents





Company
History





We were
founded in 1975, incorporated in 1981, and completed our initial public offering
in 1983.  During our first 25 years of operations, we developed a
number of patented intelligent software solutions for decision and data-mining
applications, including financial services, fraud detection and our intelligent
traffic-management systems.  In January 1997, we organized Nestor
Traffic Systems, Inc. (“NTS”) as a wholly-owned subsidiary.  In 1999
and 2000, NTS raised additional capital through two private placements of its
common stock, reducing our ownership to approximately 35%.  In 2000,
we made the strategic decision to concentrate on our traffic management
technologies and we began to dispose of our other product lines. In connection
with this restructuring effort, on September 12, 2001, we reacquired 100%
ownership of NTS through a merger transaction with another subsidiary in which
we issued common stock for the NTS shares held by outside investors. By 2003, we
exited our financial services, fraud detection, Rail CrossingGuard and
TrafficVision business lines and refocused our resources on our traffic
enforcement systems.





Our
transition to traffic management solutions involved a series of licensing
arrangements and transfers of technology rights, including a June 11, 1996
licensing agreement and an asset purchase agreement to transfer the development,
production and marketing rights of our character recognition products to
National Computer Systems. In early 2001, we also entered into two separate
source-code licensing agreements for our fraud detection product line. The first
of these was a February 1, 2001 non-exclusive license agreement with Applied
Communication, Inc., (ACI), whereby we granted ACI the right to integrate and
distribute all of our fraud detection products throughout its worldwide sales
and support network. ACI paid us $1,100,000 in the first six months of 2001, and
was required to make guaranteed minimum royalty payments during the first year
in an amount of approximately $500,000. The license requires the payment of a
15% royalty starting on February 1, 2002, but no further guaranteed minimum
royalty payments are required. This agreement replaced an earlier license to
ACI. We sold the royalty rights to Churchill Lane Associates (CLA) from this
license on July 1, 2002. On April 7, 2008, we amended our license agreement with
ACI to transfer the remaining rights we held related to our fraud detection
software product line to ACI.  ACI paid us $500,000 as full consideration
for this transfer.  We do not expect to receive future revenue from this
license.





Additionally,
on May 18, 2001, we entered into a license agreement with Retail Decisions, Inc.
(ReD).  We granted ReD a perpetual, fully-paid, worldwide license in
the field of fraud and money laundering detection and risk management in certain
defined industries; and a non-exclusive, perpetual, fully-paid, worldwide
license solely for use in the field of use of customer relationship management
in certain defined industries.  Additionally, we transferred to ReD
assets that supported the technology licensed under the license agreement to
ReD.  ReD paid us $1,800,000 under the license agreement, and we paid
ReD $968,000 for certain marketing and transition services in
2001.  No ongoing revenues are expected to be realized from
ReD.





The
licensing, royalty and other payments we received under these licensing
arrangements and other transfers of our property and technology financed our
operations during 2001 and 2002 and enabled us to develop our traffic
enforcement business.





On
January 15, 2003, Silver Star Partners I, LLC (Silver Star) purchased 49 million
shares of our pre-reverse stock split common stock (4,900,000 shares on a
post-split basis) for $2,376,500.  Following the initial Silver Star
investment, on April 11, 2003, we effected a one-for-ten reverse stock split of
our common stock.  On April 16, 2003, Silver Star purchased an
additional 4,013,557 post-reverse stock split shares for
$1,946,575.  William B. Danzell, our former President and Chief
Executive Officer is the Managing Director of Silver Star.  Upon
completion of the second sale, Silver Star owned 64% of our outstanding shares
of common stock.





On August
31, 2005, we acquired certain assets of Transol USA, one of our competitors, in
a foreclosure sale.  The assets included contracts to provide
automated red light enforcement services in six U.S. cities at an aggregate of
39 red light approaches, of which approximately 26 are fully installed and
operating, as well as related equipment, intellectual property, inventory, work
in process, accounts receivable and unbilled contract revenue related to
Transol's red light enforcement services.  We paid $1,760,000 for the
acquired assets.




-6-
 Table of Contents


Products
and Services





Our
products combine sophisticated digital camera technologies with advanced image
processing methods to detect and record traffic-related
violations.  We complement these roadside products with a full suite
of back-office processing support services, providing our customers with a
complete turnkey solution.  Our roadside systems are a combination of
Nestor- and/or Vitronic-developed modular hardware components and software that
provide monitoring for traffic-data collection, vehicle detection and tracking
and enforcement.  These roadside systems include: CrossingGuard for
red light enforcement, Poliscanspeedand
ViDARTM for mobile speed or fixed speed enforcement.  We provide
back-office processing and support services across our roadside systems using a
proprietary software solution called Citation Composer.  These
processing and support services include obtaining data from the roadside
systems, reviewing the data, preparing the citations and evidence packages and
tracking final resolution of the citations.  We believe that our
strong suite of patents covering our image processing technology provides us
with a strategic advantage and enables us to offer a comprehensive traffic
enforcement solution.







CrossingGuard
Red Light Enforcement




CrossingGuard. Our
CrossingGuard system is an automated, video-based monitoring system that
predicts and records the occurrence of a red light violation.  The
system applies high speed image processing and target-tracking technology to
real-time video scenes.   The products use digital video and high
resolution digital still cameras, computers and software to detect red light
violators at signalized intersections.  Using the captured video
frames, our systems apply algorithms to recognize objects as vehicles and
predict their motion relative to the stop line.  This advanced
proprietary technology, which effectively sees and interprets objects captured
in video images, is at the core of the CrossingGuard solution.





The
CrossingGuard system includes patented collision avoidance technology that
anticipates violations and generates a signal that can extend the red light
phase for cross traffic.  This helps prevent collisions between red
light violators and vehicles on the cross streets.  Through a system
of multiple video cameras set up to monitor and capture violators on a per
approach basis, the system simultaneously records the violation sequence,
including a view of the vehicle from the front approaching the intersection; a
view of the vehicle from the rear entering the intersection; and a close-up of
the vehicle, license plate, and the option of a close-up driver
image.  All images and videos are assigned a unique identifier,
packaged together and are electronically transmitted to the police department,
which reviews the violation and issues a citation.  Our advanced video
technology, which combined with our patented synchronized replay capability,
enables us to provide a superior evidence package, resulting in a court
dismissal rate of less than 1%.





The
CrossingGuard system consists of a video camera installed on top of a traffic
signal pole or a roadside pole installed by us that is used to track and record
the actions of an approaching vehicle.  Another camera is positioned
to view the signal lights as they change from green to yellow to red and record
the vehicle’s actions as the lights change and it enters the intersection,
capturing over 200 images of each violation.  The views from these two
cameras can also be presented in a patented side-by-side synchronized mode to
demonstrate the complete view of the violation, including extenuating
circumstances, aggressive behavior or other factors.  Finally, an
enforcement camera is positioned to obtain a close-up image of the vehicle
license plate and, where needed, the driver image, based upon vehicle location
instructions provided by the tracking camera.  A PC-based computer
system, which we install in an enclosure by the roadside link through a local
Ethernet LAN connection, runs the intelligent software and controls camera
activity.   High-speed VPN communications transmit video and data
from the intersection to a designated facility for
processing.  CrossingGuard is built upon standard PC hardware and
software components.  This design provides the reliability and
performance benefits of improving PC hardware and the ability to upgrade and add
functionality as needed.  We purchase all electronic and mechanical
components from third-party vendors, built in accordance with our
specifications, and primarily use local contractors to install the
systems.


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 Table of Contents





The
primary attributes of CrossingGuard are:





Accurate, real-time interpretation
of traffic video images.  We apply our high-speed
pattern-recognition technologies in real-time processing and video-image
interpretation for traffic management, enforcement and safety. Previous industry
attempts to provide video-based detection of traffic did not prove effective due
to the difficulty of designing robust detection algorithms under a variety of
illumination, visibility and traffic conditions, as well as the need to
implement such algorithms on cost-effective computing platforms that provide
real-time operation. Our image recognition technology is able to interpret video
images accurately and respond in a real-time environment at affordable
cost.  Our Citation Composer software can process red light violations
with a patented display of the approaching and receding videos presented side-by
side, and can re-play the violation sequence in slow motion or frame-by frame,
producing a comprehensive evidence package subject to fewer meritorious
challenges than any of our competitors’ systems.





Vehicle trajectory analysis for
real-time forecasting.  As each frame in a video sequence is
interpreted, the individual objects in the scene are identified and located.
This information, passed from frame to frame, enables the accurate tracing of
vehicles' trajectories.  Unlike competitive vision systems, which note
changing images in a fixed and static area of the image (so-called virtual
loops), our proprietary vehicle-centric technology can use the trajectories to
predict vehicle positions.  Our CrossingGuard system includes a
collision avoidance feature that anticipates violations and generates a signal
that can extend the red light phase for cross traffic, which helps prevent
collisions between violators and vehicles in the cross traffic accelerating on a
green signal.  Thus, intersections equipped with CrossingGuard have
the potential to become smarter and safer.





Compatibility with industry standard
platforms.  Our traffic monitoring solutions are built upon
dominant industry-standard platforms including Microsoft Windows operating
systems, tools and communication components and general "WinTel" hardware
specifications. This facilitates integration into a customer's existing
computing environment, leverages PC economics to offer a compelling
price/performance advantage and lowers product engineering development
costs.  Additionally, the traffic monitoring systems are designed to
support the emerging communications standards being mandated in the traffic
industry by the National Transportation Communications for Intelligent
Transportation Systems Protocol.





CrossingGuard VIP. We also
provide the CrossingGuard Video Intersection Vehicle Profiling program, a tool
that we have developed to help municipalities pre-qualify intersections. Because
intersection violation rates can range from an average of a few per day to over
50 per hour, the system helps the municipality develop an estimate of safety
issues at a given intersection and the long-term ticket volume by counting and
profiling violations for all directions at a particular
intersection.





Revenue Generation. The
economics of the CrossingGuard product are tied to the number of operating
systems in the field and, to an increasingly lesser extent, the number of
violations processed by the CrossingGuard systems. Many of our early contracts
compensate us on a per ticket paid or issued basis in return for equipment
lease, maintenance, citation processing and customer support services. More
recent red light contracts compensate us on a monthly fixed fee basis or fixed
fee in conjunction with a fee per ticket issued or paid.





As of
December 31, 2007, we had installed CrossingGuard at 302 approaches or 25
customers throughout the United States and Canada, and our contracts authorize
up to an additional 176 CrossingGuard approaches for
installations.   Management believes the majority of the
authorized approaches under these outstanding and pending contracts will be
installed, but no assurances can be given that all approaches under contract
will ultimately be installed or that pending contracts will be
finalized.  Depending upon contract terms and services provided, we
realize (a) from $11 to $99 per citation issued or paid or (b) a fixed monthly
fee ranging from $1,500 to $7,000per approach for system
delivery, lease, processing services and maintenance.


-8-
 Table of Contents


State
statutes providing for automated red light enforcement may impose liability on
the driver or the registered owner of a vehicle for a violation. Driver
liability statutes require that the driver be identified, from the photographic
evidence, and that the citation be issued and sent to the driver. Registered
owner statutes require that the vehicle’s owner be identified, through
registration records, and that the citation be issued and sent to the driver. As
only the license plate is required for identification under a registered owner
statute, program operating efficiencies are higher resulting in lower per
citation or monthly fees for systems installed in these jurisdictions. Actual
results from deployment of CrossingGuard systems are expected to fluctuate
depending upon intersection selection and configuration, driver response to
installed systems and many other factors.





Poliscanspeed  Products





Poliscanspeed.Poliscanspeed, an
innovative solution for digital speed detection and recording, is the only
multi-lane, bi-directional, scanning LiDAR (light detection and ranging) mobile
speed enforcement system in the industry. Unlike traditional photo speed
enforcement systems, which use radar or conventional LiDAR, Poliscanspeed
utilizes scanning LiDAR technology to simultaneously record and measure several
vehicles in parallel lanes, with 100 laser beams per second sweeping a 45 degree
arc, creating a real-time 3-dimensional image of the scene. The system records
the speed, classification (motorcycle, car or truck) and the distance between
every vehicle entering the coverage area. Poliscanspeed uses
a high-resolution digital camera for documentation of the speeding offense,
including pictures of the license plate, an overview picture which specifically
targets the speeding vehicle, as well as the image of the driver where
required.  Detecting all vehicles in all lanes simultaneously avoids
the ambiguity and measuring errors that are more common among our competitors'
systems, allowing many more speed offenses to be effectively recorded and
prosecuted.





The
measuring sensor developed for Poliscanspeed is
based on a scanning LiDAR that is mounted in a stationary position and transmits
short pulses of light out to a target. The transmitted light is reflected back
to the receiver of the LiDAR instrument where it is analyzed. While the LiDAR
sensor carries out the measurements with a high repetition rate, a rotating
polygonal mirror deflects the transmitted signals, so that the LiDAR sensor
covers the full region of interest (a sector of 45 degrees), allowing
simultaneous monitoring of multiple lanes. Accordingly, the Poliscanspeedsystem offers the following competitive advantages:





·
            High
      resolution all digital camera
solution


·
            All
      weather, day and night operations with no visible
    illumination


·
            100
      scans per second in the 45 degree scan
sector


·
            Multi-lane,
      multi-vehicle, bi-directional speed
enforcement


·
            Not
      restricted to straight roads (only needs 20 meters to
    operate)


·
            3D
      image processing (Scans entire road, all
lanes)


·
            Fully
      automated, unattended operations





Deployment and Set Up.With
outside dimensions of less than 14 inches per side and weighing less than 45
pounds, the PoliScanspeed unit
is designed for ease of use and maximum portability. Additionally, its small
size allows maximum versatility. Unlike competing systems, which are confined to
either a minivan or a portable unit, PoliScanspeed can
be deployed in a variety of different ways giving our customers the flexibility
to rotate enforcement to areas that have the greatest need. We offer
PoliScanspeed in a
variety of configurations, including our Mobile Speed Unit, which is a
self-contained violation capture and processing center all in one. Other
configurations include vehicle mount and tripod mount. Our proven back office
integration and citation processing systems, coupled with Poliscanspeed’s
advanced technology, provide a fully integrated automated speed enforcement
solution.





Deployment
of our competitors’ mobile speed enforcement systems can be an involved process,
including precisely aiming LiDAR, measuring radar angles for cosine effect, and
searching for level stretches of straight roadway. In contrast to conventional
measures such as radar, light barriers, and piezo-section, PoliScanspeed does
not require a complex installation and calibration of the system at the
measurement site. We require only 20 meters of roadway to deploy the
PoliScanspeed
system, which can be operational in less than five minutes.


-9-
 Table of Contents


Revenue Generation.As of
December 31, 2007, we had installed 8 PoliScanspeed
units for 2 customers within the United States, and our contracts authorize up
to an additional 11 speed units for deployment.





Enforcing
only a single lane drastically reduces potential citation rates by 2 or 3
times.  Poliscanspeed
utilizes the vehicle targeting advantages of LiDAR while covering multiple
lanes, gaining the advantages of radar. This technology solution couples the
advantages of radar and LiDAR into one unique enforcement system. Because the
system covers all vehicles in all lanes, we can issue, in some cases, twice as
many speed citations as can our competition on multi-lane or bi-directional
roads. Unlike traditional laser systems, which can require up to 90 meters
of flat, straight roadway to accurately target a speeding vehicle, our speed
unit can track at distances as short as 20 meters. This short-range LiDAR
tracking capability is a major competitive advantage, enabling speed enforcement
on roads with sharp curves and hills and enabling better image quality
regardless of lighting conditions.





ViDARTMProducts





ViDARTMincorporates
the latest in digital camera technology to capture up to 60 frames per
second.  The ViDARTMsystem
displays vehicle speeds in real-time.  Using a graphic user interface
(GUI), the system shows vehicle speeds at key intervals during the event. ViDARTM
records a video clip of every speeding violation for use as evidence and for
future verification.  The unique system time-stamps video evidence of
the violation as it happens ensuring that all data is directly correlated to the
evidence collected.  The time-stamp is accurate to 1/100 of a
second.





Most
vendors’ “evidence packages” consist of a photograph with either multiple
untargeted vehicles at short range, or a single targeted vehicle at some far,
distant range—zoomed in by near telescopic length lenses.  The
ViDARTMsystem achieves
an indisputable evidence package by taking video of the violating vehicle with
embedded vehicle speed-stamps at up to 60 frames per second
(fps).  Digital still images of the license plate provide the most
conclusive evidence of speeding violations.





Deployment and Set Up.The
complete ViDARTM system is available with all software and hardware for the
municipality to issue citations from the speed system in a fixed or mobile
configuration.





Program Management and Processing
Services





We offer
our CrossingGuard and Poliscanspeed
customers a complete package of services and support, which can be customized.
These services consist of site planning and equipment installation, user
training and support, violation review, citation preparation and processing,
account management, toll free hotline support, public education and expert
testimony. In addition, we provide direct, remote and online equipment
monitoring and maintenance primarily through our field and office personnel and
through local contractors as necessary. We also offer fine collection and
processing as an optional service for our customers.




We have
been able to leverage the infrastructure and technology developed for our
CrossingGuard system to support all of our traffic enforcement products. All of
our citation processing services utilize our proprietary Citation Composer
software, which allows us to retrieve and review images and format pictures and
other data for citation processing. Citation Composer supports the necessary
interfaces with state departments of motor vehicles, local police departments
and court systems to facilitate review and approval of citations, court
scheduling, providing evidence packages and tracking payment and resolution of
the citations. Our customer service platform supports our entire product line,
and enables us to integrate additional products without significant development
costs.





Sales,
Marketing and Methods of Distribution





We market
our products and services to municipalities and governmental traffic management
departments.  As of December 31, 2007, our direct sales force
consisted of 2 employees, and our marketing support group consisted of 2
employees.  In addition, members of senior management are actively
involved in sales and marketing.  Because our products require
technical assistance during the sales and installation processes, our marketing
team also accesses our internal staff of program managers and field
engineers.  Within the last 12 months we have also engaged the
services of several consultants and lobbyists to assist with our marketing and
sales efforts.


-10-
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We obtain
product inquiries from customer referrals, product mailings, attendance at trade
shows, trade press coverage and our Internet site.  Most contracts are
obtained through competitive proposal processes in response to requests for
proposals, or RFPs, issued by municipalities.  In some cases, our
customers may issue a sole-source contract, avoiding the RFP
process.  Our sales force actively engages in direct discussions with
potential customers to encourage sole-sourcing or the issuance of RFPs that
incorporate our products’ features.  We also subscribe to multiple
services that advise us of relevant RFPs, issued by state and local
governments.  Purchasing decisions are influenced by the advantages of
a particular product, customer references, existing relationships with the
jurisdiction, pricing, and in some cases, consultant and lobbyist
activities.  In 2007, we submitted twenty-sevenproposals to state and
local governments.  As of December 31, 2007, as a result of bids
submitted in 2007, we were awarded two contracts.   No
provider has been selected with respect to six of the RFPs to which we responded
in 2007.





Our 2008
marketing and sales plan includes the addition of a National Sales Manager and 5
additional sales and marketing personnel to increase our presence in the
marketplace.  Our state-specific marketing and comprehensive municipal
coverage will be executed by our sales team and consultants/lobbyist
engagements.  Marketing and sales plan to deliver our sales material
via aggressive advertising and direct mail campaigns, augmented by attendance at
trade shows to stimulate product awareness and interest.





Research
and Development Activities





The focus
of our research and development is on improvements to our products and
technologies in order to maintain and increase our products’ competitive
advantages as well as customer service and satisfaction. We also consider
developing new technologies and products that we believe will complement our
traffic enforcement product line.





We have
completed development and commercialized three products:





·
            Our
      "All Digital" CrossingGuard system, which enhances image quality (up
      to 12.4 megabytes), efficiency and reliability while reducing installation
      costs and supporting infrastructure needs.  The All Digital system
      uses decentralized processing and provides a completely digital Ethernet
      solution.  With internet protocol addressable cameras, it can
      provide live video for homeland security or other
      applications;





·
            Our
      CrossingGuard Speed system utilizes Vitronic’s scanning LiDAR system.
      The integration of this non-intrusive speed sensor into our product allows
      us to deliver the advantages of scanning LiDAR while maintaining the
      advantage of full motion digital video;
and





·
            ViDARTM
      utilizing distance over time calculations in combination with video
      detection and tracking technology to measure and record the scene, license
      plate and driver images from speeding
vehicles.





We spent
$414,000 and $1,383,000 in the years ended December 31, 2007 and 2006,
respectively, on research and development.  The more significant 2006
research and development expenditures are attributable to development of ViDARTM,
the CrossingGuard all digital video solution and the US commercialization and
back office integration of the PoliScanspeed
product.





Patents





We have
continually sought and obtained patent protection for our traffic enforcement
systems and for our proprietary neural networks, which have as a principal
feature rapid learning from a relatively small number of examples, or the
application of video techniques in traffic management applications. Our patented
neural network exhibits rapid learning and minimizes the internal connections
needed for its functioning.  We believe that these capabilities make
our technology uniquely suited to applications that require field trainability
or self-modification to adapt to new or changing patterns in the
data.  Our patents also cover multiple-neural-network systems, which
enabled us to develop products that combine high accuracy with high processing
speeds.


-11-
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During
2007, we received one patent relative to the CrossingGuard product
line.  The Australian patent, Traffic Violation Detection System, was
issued to us as a result of our acquisition of Transol USA in August
2005.





As of
December 31, 2007, we own 12 U.S. patents and 4 foreign patents.  We
have 2 U.S. and 2 foreign patent applications pending.  Eight of our
U.S. patents, 3 of our foreign patents and all of our patent applications are
related to our traffic enforcement business.  Three foreign patents
correspond to one or more of the U.S. patents, and one foreign patent stands
alone.  Our patents expire at various times from 2008 to 2023.  None
relevant to our traffic enforcement business expire before 2018.





Competition





We
believe that our products are more technologically advanced than competing
systems for traffic enforcement.  In red light enforcement, our
competition generally consists of multiple still image red light camera
systems.  These systems generally rely on digital still cameras (or
older wet film 35mm cameras) that record only a few frames of evidence regarding
a violation and detect vehicles through the use of in-ground sensor
loops.  In-ground sensor loops require digging up the pavement and are
generally unresponsive to vehicles moving below twelve miles per
hour.  For wet film systems, there is the added burden of retrieving,
replacing, developing and scanning the film.  Most competitors have
developed digital still systems and do not promote wet film
applications.





CrossingGuard
vehicle detection cameras are installed above the ground, on roadside poles or
mast arms.  This helps avoid some of the logistical problems
associated with installing in-ground loop sensors at an
intersection.  The system’s digital video evidence consists of both
front and rear vehicle images.  This ensures fairness so that
violations are not issued out of context (e.g., if the violation occurred to
make way for an emergency vehicle, as part of a funeral procession or to avoid a
crash).  In case of a dispute, unlike non-video systems, the violation
video sequence can be replayed.  This perception of fairness makes our
video evidence attractive to city councils, law enforcement officials, courts
and the general public.





In speed
enforcement, competition is generally limited to single-beam LiDAR or
indiscriminate radar detection systems.





Our
largest competitors in the enforcement market are Affiliated Computer Services,
Inc. (ACS), American Traffic Systems, Inc. (ATS) and Redflex Traffic Systems,
Inc.  Among others are Lasercraft, Traffipax, and
Siemens.  Although these companies generally use buried loops, digital
still cameras and/or wet film systems, single-beam LiDAR or radar, some may pose
a competitive threat due to their size, market share, legacy customer
relationships, enhanced driver image, additional products offered and/or
citation-processing experience.





Most of
our competitors have significantly greater financial, marketing and other
resources.  As a result, they may be able to respond more quickly to
new or emerging technologies or to devote greater resources to the development,
promotion and sale of their products than we may.  Competitive
pressures faced by us may materially affect our business, financial condition
and results of operations in an adverse way.





Contracts
with Governmental Entities





Our
agreements are generally service contracts with states or municipalities that in
most circumstances may be cancelled by the customer for various
reasons.  We retain all patent and other proprietary rights from
products developed and delivered under government-supported
contracts.





Revenue
from our ten largest customers have accounted for approximately 81% and 73% of
total revenue for the years ended December 31, 2007 and 2006,
respectively.  In 2007, revenue from three customers accounted for
19%, 13% and 12% of our total revenues, respectively.  In fiscal year
2006, revenue from two customers accounted for 19% and 14% of our total
revenues, respectively.


-12-
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Employees





As of
December 31, 2007, we had 89full-time employees,
comprised of 11 in engineering and product development, 32 in processing and
system support, 30 in program management and field services,4 in sales and marketing
and 12 in management, finance and office support. None of our employees
are represented by a labor union.  We have experienced no work
stoppages, and management believes our employee relationships are generally
good.




-13-
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ITEM
      1A.
            Risk
Factors








This
Annual Report on Form 10-K and other communications made by us contain
forward-looking statements, including statements about our growth and future
operating results, development of products, sales and intellectual property.
 For this purpose, any statement that is not a statement of historical fact
should be considered a forward-looking statement. We often use the words
“believe,” “anticipate,” “plan,” “expect,” “intend,” “will” and similar
expressions to help identify forward-looking statements. References to “we,”
“us,” and “our” refer to Nestor, Inc. and its subsidiaries.





We cannot
assure investors that our assumptions and expectations will prove to have been
correct. Important factors could cause our actual results to differ materially
from those indicated or implied by forward-looking statements. Such factors that
could cause or contribute to such differences include those factors discussed
below. We undertake no intention or obligation to update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise.





Risks
Related to Our Business




We
have a history of losses and expect to incur losses in the future.




We have a
history of net losses. For the years ended December 31, 2007 and 2006, our net
loss was approximately $8,023,000 and $7,491,000, respectively.  As of
December 31, 2007, we had an accumulated deficit of $76,502,000.  We
expect to continue incurring losses for the foreseeable future due to
significant marketing, product delivery, engineering and general and
administrative expenses, and those losses could be substantial. We will need to
generate significantly higher revenue, or reduce costs, to achieve
profitability, which we may be unable to do. Even if we do achieve
profitability, we may not be able to sustain or increase our profitability in
the future.




We
have substantial indebtedness.





As a
result of the May 2006 offering of secured notes due May 2011, we have
substantial indebtedness and we are highly leveraged.  As of December 31,
2007, we have total indebtedness of approximately $27,190,000.  Our
substantial indebtedness may limit our strategic operating flexibility and our
capacity to meet competitive pressures and withstand adverse economic
conditions.  In addition, our secured notes contain restrictive
covenants which, among other things, limit our ability to borrow additional
funds, sell equity, repay indebtedness, including the secured notes, before
maturity or grant security interests on our assets.  Under the terms of the
secured notes, we will be unable to refinance our existing debt on more
favorable terms.





Our
substantial indebtedness could have significant adverse consequences,
including:





·
            requiring
      us to dedicate a substantial portion of the net proceeds of the debt and
      any cash flow from operations to the payment of interest, and potentially
      principal, on our indebtedness, thereby reducing the availability of such
      proceeds and cash flow to fund working capital, capital expenditures or
      other general corporate purposes.





·
            increasing
      our vulnerability to general adverse economic and industry
      conditions,





·
            limiting
      our ability to obtain additional financing to fund future working capital,
      capital expenditures, research and development and other general corporate
      requirements;





·
            limiting
      our flexibility in planning for, or reacting to, changes in our business
      and the industry; and





·
            placing
      us at a disadvantage compared to our competitors with less debt and
      competitors that have better access to capital
  resources.


-14-
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Furthermore,
in order to repay our indebtedness at maturity, if not converted into common
stock, including the secured notes, we will need to refinance all or a portion
of that indebtedness.  There can be no assurance that we will be able
to effect any such refinancing on commercially reasonable terms or at
all.





Our
debt service costs exceed our current operating cash flow.





For the
year ended December 31, 2007, and in prior fiscal years, our debt service costs
exceeded current operating cash flow, and this may continue in future periods if
we are unable to achieve our current projections.  Our ability to make
scheduled payments of interest or principal, if any, on our indebtedness,
including the secured notes, or to fund planned capital expenditures, will
depend on our future performance, which, to some extent, is subject to general
economic, financial, competitive, legislative, regulatory and other factors that
are beyond our control.  There can be no assurance that future revenue
growth will be realized or that our business will generate sufficient cash flow
from operations to enable us to service our indebtedness or to fund our other
liquidity needs.





We
have granted a lien on substantially all of our assets.





Our
obligations under the secured notes are secured by substantially all of our
assets and substantially all of the assets of our principal subsidiaries, except
as to contracts we enter into after October 1, 2006 and all assets directly
related thereto.  Upon an event of default under the secured notes,
these lenders could elect to declare all amounts outstanding, together with
accrued and unpaid interest thereon, to be immediately due and
payable.  If we were unable to repay those amounts, such lenders will
have a first claim on our assets and the assets of our
subsidiaries.  If these creditors should attempt to foreclose on their
collateral, it is unlikely that there would be any assets remaining after
repayment in full of such secured indebtedness and our financial condition and,
thus, the value of our common stock, would be materially adversely
affected.





We
will need additional financing, which may be difficult or impossible to obtain
and may restrict our operations and dilute stockholder ownership
interest.




At
December 31, 2007, we had approximately $27,190,000 of outstanding debt, at face
value.  On July 27, 2007, we raised $4,808,000 (net of expenses)
through a private sale of our equity securities.  Although we believe
that the financing obtained in 2007 mentioned above and our liquidity at
December 31, 2007 will enable us to continue with the development and
delivery of our products and sustain operations through the next twelve months,
we may need to raise additional funds in the future to fund our operations,
deliver our products, expand or enhance our products and services, finance
acquisitions and respond to competitive pressures or perceived
opportunities.  Because the nature of our operations requires us to
bear all the up-front costs of deploying our technology, additional funds will
be crucial to our continuing operations. We cannot provide any assurance that
additional financing will be available on acceptable terms, or at all. If
adequate funds are not available or not available on acceptable terms, our
business and results of operations may suffer. We cannot provide any assurance
that we can continue as a going concern if we are unable to raise additional
financing as it becomes necessary.




Our
outstanding debt contains restrictive covenants that limit our ability to raise
additional funds through debt financings.  As a result of these
restrictions, any additional debt must be for the sole purpose of financing the
design, engineering, installation, construction, configuring, maintenance, or
operation or improvement of property or equipment at customer sites pursuant to
customer contracts entered into after October 1, 2006 and will not be available
to fund general overhead expenses.  If we raise additional funds
through a debt financing, the terms and conditions of the debt financing may
result in further restrictions on our operations or require that we grant a
security interest in some or all of the assets related to the customer contracts
toward which such financing would be applied. Any debt that we incur would
increase our leverage and could exacerbate the negative consequences described
above in “— We have
substantial indebtedness.”





Additionally,
we could be required to seek funds through arrangements with collaborative
partners or others that may require us to relinquish rights to certain of our
technologies, product candidates or products which we would otherwise pursue on
our own.


-15-
 Table of Contents


Our
outstanding debt consists of convertible notes, which contain anti-dilution
provisions which would lower the conversion price if we were to issue equity for
a price less than the conversion price.  We also have outstanding
warrants to purchase our common stock which contain anti-dilution provisions
which would lower the exercise price and increase the number of shares
issuable upon exercise if we were to issue equity for a price less than the
exercise price.  If we raise additional funds by issuing equity
securities, which would require the consent of our secured Noteholders, further
dilution to our then-existing stockholders will result and the terms of the
financing may adversely affect the holdings or the rights of such
stockholders.





We
depend on a small group of customers for a substantial portion of our revenues,
and the loss of, or a significant reduction in revenue resulting from a default
by these key customers could significantly reduce our
revenue.





A
significant portion of our revenue is derived from a single customer.  Our
largest customer accounted for 19% of our revenues in 2007 and 6% of our
revenues in 2006.  Our four largest customers, defined as our key
customers, account for 54% of our revenues in 2007 and 41% of our revenues in
2006.  The loss of, or a significant reduction in revenue from any of our
key customers, or a default by any key customer on its contractual obligations
would significantly reduce our revenue and, if we are unable to replace such key
customer, could materially and adversely affect our business and results of
operations.  We can offer no assurances that we will be able to
replace a key customer should it become necessary.





We
no longer have exclusive rights to market Poliscanspeed.




Vitronic
has elected to terminate our exclusive right to purchase and market
Poliscanspeed in
the United States because we failed to generate the necessary sales volume prior
to June 30, 2007.  Although we remain a non-exclusive distributor of
Poliscanspeed, we
cannot make assurances that Vitronic will continue to allow us to distribute on
their behalf or that Vitronic will continue to support our Poliscanspeed
units.  Because the growth of our speed business, namely the increased
deployment of Poliscanspeed
systems, is a key component of our growth strategy, the loss of our exclusive
relationship with Vitronic, or Vitronic’s failure to support our Poliscanspeed
units could adversely affect our business and results of
operations.





A
substantial portion of our debt is subject to redemption at the holder’s option
prior to maturity.





The
holders of our secured notes have the right to require us to redeem all or any
portion of those notes on May 25, 2009, unless our consolidated EBITDA (defined
as earnings before interest, taxes, depreciation and amortization, any
derivative instrument gain or loss or any employee stock option expense under
SFAS 123R, “Share-Based
Payment”) for 2008 exceeds $14,000,000.  The terms of our
secured notes do not permit us to refinance those notes or to borrow to redeem
the notes prior to maturity. Thus, our ability to redeem the secured notes if
tendered will depend upon our operating performance as well as prevailing
economic and market conditions and other factors beyond our
control.  Failure to redeem properly tendered notes would constitute
an event of default, which, if not cured or waived, could have a material
adverse effect on our financial condition, and thus, the value of our common
stock.





Our
financial condition and results of operations may be adversely affected if we
are unable to secure and maintain future contracts with government
entities.





Contracts
with government entities account for essentially all of our
revenue.  The majority of these contracts may be terminated at any
time on short notice with limited penalties.  Accordingly, we might
fail to derive any revenue from sales to government entities in any given future
period.  If government entities fail to renew or if they terminate any
of these contracts, it would adversely affect our business and results of
operations.  Our existing contracts typically authorize the
installation of our products at a specified number of approaches.  As
of December 31, 2007, our active contracts with state and local governments
authorized the installation of CrossingGuard at up to an additional 176
approaches.  In many cases, we cannot proceed with these installations
until the sites and related installation plans have been approved by the
contracting entities, which can be a lengthy process.  In those cases,
if government entities fail to approve sites, we will not be able to deliver
products and services and generate revenues.  We cannot assure you
that all approaches under contract will ultimately be
installed.


-16-
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We
face substantial competition and may not be able to compete
successfully.





Many
other companies offer products that directly compete with CrossingGuard and our
speed products.  Many of our current and potential competitors have
significantly greater financial, marketing, technical and other competitive
resources than we do and may be able to bring new technologies to market before
we are able to do so.  Some of our competitors may have a competitive
advantage because of their size, market share, legacy customer relationships,
enhanced driver imaging, additional products offered and/or citation-processing
experience.  Current and potential competitors may establish
cooperative relationships with one another or with third parties to compete more
effectively against us.  One of our competitors, Affiliated Computer
Services, Inc. (ACS), offers state and local governments solutions to a wide
variety of data processing issues, has the greatest number of red light camera
systems installed, and may have a competitive advantage because of the scope of
its relationship with, and the volume of transactions it conducts for, a
particular government.  It is also possible that new competitors may
emerge and acquire market share.  Additionally, if we are not
successful in protecting our patents, we could lose a competitive
advantage.  We cannot assure you that we will be able to compete
successfully with our competitors.  Failure to compete successfully
could have a material adverse effect on our business, financial condition and
results of operations.





The
failure of governments to authorize or maintain automated traffic enforcement
may hinder our growth and harm our business.





Currently,
24 states and the District of Columbia either authorize some use of automated
red light enforcement or allow municipalities to elect to do so under “home
rule” laws, whereby the authority to act in local affairs is transferred from
the state to local counties and municipalities through a local home rule
charter.  It is uncertain at this time which additional states, if
any, will allow the use of automated red light enforcement or if there will be
other changes in the states that currently allow the practice.  If
additional states do not authorize the use of automated red light enforcement,
our opportunities to generate additional revenue from the sale of CrossingGuard
systems and related services will be limited.





Additionally,
some states that had previously authorized some use of automated red light
enforcement could fail to maintain such authorization.  It is possible
that other states or municipalities could prohibit the use of red light
enforcement systems in the future, which could adversely affect our business,
financial condition and results of operations.





The
market for automated speed enforcement products in the United States is
limited.  Ten states and the District of Columbia either authorize
some use of automated speed enforcement or allow municipalities to elect to do
so under “home rule” laws.  Some of these states authorize automated
speed enforcement only in limited circumstances such as school or work
zones.  If additional states do not authorize automated speed
enforcement, our opportunities to generate additional revenue from the sale of
automated speed enforcement systems and related services will be
limited.





We could
be subject to differing and inconsistent laws and regulations with respect to
our products.  If that were to happen, we may find it necessary to
eliminate, modify or cancel components of our services that could result in
additional development costs and the possible loss of revenue.  Future
legislative changes or other changes in the laws of states authorizing automated
red light or speed enforcement in the administration of traffic enforcement
programs could have an adverse effect on our business, financial condition and
results of operations.





In states
in which municipalities or counties are allowed to use automated enforcement
under home rule laws, those municipalities or counties must act in accordance
with state law in exercising that authority. The failure to act in accordance
with state law would subject its automated enforcement program to legal
challenge, which, if successful, could invalidate the program. As a result, we
could lose our contract with that municipality or county and be required to
refund revenue from that program.  Currently, our program in
Davenport, Iowa is suspended following a district court ruling that Davenport’s
ordinance authorizing automated traffic enforcement exceeds the city's home rule
authority.


-17-
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Our
products might not achieve market acceptance, which could adversely affect our
growth.





The
market for our products is still emerging.  The rate at which state
and local government bodies have accepted automated enforcement programs has
varied significantly by locale.  We expect to continue to experience
variations in the degree to which these programs are accepted.  Our
ability to grow will depend on the extent to which our potential customers
accept our products.  This acceptance may be limited by:





·
            The
      failure of states to adopt or maintain legislation enabling the use of
      automated traffic enforcement
systems;





·
            The
      failure of prospective customers to conclude that our products are
      valuable and should be used;





·
            The
      reluctance of our prospective customers to replace their existing
      solutions with our products;





·
            Marketing
      efforts of our competitors; and





·
            The
      emergence of new technologies that could cause our products to be less
      competitive or obsolete.





Because
automated traffic enforcement in the United States is still in an early stage of
development, we cannot accurately predict how large the market will become, and
we have limited insight into trends that may emerge and affect our
business.  For example, without knowing how commonplace automated
enforcement will become, we may have difficulties in predicting the competitive
environment that will develop.





Our
speed products are not certified by the International Association of Chiefs of
Police.





Potential
customers may require or prefer IACP certification of automated speed
enforcement equipment. Were a potential customer to require or prefer IACP
certification, we would or could lose that potential customer, which would have
a material adverse effect on our business, financial condition and results of
operations.





Earnings
for future periods may be affected by impairment charges.





Because
of the nature of our business, long-lived assets, including intangibles,
represent a substantial portion of our assets. The Company evaluates long-lived
assets for impairment at least annually or when events or changes in
circumstances indicate, in management’s judgment, that the carrying value of
such assets used in operations may not be recoverable. The determination of
whether an impairment has occurred is based on management’s estimate of
undiscounted future cash flows attributable to the assets as compared to the
carrying value of the assets. If an impairment occurs, the amount of the
impairment recognized will be determined by estimating the fair value for the
assets and we will record a charge against earnings if the carrying value is
greater than fair value.





Concerns
about privacy rights and negative publicity regarding our industry could slow
acceptance of our products.





Various
advocacy groups and some politicians have expressed concerns that automated
traffic enforcement products infringe individual privacy and due process
rights.  Such concerns can delay the acceptance of our products and
result in legal challenges that impede implementation of our traffic enforcement
systems. Our business is more vulnerable to these types of challenges because
the automated traffic enforcement industry is emerging. Furthermore, in the
event of adverse publicity, whether directed at us or our competitors’ products,
due to processing errors or other system failures, the automated traffic
enforcement industry could suffer as a whole, which would have a material
adverse effect on our business, financial condition and results of
operations.


-18-
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Concentration
of our processing operations in one location exposes us to potential business
interruption in the event of a natural disaster.





We
maintain substantially all of our operations, including a majority of our red
light and speed enforcement equipment, at our Providence, Rhode Island
headquarters.  A disruption of our operations for any reason,
including theft, government intervention or a natural disaster such as fire,
earthquake, flood or other casualty could cause us to limit or cease our
operations, which would have a material adverse effect on our business,
financial condition and results of operation.  Although we maintain
business interruption insurance to cover natural disasters, no assurance can be
given that such insurance will continue to be available to us on commercially
reasonable terms, if at all, or that such insurance would be sufficient to
compensate us for damages resulting from such casualty.  In addition,
no assurance can be given that an interruption in our operations would not
result in permanent loss of significant customers, which would have a material
adverse effect on our business, financial condition and results of
operation.








Our
financial results will depend significantly on our ability to continually
develop our products and technologies.





Our
financial performance will depend to a significant extent on our ability to
successfully develop and enhance our products.  We must successfully
identify product and service opportunities, and develop and bring our products
and technologies to market in a timely manner.  The success of our
product introductions will depend on several factors, including:





·
            Proper
      product definition;





·
            Timely
      completion and introduction of enhanced product
  designs;





·
            The
      ability of subcontractors and component manufacturers to effectively
      design and implement the manufacture of new or enhanced products and
      technologies;





·
            The
      quality of our products and
technologies;





·
            Product
      and technology performance as compared to competitors' products and
      technologies;





·
            Market
      acceptance of our products; and





·
            Competitive
      pricing of products, services and
technologies.





We have
in the past experienced delays in completing the development or the introduction
of new products.  Our failure to successfully develop and introduce
new or enhanced products and technologies or to achieve market acceptance for
such products and technologies may materially harm our business and results of
operations.








Fluctuations
in our results of operations make it difficult to predict our future performance
and may result in volatility in the market price of our common
stock.





Our
quarterly operating results have fluctuated in the past and may fluctuate
significantly in the future.  We may incur significant expenses in
anticipation of revenue, which may not materialize and we may not be able to
reduce spending quickly if our revenue is lower than expected.  In
addition, our ability to forecast revenue, particularly with respect to our new
speed products, is limited.  As a result, our operating results are
volatile and difficult to predict and you should not rely on the results of one
quarter as an indication of future performance.  Factors that may
cause our operating results to fluctuate include the risks discussed in this
section as well as:





·
            Costs
      related to customization of our products and
  services;





·
            Announcements
      or introductions of new products and services by our
      competitors;


-19-
 Table of Contents





·
            The
      failure of additional states to adopt or maintain legislation enabling the
      use of automated traffic enforcement
systems;





·
            Determinations
      by state and local government bodies to utilize our equipment without the
      additional processing services we
provide;





·
            Software
      defects and other product quality
problems;





·
            A
      shift towards fixed rate, as opposed to per ticket, compensation
      arrangements for our speed products, which could adversely affect
      revenues;





·
            Adjustments
      in the estimates used to report revenue under contracts that require
      payment only after our customer has collected the
  fine;





·
            The
      discretionary nature of our customers’ internal evaluation, approval and
      order processes;





·
            The
      varying size, timing and contractual terms of orders for our products and
      services;





·
            The
      mix of revenue from our products and
services;





·
            The
      change in market value of our embedded debt and warrant derivatives;
      and





·
            The
      change in our stock compensation charges relative to our equity incentive
      programs.











Our
sales cycles vary significantly, making it difficult to plan our expenses and
forecast our results.





Our sales
cycles typically range from several months to over a
year.  Accordingly, it is difficult to predict the quarter in which a
particular sale will occur and to plan our expenses accordingly.  The
period between our initial contact with potential customers and the installation
of our products, the use of our services and our generation of revenue, if any,
varies due to several factors, including:





·
            The
      complex nature of our products and
services;





·
            Political
      or legal challenges to legislation authorizing the use of automated
      traffic enforcement systems;





·
            The
      novelty of automated traffic enforcement in many jurisdictions and a lack
      of familiarity with automated traffic enforcement systems on the part of
      legislative, executive and judicial bodies and the
  public;





·
            The
      selection, award and contracting processes at municipalities and other
      government entities, including protests by other bidders with respect to
      competitive awards;





·
            Our
      customers’ internal evaluation, approval and order
    processes;





·
            The
      site evaluation and analysis process;
and





·
            Our
      customers' delays in issuing requests for proposals or in awarding
      contracts because of announcements or planned introductions of new
      products or services by our
competitors.


-20-
 Table of Contents





Any delay
or failure to complete installations in a particular quarter could reduce our
revenue in that quarter, as well as subsequent quarters over which revenue would
likely be recognized.  If our installation cycles unexpectedly
lengthen in general or for one or more large customers, it would delay our
generation of the related revenue.  If we were to experience a delay
of several weeks or longer on a large customer, it could harm our ability to
meet our forecasts for a given quarter.





Our
intellectual property might not be protectible, and if we fail to protect and
preserve our intellectual property, we may lose an important competitive
advantage.





We rely
on a combination of copyright, trademark, patent and trade-secret laws, employee
and third-party nondisclosure agreements and other arrangements to protect our
proprietary rights.  Despite these precautions, it may be possible for
unauthorized parties to copy our products or obtain and use information that we
regard as proprietary to create products that compete against
ours.  In addition, some of our competitors have been able to offer
products with some similar features that do not infringe our
patents.  For example, during the past 18 months we initiated two
patent infringement suits against competitors, Redflex Traffic Systems, Inc. and
Transol USA, Inc., both of which have been dismissed without a finding of
infringement.  The scope of United States patent protection in the
software industry is not well defined and will evolve as the United States
Patent and Trademark Office grants additional patents.  Because some
patent applications in the United States are not publicly disclosed until the
patent is issued or 18 months after the filing date, applications may exist that
would relate to our products and are not publicly
accessible.  Moreover, a patent search has not been performed in an
attempt to identify patents applicable to our business and, even if such a
search were conducted, all patents applicable to the business might not be
located.  If we are unable to protect our proprietary rights, we may
lose an important competitive advantage, and our business, financial condition
and results of operations could suffer.





We
are at risk of claims that our products or services infringe the proprietary
rights of others.





Given our
ongoing efforts to develop and market new technologies and products, we may from
time to time be served with claims from third parties asserting that our
products or technologies infringe their intellectual property
rights.  If, as a result of any claims, we were precluded from using
technologies or intellectual property rights, licenses to the disputed
third-party technology or intellectual property rights might not be available on
reasonable commercial terms, or at all, which could restrict our ability to sell
our products and services.  We may initiate claims or litigation
against third parties for infringement of our proprietary rights or to establish
the validity of our proprietary rights.  Litigation, either as
plaintiff or defendant, could result in significant expense and divert the
efforts of our technical and management personnel from productive tasks, whether
or not litigation is resolved in our favor.  An adverse ruling in any
litigation might require us to pay substantial damages, to discontinue our use
and sale of infringing products and to expend significant resources in order to
develop non-infringing technology or obtain licenses for our infringing
technology.  A court might also invalidate our patents, trademarks or
other proprietary rights.  A successful claim against us, coupled with
our failure to develop or license a substitute technology, could cause our
business, financial condition and results of operations to be materially
adversely affected.  As the number of software products increase and
the functionality of these products further overlaps, we believe that our risk
of infringement claims will increase.





If
we are unable to safeguard the integrity, security and privacy of our data or
our customers' data, our revenue may decline, our business could be disrupted
and we may be sued.





We need
to preserve and protect our data and our customers' data against loss,
corruption and misappropriation caused by system failures and unauthorized
access.  We could be subject to liability claims by individuals, whose
data resides in our databases, for misuse of personal
information.  These claims could result in costly
litigation.  A party who is able to circumvent our security measures
could misappropriate or destroy proprietary information or cause interruptions
in our operations.  We may be required to make significant
expenditures to protect against systems failures, security breaches or to
alleviate problems caused by any failures or breaches.  Any failure
that causes the loss or corruption of, or unauthorized access to, this data
could reduce customer satisfaction, expose us to liability and, if significant,
could cause our revenue to decline and our expenses to
increase.


-21-
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We
may be subject to product liability claims that could result in costly and
time-consuming litigation.





Although
our customer contracts typically contain provisions designed to limit our
exposure to product liability claims, existing or future laws or unfavorable
judicial decisions could negate these limitation of liability
provisions.  Any product liability claim brought against us, even if
unsuccessful, would likely be time-consuming and costly, and potential
liabilities could exceed our available insurance coverage, which could have an
adverse effect on our financial condition and results of
operations.





The
failure of our suppliers to deliver components, equipment and materials in
sufficient quantities and in a timely manner could adversely affect our
business.





Our
business employs a wide variety of components, equipment and materials from a
limited number of suppliers.  To date, we have found that the
components, equipment and materials necessary for the development, testing,
production and delivery of our products and services have sometimes not been
available in the quantities or at the times we have required.  Our
failure to procure components, equipment and materials in particular quantities
or at a particular time may result in delays in meeting our customers’ needs,
which could have a negative effect on customer satisfaction and on our business,
financial condition and results of operations.





If
we lose our key personnel or are unable to attract and retain additional
personnel, our operations could be disrupted and our business could be
harmed.





We
believe that the hiring and retaining of qualified individuals at all levels in
our organization will be essential to our ability to sustain and manage growth
successfully.  Competition for highly qualified technical personnel is
intense and we may not be successful in attracting and retaining the necessary
personnel, which may limit the rate at which we can develop products and
generate sales.  We will be particularly dependent on the efforts and
abilities of our senior management personnel.  The departure of any of
our senior management members or other key personnel could harm our
business.





We
may make acquisitions, which could divert management’s attention, cause
ownership dilution to our stockholders and be difficult to
integrate.





We may
seek to expand our operations through the acquisition of complementary
businesses.  Our future growth may depend, in part, upon the continued
success of our acquisitions.  Acquisitions involve many risks, which
could have a material adverse effect on our business, financial condition and
results of operations, including:





·
            Acquired
      businesses may not achieve anticipated revenues, earnings or cash
      flow;





·
            Integration
      of acquired businesses and technologies may not be successful and we may
      not realize anticipated economic, operational and other benefits in a
      timely manner, particularly if we acquire a business in a market in which
      we have limited or no current expertise or with a corporate culture
      different from ours;





·
            Potential
      dilutive effect on our stockholders from the issuance of common stock as
      consideration for acquisitions;





·
            Adverse
      effect on net income from impairment charges related to goodwill and other
      intangible assets, and other acquisition-related charges, costs and
      expenses effects on net income;





·
            Competing
      with other companies, many of which have greater financial and other
      resources, to acquire attractive companies, making it more difficult to
      acquire suitable companies on acceptable terms or at all;
    and





·
            Disruption
      of our existing business, distraction of management, diversion of other
      resources and difficulty in maintaining our current business standards,
      controls and procedures.


-22-
 Table of Contents


Risks
Related to Our Common Stock





Our
common stock price is volatile and may decline in the future.





The
market price of our common stock has fluctuated significantly and may be
affected by our operating results, changes in our business, changes in the
industry in which we conduct business, and general market and economic
conditions that are beyond our control.  In addition, the stock market
in general has recently experienced extreme price and volume
fluctuations.  These fluctuations have affected stock prices of many
companies without regard to their specific operating
performance.  These market fluctuations may make it difficult for
stockholders to sell their shares at a price equal to or above the price at
which the shares were purchased.  In addition, if our results of
operations are below the expectations of market analysts and investors, the
market price of our common stock could be adversely affected.





Our
board of directors can, without stockholder approval, cause preferred stock to
be issued on terms that could adversely affect common stockholders.





Under our
certificate of incorporation, our board of directors is authorized to issue up
to 10,000,000 shares of preferred stock, of which 180,000 shares are issued and
outstanding, and to determine the price, rights, preferences, privileges and
restrictions, including voting rights, of those shares without any further vote
or action by our stockholders.  If the board causes any additional
preferred stock to be issued, the rights of the holders of our common stock
could be adversely affected.  The board's ability to determine the
terms of preferred stock and to cause its issuance, while providing desirable
flexibility in connection with possible acquisitions and other corporate
purposes, could have the effect of making it more difficult for a third party to
acquire a majority of our outstanding voting stock.  We have no
current plans to issue additional shares of preferred stock.





Provisions
of our secured notes and secured note warrants could delay or prevent a change
of control.





There are
provisions in our secured notes and secured note warrants that may discourage,
delay or prevent a merger or acquisition because, upon a change of control (as
defined in the notes), the holders of the secured notes have the right to redeem
some or all of their secured notes and the holders of the secured note warrants
will have the right to effectively accelerate the maturity date and demand
payment.





We
have not paid, and do not intend to pay, dividends and therefore, unless our
common stock appreciates in value, our investors may not benefit from holding
our common stock.





We have
not paid any cash dividends since inception.  We intend on retaining
any future earnings to support the development and expansion of our business,
and, therefore, we do not anticipate paying any cash dividends in the
foreseeable future.  As a result, our investors will not be able to
benefit from owning our common stock unless the market price of our common stock
becomes greater than the basis that these investors have in their
shares.





We
have a significant number of options, warrants and convertible securities
outstanding, which if exercised or converted, will have a dilutive effect upon
our stockholders.  The anti-dilution provisions of some of these
securities could magnify that dilutive effect.





As of
December 31, 2007, we have issued and outstanding warrants and options to
purchase up to 6,746,132 shares of our common stock, preferred stock convertible
into 18,000 shares of our common stock and debt convertible into 7,136,111
shares of our common stock.





Furthermore,
the documents governing our convertible debt have anti-dilution provisions,
pursuant to which the conversion price is reduced if we sell common stock at a
price below the conversion price, which is now $3.60 per share.  The
secured notes provide “full ratchet” anti-dilution protection until May 25, 2009
and “weighted average” anti-dilution protection thereafter.  The
holders of our 5% notes also have “full ratchet” anti-dilution protection until
maturity of the notes.  In addition, some of our warrants contain
weighted average anti-dilution provisions that would lower the exercise price
and increase the number of shares issuable upon exercise if we sell stock at a
price below $4.35 per share.





Unlike
ordinary anti-dilution provisions, “full ratchet” anti-dilution provisions have
the effect of extending a “lowest price guarantee” to the holders of the secured
notes and the 5% notes.


-23-
 Table of Contents


If the
holders of these securities convert the notes or exercise the options and
warrants, we will issue shares of our common stock and such issuances will be
dilutive to our stockholders.  Because the conversion price of the
notes and the exercise price of the warrants may be adjusted from time to time
in accordance with the anti-dilution provisions of the notes and the warrants,
the number of shares that could actually be issued may be greater than the
amount described above.  In addition, if such investors or our other
stockholders sell substantial amounts of our common stock in the public market
during a short period of time, our stock price may decline
significantly.





The
price of our common stock may decline because a substantial amount of our common
stock is available for trading in the public market.





Availability
of shares of our common stock could depress the price of our common
stock.  A substantial amount of common stock is available for trading
in the public market.  This amount of stock in the market may cause
the price of our common stock to decline.  In addition, if our
stockholders sell substantial amounts of our common stock in the public markets,
the market price of our common stock could fall.  These sales might
also make it more difficult for us to sell equity or equity-related securities
at a time and price that we would deem appropriate.  We also have
issued options, warrants and convertible securities that can be exercised for,
or converted to, shares of common stock, many of which would be freely tradable
without restrictions or further registration under the Securities
Act.





There
were 28,954,219shares of our common
stock outstanding as of December 31, 2007, of which approximately 9,329,390
shareswere freely
tradable without restrictions or further registration under the Securities
Act.  Silver Star Partners, a significant stockholder, has the right
to require us to register under the Securities Act their resale of all 9,936,430
shares of common stock that it owns, as soon as practicable after Silver Star
Partners requests that registration, of which 220,589 were registered on our
registration statement (File No. 333-133468) that was declared effective on July
14, 2006.





The
Nasdaq Capital Market may cease to list our common stock which may cause the
value of an investment in our Company to substantially decrease and may result
in a default under our senior secured notes.




We have
been out of compliance with the Nasdaq Capital Market continued listing minimum
bid price requirement and remain so to this date.  We presently remain
listed on the Nasdaq Capital Market pursuant to a grace period which expires on
April 21, 2008.  We are susceptible to volatility of our stock and could
remain out of compliance if appropriate steps are not taken to cure our
non-compliance. We can give no assurances that the steps we propose will be
approved by our stockholders or that they will be effective in curing our
non-compliance.  In addition, we may not meet other Nasdaq Capital Market
continued listing requirements which could result in our common stock being
delisted from the Nasdaq Capital Market.  If our common stock is not listed
on the Nasdaq Capital Market or other national stock market or exchange for a
period of five consecutive days or for more than an aggregate of ten days in any
365-day period, we would be in default of our senior secured notes and could be
subject to the remedies available to the holders of such notes, including
acceleration of repayment of the indebtedness hereunder.  In addition,
delisting from the Nasdaq Capital Market would adversely affect the trading
price and limit the liquidity of our common stock and therefore may cause the
value of an investment in our Company to decrease.





Our
business and results of operations could be materially and adversely affected if
the Ohio Federal District Court makes an adverse ruling in pending cases in
Ohio.





We are
parties to two pending lawsuits, Mendenhall
v. The City of Akron, et al., and Sipe, et
al. v. Nestor Traffic Systems, Inc., et al., which have been consolidated
in the United States District Court, Northern District of Ohio, Eastern
Division.  Recently, the Ohio Supreme Court resolved a certified
question with respect to these cases allowing that the Ohio Constitution’s home
rule provisions permitted municipalities to pass local ordinances authorizing
automated speed enforcement.  Accordingly, a major legal hurdle has
been overcome.  The cases, however, remain pending before the United
States District Court, Northern District of Ohio, Eastern Division to resolve
certain other constitutional issues.  Although we believe the Court
will rule in our favor, an adverse ruling on any constitutional question could
render us unable to continue to operate in Ohio without substantial
modifications to our programs there.  We can offer no assurances that
our programs in Ohio can be sufficiently modified such that they would conform
to an adverse ruling in these lawsuits or that the affected municipalities would
agree to such modifications.  The loss of business in Ohio would have
a material adverse effect on our business and results of
operations.


-24-
 Table of Contents





ITEM
2.                      Properties.





Our
properties consist of leased office and warehouse facilities for logistics,
engineering, processing, support, research and development, administrative and
other professional personnel.  Our corporate headquarters are located
at 42 Oriental Street, Third Floor, Providence, Rhode Island.  We
lease 12,700 square feet of office space and 11,000 square feet of warehouse
space at this location under an operating lease that expires in
2010.





We also
lease 12,500 square feet of office and warehouse space in North Hollywood,
California to service our customers located on the West Coast.  We
lease this space under an operating lease that expires in 2011.








ITEM
3.                      Legal Proceedings.





On April
13, 2007, the Company filed suit against Place Motor, Inc. and Clair Ford,
Lincoln Mercury, Inc.  (Nestor Traffic Systems, Inc.
Plaintiff, vs. Place Motor, Inc., et al., Rhode Island Superior Court, C.A. No.
PC-07-1963).  Place Motor, Inc. and Clair Ford, Lincoln
Mercury, Inc. are in possession of title for eight vans for which Nestor has
paid in full.  Nestor has alleged that it paid for these vans by
making payment to the defendants’ agent, Northeast Conversions,
LLC.  Although Northeast Conversions never forwarded our payment to
the defendants, Nestor believes that it satisfied its obligation to pay for the
vans when it delivered payment to the defendants’ agent.  Accordingly,
Nestor seeks declaratory judgment in favor stating that the Defendants’ must
take any action necessary to deliver the vans together with valid title
certificates to Nestor Traffic Systems.  The defendants have answered
the complaint with general denials of the basis for Nestor’s claims and
asserting certain affirmative defenses.  Neither party asserted any
counterclaims.  At present, discovery is ongoing with Clair Ford,
Lincoln Mercury, Inc. and a default is pending with respect to Place Motor, Inc.
for its failure to respond to discovery.




Two suits
have been filed against us and the City of Akron seeking to enjoin the City of
Akron speed program and damages.  These cases have been consolidated
in the U.S. District Court for the Northern District of Ohio.  These
cases are:





Mendenhall v. The City of
Akron, et al., United States District Court, Northern District of Ohio,
Eastern Division, No. 5:06CV0139, in which plaintiff filed a complaint and class
action for declaratory judgment, injunctive relief and for a money judgment in
an unspecified amount against City of Akron and all of its City Council members
in their official capacity and us alleging federal and state constitutional
violations.  The action was filed in the Summit County Court of Common
Pleas and was removed to federal court.  On February 17, 2006, we and
the other defendants filed a joint motion for judgment on the
pleadings.  Plaintiff filed an opposition to that motion on March 24,
2006.  On May 19, 2006, the court ruled that the Akron ordinance
permitting photo enforcement of speeding laws was a proper exercise of municipal
power under the Ohio Constitution, but deferred ruling on the alleged due
process violations pending an opportunity for discovery by the plaintiff, which
was completed on October 20, 2006.   The plaintiff amended her
complaint on August 8, 2006 to include equal protection violations among her
federal constitutional claims.  We filed an answer to that amended
complaint on August 18, 2006 and all dispositive motions in the case were filed
by November 22, 2006.





Sipe, et al. v. Nestor
Traffic Systems, Inc., et al., United States District Court, Northern
District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiffs filed a
complaint and class action for declaratory judgment, injunctive relief and for a
money judgment in an unspecified amount against us, various past and present
employees of ours and the City of Akron and alleging fraud, civil conspiracy,
common plan to commit fraud, violations of the Consumer Sales Practices Act,
nuisance, conversion, invasion of privacy, negligence, and federal
constitutional violation. The action was filed in the Summit County Court of
Common Pleas and was removed to federal court.  On February 17, 2006,
we and the other defendants filed a joint motion for judgment on the
pleadings.  Plaintiff filed an opposition to that motion on March 24,
2006.  On May 19, 2006, the court ruled that the Akron ordinance
permitting photo enforcement of speeding laws was a proper exercise of municipal
power under the Ohio Constitution, but deferred ruling on the alleged due
process violations pending an opportunity for discovery by the plaintiff, which
was completed on October 20, 2006 and all dispositive motions in the case were
filed by November 22, 2006.


-25-
 Table of Contents





With
respect to both of the above cases, on January 31, 2008, the Ohio Supreme Court
determined in the affirmative the following certified question:





Whether a
municipality has the power under home rule to enact civil penalties for the
offense of violating a traffic signal light or for the offense of speeding, both
of which are criminal offenses under the Ohio Revised Code.





On
February 7, 2007, the Ohio Supreme Court accepted the case for determination of
the question presented.  The Ohio Supreme Court has received briefs
from all parties, and oral arguments were heard on September 18,
2007.  On January 31, 2008, the Ohio Supreme Court unanimously ruled
that the municipality does have power under home rule to enact civil penalties
for violating a traffic signal light and speeding.  This ruling will
permit the Federal District Court to resolve any remaining Constitutional issues
raised by the plaintiffs, including issues related to due process.





We do not
currently have any pending material litigation other than that described
above.








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





The
Company held its Annual Meeting of Stockholders on December 12,
2007.  The matters voted upon at this meeting and the number of shares
cast for and against each item are as follows:




1.
              To
      amend and restate the Company’s Restated Certificate of Incorporation to
      divide the Company’s Board of Directors into three classes, as nearly
      equal in number as possible, to be known as Class I, Class II and Class
      III with each class to serve staggered three year
  terms:
  FOR:
                17,151,593
                
                AGAINST:
                10,260,333
                
                ABSTAIN:
                46,270





2.
            To
      elect the following people to the Board of
  Directors:




DIRECTOR
            FOR
            ABSTAIN1-David
      N. Jordan (Class I)
            17,241,564
            10,261,6332-Nina
      R. Mitchell (Class I)
            17,241,863
            10,261,3343-Theodore
      Petroulas (Class I)
            17,241,514
            10,216,6834-George
      L. Ball (Class II)
            17,242,264
            10,215,9335-Harold
      E. Ford (Class II)
            17,240,764
            10,217,4336-Edward
      F. Heil (Class II)
            17,240,514
            10,217,6837-Clarence
      A. Davis (Class (III)
            17,212,935
            10,245,2628-Michael
      C. James (Class III)
            17,241,764
            10,216,4339-Daryl
      Silzer (Class III)
            17,241,863
            10,216,334






3.
            To
      ratify the appointment of Carlin, Charron & Rosen, LLP as independent
      registered public accountants for the Company for
    2007:





FOR:
            17,249,644
            
            AGAINST:
            10,164,564
            
            ABSTAIN:
            43,988











4.
              To
      amend and restate the Company’s By-Laws to increase the maximum number of
      directors of the Company from nine to
  eleven:
 
 FOR:
              17,128,314
              
              AGAINST:
              10,261,312
              
              ABSTAIN:
              68,568














-26-
 Table of Contents


PART
      II





ITEM
      5.
            Market
      for Registrant’s Common Stock, Related Stockholder Matters and Issuer
      Purchases of Equity
Securities.





The
Company’s common stock was traded on the Nasdaq Global Market under the symbol
“NEST” through November 26, 2006.  The Company transferred to the
Nasdaq Capital Market at the opening of business on November 27,
2006.  The Company’s trading symbol did not change.  The
following table reflects the range of the reported high and low last sale prices
on the respective Nasdaq Market for the periods indicated:









Year
      Ended December 31, 2007
            Low
            High1st
      Quarter
            $0.70
            $1.502nd
      Quarter
            $0.32
            $0.893rd
      Quarter
            $0.40
            $0.924th
      Quarter
            $0.45
            $0.78






Year
      Ended December 31, 2006
            Low
            High1st
      Quarter
            $2.80
            $6.002nd
      Quarter
            $2.80
            $3.803rd
      Quarter
            $2.30
            $3.384th
      Quarter
            $1.10
            $2.89








Holders
of Common Stock





At April
10, 2008, the number of holders of record of the issued and outstanding common
stock of the Company was 416.








Dividend
Policy





The
Company has not paid any cash dividends with respect to its common stock since
formation and does not expect to pay cash dividends in the foreseeable
future.





Securities
Authorized for Issuance Under Equity Compensation Plans





Incorporated
by reference from the Company's definitive proxy or information statement to be
filed with the Securities and Exchange Commission not later than 120 days
following the end of the Company’s fiscal year.


-27-
 Table of Contents


ITEM
      6.
            Selected Financial
      Data.





The
following is a summary of key financial measurements monitored by
management.  The financial statements for fiscal years 2004 and 2003
and for the fiscal quarters therein, along with the first three quarters of
fiscal 2005, have been restated. You should read the data set forth below in
conjunction with Item 7, “Management’s Discussion and Analysis of Financial
Condition and Result of Operations,” Item 1A, “Risk Factors,” and our
consolidated financial statements and related notes appearing elsewhere in this
Annual Report on Form 10-K.





Years
      Ended December 31,(In
      Thousands, Except Share and Per Share Information)(As
      Restated)
            
            
            (As
      Restated)2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            2003Revenue
            
            $
            11,505
            
            
            $
            8,087
            
            
            $
            7,769
            
            
            $
            6,035
            
            
            $
            2,706Operating
      loss
            
            
            (4,399
            )
            
            
            (13,902
            )
            
            
            (9,277
            )
            
            
            (4,647
            )
            
            
            (4,261
            )Modified
      EBITDA
            
            
            (252
            )
            
            
            (6,055
            )
            
            
            (6,879
            )
            
            
            (2,102
            )
            
            
            (3,249
            )Net
      loss
            
            $
            (8,023
            )
            
            $
            (7,491
            )
            
            $
            (6,764
            )
            
            $
            (6,178
            )
            
            $
            (5,325
            )Loss
      per share:Weighted
      number of outstanding shares –basic
      and diluted
            
            
            24,112,378
            
            
            
            20,277,770
            
            
            
            18,826,966
            
            
            
            18,223,609
            
            
            
            12,964,498Loss
      per share
            
            $
            (0.33
            )
            
            $
            (0.37
            )
            
            $
            (0.36
            )
            
            $
            (0.34
            )
            
            $
            (0.41
            )








SELECTED
BALANCE SHEET DATA:





Cash
      and marketable securities
            
            $
            3,135
            
            
            $
            3,010
            
            
            $
            1,280
            
            
            $
            6,422
            
            
            $
            5,410Capitalized
      systems investment
            
            $
            4,563
            
            
            $
            6,270
            
            
            $
            3,562
            
            
            $
            1,829
            
            
            $
            2,341Total
      assets
            
            $
            25,046
            
            
            $
            24,511
            
            
            $
            19,215
            
            
            $
            18,847
            
            
            $
            16,299Working
      capital (deficit)
            
            $
            3,041
            
            
            $
            3,433
            
            
            $
            (2,097
            )
            
            $
            6,786
            
            
            $
            3,294Long-term
      liabilities
            
            $
            18,029
            
            
            $
            14,942
            
            
            $
            6,420
            
            
            $
            7,812
            
            
            $
            3,322





(Note:
Earnings per share information as previously reported for fiscal year ended
December 31, 2002 has been adjusted to a post-reverse split basis.)





We are a
capital-intensive business, so in addition to focusing on GAAP measures, we
focus on modified EBITDA to measure our results. We calculate this number by
first calculating EBITDA, which we define as net income before interest expense,
debt restructuring or debt extinguishment costs (if any during the relevant
measurement period), provision for income taxes, and depreciation and
amortization. Then we exclude derivative instrument income or expense, debt
discount expense, share-based compensation expense, and asset impairment
charges.   These measures eliminate the effect of financing
transactions that we enter into on an irregular basis based on capital needs and
market opportunities, and these measures provide us with a means to track
internally generated cash from which we can fund our interest expense and our
growth. In comparing modified EBITDA from year to year, we also ignore the
effect of what we consider non-recurring events not related to our core business
operations to arrive at what we define as modified EBITDA. Because modified
EBITDA is a non-GAAP financial measure, we include in the tables below
reconciliations of modified EBITDA to the most directly comparable financial
measures calculated and presented in accordance with accounting principles
generally accepted in the United States.





We
present modified EBITDA because we believe it provides useful information
regarding our ability to meet our future debt payment requirements, capital
expenditures and working capital requirements, and that it provides an overall
evaluation of our financial condition. In addition, modified EBITDA is defined
in certain financial covenants under our Senior Secured Convertible Notes and
may be used to adjust the interest rate on those notes at January 1, 2009 and
determine whether the holders of those notes have a redemption right at May 25,
2009.


-28-
 Table of Contents


Modified
EBITDA has certain limitations as an analytical tool and should not be used as a
substitute for net income, cash flows or other consolidated income or cash flow
data prepared in accordance with generally accepted accounting principles in the
United States or as a measure of our profitability or our
liquidity.





When
evaluating modified EBITDA as a performance measure, and excluding the
above-noted items, all of which have material limitations, investors should
consider, among other factors, the following:





•
            increasing
      or decreasing trends in modified EBITDA;•
            how
      modified EBITDA compares to levels of debt and interest
      expense.





Because
modified EBITDA, as defined, excludes some but not all items that affect our net
income, modified EBITDA may not be comparable to a similarly titled performance
measure presented by other companies.





The table
below is a reconciliation of modified EBITDA to net loss for the years ended
December 31, 2007 and 2006:





Year
      Ended December 31,2007
            
            
            2006GAAP
      net income (loss)
            
            $
            (8,023
            )
            
            $
            (7,491
            )Interest
      and financing expense, net of interest income
            
            
            2,519
            
            
            
            1,865Income
      tax expense
            
            
            ---
            
            
            
            ---Depreciation
      and amortization
            
            
            3,533
            
            
            
            2,975EBITDA
            
            $
            (1,971
            )
            
            $
            (2,651
            )Derivative
      instrument (income) expense
            
            
            (2,926
            )
            
            
            (16,940
            )Debt
      discount expense
            
            
            4,031
            
            
            
            8,664Stock-based
      compensation expense
            
            
            614
            
            
            
            2,506Asset
      impairment charge
            
            
            ---
            
            
            
            2,366Modified
      EBITDA
            
            $
            (252
            )
            
            $
            (6,055
            )





-29-
 Table of Contents





ITEM
7.                      Management’s
Discussion and Analysis of Financial Condition and Results of
Operations





Our
management’s discussion and analysis of our financial condition and results of
our operations contains forward-looking statements, including statements about
our growth and future operating results, development of products, sales and
intellectual property. For this purpose, any statement that is not a statement
of historical fact should be considered a forward-looking statement. We often
used the words “believe,” “anticipate,” “plan,” “expect,” “intend,” “may,”
“will” and similar expressions to help identify forward-looking
statements.





Actual
results may differ from those indicated by such forward-looking statements as a
result of various important factors, including, without limitation, those
factors discussed in this annual report under the heading “Risk
Factors.”





Executive
Summary





We are a
leading provider of innovative, automated traffic enforcement systems and
services to state and local governments throughout the United States and
Canada.  We are the only provider of both a fully video-based
automated red light enforcement system and a multi-lane, bi-directional scanning
light detection and ranging, or LiDAR, speed enforcement system.  We
also offer a newly developed ViDARTM speed detection and imaging system as
complement to our other products or as a stand-alone speed enforcement system.
CrossingGuard, our red light enforcement product, uses our patented image
processing technology to predict and record the occurrence of a red light
violation, and manages the process of issuing and processing a
citation.  Poliscanspeed, one
of our speed enforcement products, uses technology developed by Vitronic
GmbH.  ViDARTM uses average speed over distance calculations to detect
and record evidence of speeding vehicles.  By combining CrossingGuard,
Poliscanspeed and
ViDARTM with Citation Composer, our proprietary citation preparation and
processing software, we are able to provide fully integrated, turnkey red light
and speed enforcement solutions.





We
generate recurring revenue through contracts that provide for equipment leasing
and services on a fixed and/or per citation fee basis.  These revenues
are tied to the number of operating systems in the field and the number of
violations processed by such systems.  Customer pricing entails fixed
monthly fees, variable per ticket fee pricing structures, or a combination of
both.  Because fixed fees are based upon the expected level of
violations over the contract term, the shift to monthly fixed fee contracts may
result in a more stable revenue stream for those installations.  Many
of our initial red light and speed contracts, however, compensate us on a per
ticket paid or issued basis in return for both equipment lease and maintenance
and citation processing and customer support services.  Depending on
the terms of each contract, we realize from $11 to $99 per citation issued or
paid and/or fixed monthly fees ranging from $1,500 to $7,000 per approach for
system delivery and processing services.





State
statutes providing for automated enforcement may impose liability on either the
driver or the registered owner of a vehicle for a violation.  Driver
liability statutes require that the driver be identified, from the photographic
evidence, and that the citation be issued and sent to the
driver.  Registered owner statutes require that the vehicle’s owner be
identified, through registration records, and that the citation be issued and
sent to the registered owner.  Because only the license plate is
required for identification under a registered owner statute, program operating
efficiencies are much higher, resulting in lower per citation costs and monthly
fees for CrossingGuard systems installed in these jurisdictions. Of the
twenty-four jurisdictions that currently allow for automated red light
enforcement programs, five require that a driver be identified; the other states
limit identification to the vehicle license plate and impose liability on the
registered owner.  Driver identification states include California,
Arizona, Oregon, Utah, and Colorado.





Almost
all of our contracts provide for the lease of equipment and the services as a
bundled, turnkey program over three to five years.  The equipment
leases are generally classified as operating leases under FAS 13, “Accounting
for Leases,” and the revenues are realized along with service revenues as
services are delivered to a customer over the life of the
contract.  One contract with Delaware DOT provided for a monthly lease
of the roadside equipment, and we transferred this lease to GE Municipal
Services for the face value of the roadside equipment, or $80,000 per
approach.  In accordance with FAS 13, this lease qualified as a
sales-type financing lease, and we recognized the value received from the leased
equipment and expensed the associated costs of the system in the same
period.


-30-
 Table of Contents


Our
existing CrossingGuard contracts with government entities typically authorize
the installation of systems at a specified number of
approaches.   As of December 31, 2007, our existing active
contracts authorized the installation of our CrossingGuard product at up to an
additional 176 approaches.  Management believes the majority of the
authorized approaches under existing active contracts will be installed, but no
assurances can be given that all approaches under contract will ultimately be
installed due to factors including locating qualifying intersections, budget or
personnel considerations, etc.





The
following table provides summary information regarding our active CrossingGuard
contracts.





December
      31,2007
            
            
            2006Number
      of Approaches and Units:Installed, operational and
      revenue-generating:CrossingGuard red light
      approaches
            
            
            302
            
            
            
            212Poliscanspeed
      Units
            
            
            8
            
            
            
            11Additional Authorized
      Approaches:CrossingGuard red light
      approaches
            
            
            176
            
            
            
            245Poliscanspeed
      Units
            
            
            11
            
            
            
            13Total
            
            
            497
            
            
            
            481





We
receive fees from $19 per ticket paid to 40% of the ticket fine paid under the
existing speed agreements with our customers.  We expect that a
majority of any future speed enforcement contracts will compensate us on a per
ticket paid basisin return for both
equipment lease and citation processing and customer support
services.  We anticipate that we will generally receive fees from $19
to $35 per ticket under future speed enforcement contracts depending on factors
including number of units ordered, length of contract, service levels provided,
state statutes and competition.





During
our first 25 years of operations, we developed a number of patented intelligent
software solutions for decision and data-mining applications, including
financial services, fraud detection and intelligent traffic-management
systems.  In 2000, we made the strategic decision to concentrate on
our traffic management technologies and began to dispose of our other product
lines.  By 2003, we had exited our financial services, fraud detection
and Rail CrossingGuard and TrafficVision business lines, and had refocused our
resources on our traffic safety and enforcement systems such as CrossingGuard,
our current primary source of revenue.   This transition involved
a series of licensing arrangements and transfers of our rights.  In
early 2001, we also entered into two separate source-code licensing agreements
for our fraud detection product line appointing Applied Communications, Inc., or
ACI, and Retail Decisions, Inc., or ReD, as co-exclusive resellers in the
transaction processing industry.  Royalty revenues from ACI continued
through June 2002 when the royalty stream was assigned to Churchill Lane
Associates, or CLA.  We do not expect to receive future revenues from
this license. Additionally, we transferred to ReD certain of our assets that
supported the technology licensed under our license to ReD.  No
ongoing revenues are expected to be realized from ReD.  The licensing,
royalty and other payments we received under these licensing arrangements and
other transfers of our property and technology financed our operations during
2001 and 2002 and enabled us to develop our traffic enforcement
business.





On August
31, 2005, we acquired certain assets of Transol USA, one of our competitors, in
a foreclosure sale.  The assets included contracts to provide
automated red light enforcement services in six U.S. cities at an aggregate of
39 red light approaches, as well as related equipment, intellectual property,
inventory, work-in-process, accounts receivable and unbilled contract revenue
related to Transol’s red light enforcement services.  We paid $1.8
million for the acquired assets.  We funded the acquisition of the
acquired assets with internal working capital.





Critical
Accounting Policies and Estimates





Our
consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States, which require us to make
estimates and assumptions.  For more information, see Note 2 to the
audited financial statements included elsewhere in this report.  We
believe that of our significant accounting policies, the following may involve a
higher degree of judgment and complexity.


-31-
 Table of Contents


Revenue
Recognition





In
accordance with Staff Accounting Bulletin 104, “Revenue Recognition in Financial
Statements,” (“SAB 104”) revenue is generally recognized and earned when all of
the following criteria are satisfied: (a) persuasive evidence of a sales
arrangement exists, (b) delivery of products and/or services has occurred, (c)
the sales price is fixed or determinable, and (d) collectability is reasonably
assured.  In those cases where all four criteria are not met, we defer
recognition of revenue until the period these criteria are
satisfied.





The
majority of our revenue is derived from three types of customer
arrangements:





a)
            We
      provide hardware and equipment and related third party embedded software.
      (“roadside systems”)  The third party embedded software is
      considered incidental to the system as a whole.  In these
      arrangements, we typically sell or lease the system as a stand-alone
      roadside system.  For direct sales of roadside systems, we
      recognize revenue upon shipment.  We account for one of our
      leasing arrangements as a sales-type lease, as it meets the criteria in
      accordance with Statement of Financial Accounting Standards (SFAS) No. 13,
      “Accounting for Leases.”  In this instance, we recognized
      revenue upon inception of the transaction; interest income related to
      payments against the lease is recognized ratably over the term of the
      lease.  All other leasing arrangements are operating
      leases.  We recognize revenue on these leases on a monthly basis
      over the life of the contract with the
customer.





b)
            We
      provide services, which typically include citation processing, back office
      and hosting services. Software is more than incidental to the services as
      a whole, but 1) is used by us to capture and internally process the
      violations, and 2) customers do not have the right to and do not take
      possession of our detection and tracking, citation processing and back
      office software.  For these services, we typically recognize
      revenue on a fixed monthly fee or a per citation fee
      basis.  Revenue usually commences for these service arrangements
      upon the first month after inception of
  operations.





c)
            For
      two current customers who process their own citations, we lease our
      detection and tracking and citation processing and back office software
      and provide monthly customer support on the software. For these
      arrangements, we recognize revenue in accordance with AICPA Statement of
      Position 97-2, “Software Revenue Recognition.”  Although all
      software deliverables are complete in the initial month of operations, and
      the monthly customer support is the only undelivered element, we recognize
      revenue on a monthly basis as the citations are
  issued.





Some
contracts include penalty provisions relating to timely performance and delivery
of systems and services by us. Penalties are charged to operations in the period
the penalty is determinable.





Allowance
for Doubtful Accounts





The
allowance for doubtful accounts is evaluated on a regular basis and adjusted
based on management’s best estimate of probable losses inherent in receivables,
based on historical experience.  Receivables are considered to be past
due if they have not been paid by the payment due dates.  Debts are
written off against the allowance when deemed to be
uncollectible.  Subsequent recoveries, if any, are credited to the
allowance when received.





Inventory
Obsolescence





We
evaluate our inventory for excess and obsolescence on a quarterly
basis.  In preparing our evaluation, we look at the expected demand
for our products for the next three to twelve months in order to determine
whether such equipment requires a change in the inventory reserve in order to
record the inventory at net realizable value.  After discussions with
the senior management team, a reserve is established so that inventory is
appropriately stated at the lower of cost or net realizable
value.


-32-
 Table of Contents


Capitalization
of Internal Buildout Costs





The
Company's CrossingGuard red light enforcement business requires us to install
our technology in the communities that we serve. To do this, the Company deploys
internal resources to design, help install and configure its software and
equipment in those communities (i.e. buildout). Buildout costs are defined as
directly related payroll, fringe, and related travel and entertainment expenses.
Those buildout costs are capitalizable as part of the cost of the system
deployed under contract in a community we serve and depreciated over the life of
the contract. The Company accumulates the amount of those internal buildout
costs incurred on a quarterly basis and capitalizes them.  Internal
buildout costs capitalized in 2007 and 2006 were approximately $481,000 and
$598,000, respectively.








Share-Based
Compensation





In the
first quarter of 2006, we adopted the provisions of Statement of Financial
Accounting Standards No. 123(R), "Share-Based Payment" ("SFAS 123(R)"), which
require measurement of compensation cost for all stock awards at fair value on
the date of grant and recognition of compensation over the service period for
awards expected to vest. We continue to use the Black-Scholes option pricing
model to determine fair value of options under SFAS 123(R) and have elected to
use the modified prospective transition method.  Under this
application, we are required to record compensation cost for all share-based
payments granted after the date of adoption based on the grant date fair value
estimated in accordance with the provisions of SFAS 123(R) and for the unvested
portion of all share-based payments previously granted that remain outstanding
which were based on the grant date fair value estimated in accordance with the
original provisions of SFAS 123.





The
calculation of stock-based compensation requires the use of a valuation model
and related assumptions.  The use of the Black-Scholes option pricing
model requires the use of subjective assumptions including an estimate of the
volatility of our stock, the expected life of our share-based instruments, the
expected forfeitures of share-based instruments, the expected dividend rate on
our common stock, and the risk-free interest rates that can materially affect
our fair value estimate of our share-based instruments.  Changes in
these estimates and assumptions could materially impact the calculation of
stock-based compensation.





Derivative
Instruments





In
connection with the sale of debt or equity instruments, the Company may sell
options or warrants to purchase our common stock.  In certain
circumstances, these options or warrants may be classified as derivative
liabilities rather than equity.  Additionally, the debt or equity
instruments may contain embedded derivative instruments such as variable
conversion options, which in certain circumstances may be required to be
bifurcated from the host instrument and accounted for separately as a derivative
instrument liability.





Derivative
instrument liabilities are re-valued at the end of each reporting period, with
changes in fair value of the derivative liability recorded as charges or credits
to income in the period in which the changes occur.  For options,
warrants and bifurcated conversion options that are accounted for as derivative
instrument liabilities, we determine the fair value of these instruments using
the Black-Sholes option pricing model, binomial stock price probability trees,
or other valuation techniques, sometimes with the assistance of a certified
valuation expert. These models require assumptions related to the remaining term
of the instruments and risk-free rates of return, our current common stock price
and expected dividend yield, and the expected volatility of our common stock
price based on not only the history of our stock price but also the experience
of other entities considered comparable to us.  The identification of,
and accounting for, derivative instruments and the assumptions used to value
them can significantly affect our financial statements.





Long-Term
Asset Impairment





In
assessing the recoverability of our long-term assets, management must make
assumptions regarding estimated future cash flows, contract renewal options and
other factors to determine its fair value.  If these estimates change
in the future, we may be required to record impairment charges that were not
previously recorded.  No impairment charges were taken in
2007.  We recorded impairment charges of $2,366,000 in 2006, primarily
related to our Transol red light contracts.


-33-
 Table of Contents


Deferred
Taxes





We record
a valuation allowance to reduce our deferred tax assets to the amount that is
more likely than not to be realized. We have considered future taxable income
and ongoing prudent and feasible tax planning strategies in assessing the need
for the valuation allowance. In the event we determine that we would be able to
realize our deferred tax assets in excess of their net recorded amount, an
adjustment to the deferred tax asset would increase income in the period such
determination was made.





Concentrations
of credit risk





Our
financial instruments that are exposed to concentrations of credit risk consist
primarily of cash and cash equivalents, marketable equity securities and trade
accounts receivable.  We place our cash and temporary cash investments
with high credit quality financial institutions.  Such investments may
be in excess of amounts insured by the FDIC.  Senior management
continually reviews the financial stability of these financial
institutions.  We routinely assess the financial strength of our
customers, most of which are municipalities, and, as a result, believe that our
trade accounts receivable credit risk exposure is limited.  We do not
require collateral from our customers.











Liquidity
and Capital Resources





Cash
Position and Working Capital





We had
cash, cash equivalents and marketable securities totaling $3,135,000 at December
31, 2007 compared with $3,010,000 at December 31, 2006.  At December
31, 2007, we had working capital of $3,041,000 compared
with  $3,433,000 at December 31, 2006.  Our net worth at December
31, 2007 was $2,940,000 compared with $5,502,000 at December 31,
2006.





The
$125,000 increase in cash is primarily due to: (i) our private stock placement
on July 27, 2007 that raised $4,808,000, net of expenses, and (ii) proceeds of
$1,413,000, net of expenses, received from our placement of $1,500,000 in
Variable Rate Senior Notes on April 1, 2007.  These net proceeds were
offset by (i) cash used in our operations in the year of $1,391,000, and (ii)
investments in capitalized systems of $4,563,000 which are expected to generate
revenue in future periods.





The
decrease in net worth was primarily the result of our net loss, excluding stock
compensation costs, of $7,409,000 in 2007, partially offset by the private stock
placement discussed above.





Historically,
we have raised capital by/through a series of privately placed debt and equity
transactions.See
Notes 6 and 8 to the consolidated financial statements.





On March
30, 2007, we entered into a Note Purchase Agreement with four accredited
investors to sell $1.5 million of Variable Rate Senior Notes due May 25, 2011
(the “Speed Notes”).  Among the purchasers were Foundation Partners I,
LLC, an affiliate of the Company, who purchased $750,000 of these Speed Notes,
and Kuekenhof Equity Fund, L.P., an affiliate of the Company, who purchased
$250,000 of these Speed Notes.  The Speed Notes are secured by a first
priority security interest in all of the Company’s assets which are directly and
exclusively used for the implementation and performance of existing (entered
into after October 1, 2006) and future contracts for fixed and mobile automated
speed enforcement units.





On July
27, 2007, we sold 8,532,403 shares of our common stock to six accredited
investors at $0.5802 per share raising $4,808,000, net of
expenses.  Among the purchasers was Edward Heil, an affiliate of the
Company, who purchased 4,739,745 shares; L-J Holdings, Inc., an affiliate of the
Company, who purchased 646,329 shares; and Kuekenhof Equity Fund, L.P., an
affiliate of the Company, who purchased 430,886 shares.


-34-
 Table of Contents





We
continue to seek additional sources of equity and debt financing to fund system
installations and to position ourselves to capitalize on new market and growth
opportunities; however, there can be no assurance that the funds will be
available on terms acceptable to us, if at all.








Capital
Resources





We are a
capital intensive business.  As of December 31, 2007, we are
authorized to build out 176 additional Red Light approaches and deploy 11
additional speed units.  We must incur significant up-front capital
expenditures to construct and operate each additional Red Light approach and
deploy each speed unit.  As such, our future capital requirements will
depend on many factors, including but not limited to the success of our sales
and marketing efforts to secure new customers; the scope and progress made in
our research and development activities as it relates to our current line of
products and services; and continued investment in our intellectual property
portfolio.  Should we need to secure additional financing to fund
these objectives, we may not be able to secure such financing or obtain such
financing on favorable terms.








Commitments,
Contractual Obligations and Off-Balance Sheet Arrangements





The
following table summarizes our contractual obligations at December 31, 2007 and
the effect such obligations are expected to have on its cash flow in future
periods:








Payments
      due in:
            
            Operating
      Leases(1)
            
            
            Senior
      Convertible Notes
            
            
            Senior
      Secured Convertible Notes
            
            
            Variable
      Rate Senior Notes
            
            
            Debt
      Interest
            
            
            Total2008
            
            $
            357,000
            
            
            $
            ---
            
            
            $
            ---
            
            
            $
            ---
            
            
            $
            2,348,000
            
            
            $
            2,705,0002009
            
            
            357,000
            
            
            
            2,850,000
            
            
            
            ---
            
            
            
            ---
            
            
            
            2,254,000
            
            
            
            5,461,0002010
            
            
            313,000
            
            
            
            ---
            
            
            
            ---
            
            
            
            ---
            
            
            
            2,206,000
            
            
            
            2,519,0002011
            
            
            113,000
            
            
            
            
            
            
            
            22,840,000
            
            
            
            1,500,000
            
            
            
            882,000
            
            
            
            25,335,000$
            1,140,000
            
            
            $
            2,850,000
            
            
            $
            22,840,000
            
            
            $
            1,500,000
            
            
            $
            7,690,000
            
            
            $
            36,020,000





(1)
            Primarily
      facility lease obligations in Providence, RI and North Hollywood,
      CA.





As of
December 31, 2007, we have no off balance sheet arrangements.





For the
twelve months ended December 31, 2007, we invested $4,563,000 in capitalized
systems compared to $6,270,000 in the same period last year.  We
expect to make substantial future commitments for systems related to our
CrossingGuard contracts.


-35-
 Table of Contents


Results
of Operations





The
following table sets forth selected operating results, including as a percentage
of revenue, for the periods indicated:





Fiscal
      Year Ended December 31,2007
                
                
                
                %
                
                
                
                2006
                
                
                
                %Lease
      & Service Fees
                
                $
                11,483,000
                
                
                
                100
                %
                
                $
                8,079,000
                
                
                
                100
                %Royalty
      Revenue
                
                
                22,000
                
                
                
                ---
                
                
                
                8,000
                
                
                
                ---Total Revenue
                
                
                11,505,000
                
                
                
                100
                %
                
                
                8,087,000
                
                
                
                100
                %Cost
      of sales
                
                
                7,127,000
                
                
                
                62
                %
                
                
                6,313,000
                
                
                
                78
                %Gross
      profit
                
                
                4,378,000
                
                
                
                38
                %
                
                
                1,774,000
                
                
                
                22
                %Operating
      expenses, excluding impairment charges
                
                
                8,777,000
                
                
                
                76
                %
                
                
                13,310,000
                
                
                
                165
                %Impairment
      charge for long lived assets
                
                
                ---
                
                
                
                ---
                
                
                
                2,366,000
                
                
                
                29
                %Loss
      from operations
                
                
                (4,399,000
                )
                
                
                38
                %
                
                
                (13,902,000
                )
                
                
                172
                %Other
      income (expense)
                
                
                (2,519,000
                )
                
                
                22
                %
                
                
                (1,865,000
                )
                
                
                23
                %Derivative
      instrument expense
                
                
                2,926,000
                
                
                
                25
                %
                
                
                16,940,000
                
                
                
                209
                %Debt
      discount expense
                
                
                (4,031,000
                )
                
                
                35
                %
                
                
                (8,664,000
                )
                
                
                107
                %Net
      loss
                
                $
                (8,023,000
                )
                
                
                70
                %
                
                $
                (7,491,000
                )
                
                
                93
                %





Analysis
of the Years Ended December 31, 2007 and December 31, 2006




Revenue




During
the year ended December 31, 2007, revenue increased $3,418,000, or 42%, to
$11,505,000 from $8,087,000 in the comparable period in 2006.  The
increase in overall revenue was primarily the result of increases in lease and
service fees.





Lease and
service fee revenues totaled $11,483,000 in 2007, as compared with $8,079,000 in
2006, an increase of $3,404,000, or 42%, primarily due to (1) an increase in
revenues from our speed programs.  Revenues related to our speed
programs totaled $2,506,000 in 2007 compared with $981,000 in 2006; and (2)
additional revenue generating Red Light approaches.  Installation
activity for 2007 was as follows:





Red Light
            
            
            Speed
            
            
            TOTALTotal
      at beginning of year
            
            
            222
            
            
            
            11
            
            
            
            233New
      installations
            
            
            102
            
            
            
            2
            
            
            
            104Decommissioned
            
            
            (22
            )
            
            
            (5
            )
            
            
            (27
            )Total
      at end of year
            
            
            302
            
            
            
            8
            
            
            
            310





Of the 22
Red Light approaches decommissioned during 2007, 9 approaches were suspended due
to legislative activity in the corresponding states, and 13 approaches were
decommissioned due to termination of underperforming programs.  All 5
Speed units decommissioned during 2007 were suspended due to legislative
activity in the corresponding states.





Cost
of Sales




For the
year ended December 31, 2007, cost of sales totaled $7,127,000, an increase of
$814,000, or 13%, compared to $6,313,000 in 2006.  The increase in
cost of sales is primarily due to increased amortization of capitalized systems
and associated direct processing and support costs for more revenue-generating
red-light approaches.


-36-
 Table of Contents


Gross
Profit




For the
year ended December 31, 2007, gross profit increased by $2,604,000, or 147%, to
$4,378,000 from $1,774,000 in 2006, while gross margin increased by 16
percentage points to 38% for the year ended December 31, 2007 from 22% for the
year ended December 31, 2006.  The increase in gross profit is
attributable to (1) substantial increases in revenues in both our Red Light and
speed programs; (2) improved absorption of our fixed costs.  As our
revenues have increased, fixed costs represent a lower percentage of total
revenues; and (3) continued efforts to reduce costs related to our program
operations during 2007.





Operating
Expenses




Total
operating expenses amounted to $8,777,000 in 2007, a decrease of $6,899,000, or
44%, compared to operating expenses of $15,676,000 in 2006.  This
decrease is primarily due to (1) the recording of a $2,366,000 nonrecurring
non-cash impairment charge in 2006 relating to our long-lived assets, mostly
associated with our Transol contracts acquired in 2005 that did not repeat in
2007; (2) a decrease of $1,892,000 in stock compensation expense in 2007
compared to 2006; and (3) the realization of cost reductions effected in
November 2006.  We implemented a reorganization plan intended to focus
our operations on program delivery and support and reduce current operating
expense levels.  This reorganization resulted in the reduction of 27
employees, or approximately 20% of the workforce.





Engineering
and operations expenses totaled $4,026,000 in the year ended December 31, 2007,
a decrease of $347,000, or 8%, compared to $4,373,000 in 2006.  This
decrease is primarily the result of the November 2006 cost reduction
program.





Research
and development expenses totaled $414,000 in the year ended December 31, 2007, a
decline of $969,000 compared with $1,383,000 in the comparable year of
2006.  The decrease is the result of the November 2006 cost reduction
program, as we substantially completed our transition of our red light
technology from analog to digital as well as the commercialization of our mobile
speed enforcement technology in 2006.





Selling
and marketing expenses totaled $856,000 in the year ended December 31, 2007, a
decrease of $1,324,000, or 61%, compared with $2,180,000 in 2006.  The
decrease is primarily due to reduced head count as a result of our November 2006
cost reduction program.





General
and administrative expenses totaled $3,481,000 for the year ended December 31,
2007, a decrease of $1,893,000, or 35%, compared with $5,374,000 in
2006.  This decrease is largely attributable to a decrease in stock
compensation expense, which was approximately $1,704,000 lower in
2007.





We assess
potential impairment of our long-lived assets on an annual basis or more
frequently as events or circumstances indicate that an asset may be
impaired.  Our long-lived assets are primarily capitalized systems,
property and equipment, and our identifiable intangible assets such as goodwill
and customer contracts.  We determine such impairment by measuring the
estimated undiscounted future cash flow generated by the assets, comparing the
result to the asset carrying value and adjust the asset to the lower of its
carrying value or fair value and charging current operations for the measured
impairment.  The determination of the asset fair value is subject to
significant judgment.  We did not record any impairment charges in
2007.  In the second quarter of 2006, the Company recorded a $175,000
impairment charge relating to two of our red-light contracts. In the fourth
quarter of 2006, the Company recorded a $2,191,000 impairment charge primarily
relating to long-lived assets associated with underperforming contracts we
acquired from Transol, Inc. in 2005.  These impairment charges had no
impact on our operating covenants associated with our debt
agreements.





Derivative
instrument income





Derivative
instrument income for the year ended December 31, 2007 totaled $2,926,000
compared to $16,940,000 for the year ended December 31, 2006.





The
changes were attributable to changes in the fair market value of embedded
derivatives issued with our convertible debt.  The fair value of the
derivatives will fluctuate based on: our stock price at particular points in
time, the debt conversion price, the volatility of our stock price over a period
of time, changes in the value of the risk free interest rate, and the remaining
time to maturity of the outstanding debt.


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The major
factors contributing to the change for the year ended 2007 were the decline in
the fair market value of our derivative instrument liabilities relating to our
convertible debt due to the passage of time and a decline in our stock
price.





Debt
discount expense





Debt
discount expense was $4,031,000 for the year ended December 31, 2007 compared to
$8,664,000 for the year ended December 31, 2006.  The decrease is
primarily due to higher debt discounts in 2006 associated with the sale of our
Senior Secured Convertible Notes and higher debt discounts on the extension of
our Senior Convertible Notes.  These debt discounts were established
at the time a derivative is bifurcated from the host debt agreement at issuance
and amortized over the life of the note.





Other
Expense - Net




Other
expense, net totaled $2,519,000 in the year ended December 31, 2007, an increase
of $654,000, or 35%, compared with other expense, net of $1,865,000 in
2006.  The increase is primarily attributable to higher debt levels
and higher interest expense on the Senior Secured Convertible Notes, as the
interest rate increased from 7% to 9% effective July 1, 2007 and interest
expense incurred in 2007 on the Variable Rate Senior Notes.





Net
Loss




For the
year ended December 31, 2007, we incurred a net loss of $8,023,000, or $0.33 per
share, an increase of $532,000 compared with a net loss of $7,491,000, or $0.37
per share, in 2006.  The increase in net loss was primarily due to
$14,014,000 less derivative income in 2007 compared to 2006, offset by (1)
higher revenues of $3,418,000; (2) lower operating expenses of $6,899,000; and
(3) lower debt discount expense of $4,633,000.





The
decrease in net loss per share was primarily due to the increase in basic and
diluted weighted average shares outstanding as a result of our private stock
placement in July 2007, offset by the increase in our net loss discussed
above.  During the year ended December 31, 2007, there were 24,112,378
basic and diluted weighted average shares outstanding compared with 20,277,770
for the year ended December 31, 2006.








Analysis
of the Years Ended December 31, 2006 and December 31, 2005




Revenue




During
the year ended December 31, 2006, revenue increased $318,000, or 4%, to
$8,087,000 from  $7,769,000 in the comparable period in
2005.  The increase in overall revenue was primarily the result of a
35% increase in lease and service fees offset by no product sales in
2006.





Lease and
service fee revenues totaled $8,079,000 in 2006, as compared with $5,975,000 in
2005, an increase of $2,104,000, or 35%, primarily due to additional revenue
generating approaches. For the 2006 year, our Red light business began the year
with 171 revenue generating approaches and ended with 222 revenue generating
approaches.  During the 2006 year, we installed 51 revenue generating
approaches and did not decommission any.   In 2005, we started
the year with 111 revenue generating approaches, installed 51 revenue generating
approaches, had 26 installed approaches decommissioned and acquired 35
approaches on August 31 from Transol USA.   The 26 decommissioned
approaches resulted from: (i) on June 30, 2005 14 approaches in Falls Church and
Vienna, Virginia were turned off due to the expiration of the enabling law in
Virginia, and (ii) the conclusion of a contract with one customer with 12
approaches.  Additionally, average monthly revenue generated from
approaches installed in 2005 and before, decreased in 2006 as violation rates
declined, which typically occurs due to modified driver behavior.





There
were no direct product sales or product sales recognized from sales-type leases
for CrossingGuard roadside systems in 2006 as compared to $1,600,000 in the 2005
period. Prior year direct product sales were with one customer for $158,000 and
product sales recognized from sales-type leases were primarily attributable to
twenty Delaware approaches being completed and funded (under sales-type leasing)
during the year. These product sales are unique and are one-time, non-recurring
in nature. Residual royalty streams from two customers relating to technology
licenses to IBM and NCS accounted for product royalty revenues of $7,000 and
$36,000 in 2006 and 2005, respectively.


-38-
 Table of Contents


Cost
of Sales




For the
year ended December 31, 2006, cost of sales totaled $6,313,000, an increase of
$581,000, or 10%, compared to $5,732,000 in 2005.   The increase
in cost of sales is primarily due to increased amortization of capitalized
systems and associated direct processing and support costs for more
revenue-generating red-light approaches and speed units. The twelve months of
2006 also includes higher costs related to our Transol contracts, which we
acquired in September 2005 as well as indirect costs for our Poliscanspeed
speed business which is not yet profitable. These increases in costs are
partially offset by the decline in product cost of sales as a result of no
one-time, nonrecurring sales in 2006.





Gross
Profit




For the
year ended December 31, 2006, gross profit declined $263,000, or 13%, to
$1,774,000 from $2,037,000 in 2005, while gross margin decreased by four
percentage points to 22% for the year ended December 31, 2006 from 26% for the
year ended December 31, 2005.  The decline in gross profit is
primarily attributable to a higher mix of lower margin sales-type leases in 2006
versus 2005, particularly related to our acquired Transol contracts and initial
investment in our speed business.





Operating
Expenses




Total
operating expenses amounted to $15,676,000 in 2006, an increase of $4,362,000,
or 39%, over total operating expenses of $11,314,000 in 2005.  The
increase is primarily due to (1) the recording of a $2,366,000 nonrecurring
non-cash impairment charge in the year relating to our long lived assets mostly
associated with our Transol contracts acquired in 2005, and (2) the adoption of
FAS123R in 2006 by recording a $2,506,000 non-cash stock compensation charge,
offset by (3) steps taken to reduce costs including the reduction in salaries to
most employees by 10% during the year including management under employment
contract, and terminating nine employees in the first quarter and 27 in the
fourth quarter. The severance cost of these actions was $66,000 and is primarily
included in operating expense during the year.





In March
2006, the Company took steps to reduce costs including the reduction in salaries
to most employees by 10% including management under employment contract, and
terminated nine employees. The severance cost of this action was $102,000 and
primarily affected our operating expenses. In November 2006, we instituted
additional operational cost reductions in an internal reorganization intended to
focus the company's operations on program delivery and support and reduce
current operating expense levels. The reorganization resulted in the reduction
of 27 employees, or approximately 20% of the workforce, which is expected to
result in an annual payroll reduction of over $1.5 million. The cost savings of
the actions taken in the fourth quarter of 2006 actions are not expected to
begin to affect our financial results until the first quarter of
2007.





Engineering
and operations expenses totaled $4,373,000 in the year ended December 31, 2006,
an increase of $323,000, or 8%, compared to $4,050,000 in
2005.  Excluding the $290,000 stock compensation charge recorded in
2006, the increase in costs related to supporting our increased install base
partially offset by the impact of the March 2006 cost reduction
program.





Research
and development expenses totaled $1,383,000 in the year ended December 31, 2006,
a decline of $354,000 compared with $1,737,000 in the comparable year of
2005.  Excluding the $119,000 stock compensation charge recorded in
2006, research and development expenses declined $473,000. The transition of our
red light technology from analog to digital as well as the commercialization of
our mobile speed enforcement technology was substantially completed in 2006
resulting in a decline in R&D costs in the latter half of the year. We
expect research and development costs to continue to decline in
2007.





Selling
and marketing expenses totaled $2,180,000 in the year ended December 31, 2006,
an increase of $123,000, or 6%, compared with $2,057,000 in
2005.  Excluding the $79,000 stock compensation charge recorded in
2006, sales and marketing costs were relatively flat with the prior
year.





General
and administrative expenses totaled $5,374,000 for the year ended December 31,
2006, an increase of $1,904,000, or 55%, compared with $3,470,000 in 2005.
Excluding the $1,992,000 stock compensation charge recorded in 2006, general and
administrative expenses declined slightly primarily due to the reduction in
legal expenses associated with the conclusion of a patent infringement case in
June 2005.


-39-
 Table of Contents


We assess
potential impairment of our long-lived assets on an annual basis or more
frequently as events or circumstances indicate that an asset may be impaired.
Our long-lived assets are primarily capitalized systems, property and equipment,
and our identifiable intangibles such as goodwill and customer contracts. We
determine such impairment by measuring the estimated undiscounted future cash
flow generated by the assets, comparing the result to the asset carrying value
and adjust the asset to the lower of its carrying value or fair value and
charging current operations for the measured impairment.  The
determination of the asset fair value is subject to significant
judgment.   In the second quarter of 2006, the Company recorded a
$175,000 impairment charge relating to two of our red-light contracts. In the
fourth quarter of 2006, the Company recorded a $2,191,000 impairment charge
primarily relating to long-lived assets associated with underperforming
contracts we acquired from Transol, Inc. in 2005.  These impairment
charges had no impact on our operating covenants associated with our debt
agreements.





Derivative
instrument income





Derivative
instrument income for the year ended December 31, 2006 totaled $16,940,000 as
compared to income of $7,780,000 for the year ended December 31,
2005.





The
changes were attributable to changes in the fair market value of embedded
derivatives issued with our convertible debt.  The fair value of the
derivatives will fluctuate based on: our stock price at particular points in
time, the debt conversion price, the volatility of our stock price over a period
of time, changes in the value of the risk free interest rate, and the remaining
time to maturity of the outstanding debt.





The major
factors contributing to the change for the year ended 2006 was due to the
decline in the fair market value of our derivative instrument liabilities
relating to our convertible debt due to the passage of time and a decline in our
stock price.





Debt
discount expense





Debt
discount expense for the year ended December 31, 2006 totaled $8,664,000 as
compared to an expense of $4,054,000 for the year ended December 31,
2005.





The
increase in year ending December 31, 2006 is primarily due to higher debt
discounts associated with the sale of our Senior Secured Convertible Notes, and
higher debt discounts on the extension of our Senior Convertible Notes in May
2006.  These debt discounts are established at the time a derivative
is bifurcated from the host debt agreement at issuance and amortized over the
life of the note.





Loss
on Debt Refinancing





During
December 2005, the company retired a Laurus convertible note issued in May 2005
in the face amount of $6,000,000 which resulted in a loss on retirement of
$509,000 related to the write-off of the discount applied to the note for the
value of the warrants originally issued with the note.  The note was
retired in conjunction with the issuance of a new, non-convertible note to
Laurus with a face value of $6,000,000.





Other
Expense - Net




Other
expense, net totaled $1,865,000 in the year ended December 31, 2006, an increase
of $1,161,000, or 65%, compared with other expense, net of $704,000 in
2005.  The increase is primarily attributable to higher levels of
interest expense on the new Senior Secured Convertible Notes.





Net
Loss




For the
year ended December 31, 2006, we incurred a net loss of $7,491,000, or $0.37 per
share, an increase of $727,000, compared with a net loss of $6,764,000, or $0.36
per share, in 2005.  The increase in net loss was primarily due to (1)
the recording of a $2,366,000 nonrecurring non-cash impairment charge in the
year relating to our long lived assets mostly associated with our Transol
contracts acquired in 2005, (2) the adoption of FAS123R in 2006 by recording a
$2,506,000 non-cash stock compensation charge, (3) $4,610,000 higher debt
discount amortization, (5) $1,161,000 higher other expense, primarily interest,
offset by (4) $9,160,000 of higher derivative instrument income in the
year.


-40-
 Table of Contents


The
increase in net loss per share was primarily due to the increase in our net loss
discussed above, partially offset by the increase in outstanding shares. During
the year ended December 31, 2006, there were 20,277,770 basic and diluted
weighted average shares outstanding compared with 18,826,966 for the year ended
2005.








ITEM
7A.                      Quantitative
and Qualitative Disclosure about Market Risk




Disclosures
required under this item are not applicable, as the Company has elected to
follow the reduced disclosure requirements as a smaller reporting company, as
defined in Rule 12b-2 of the Exchange Act.





-41-
 Table of Contents





ITEM
8.                      Financial Statements.





The
following consolidated financial statements and the related notes thereto of
NESTOR, Inc. and the Report of Independent Registered Public Accounting Firm are
filed as a part of this annual report on form 10-K:



























































CONSOLIDATED
FINANCIAL STATEMENTS





December 31,
2007


-42-
 Table of Contents











NESTOR,
INC.





CONTENTS








Page
      NumberReport
      of Independent Registered Public Accounting Firm
            44Item 1
            
            Financial
      Statements:Consolidated
      Balance Sheets
            45December
      31, 2007 and 2006Consolidated
      Statements of Operations
            46For
      the Years Ended December 31, 2007 and 2006Consolidated
      Statements of Stockholders’ Equity
            47For
      the Years Ended December 31, 2007 and 2006Consolidated
      Statements of Cash Flows
            48For
      the Years Ended December 31, 2007 and 2006Notes
      to Consolidated Financial Statements
            49














-43-
 Table of Contents











Report
of Independent Registered Public Accounting Firm

















The Board
of Directors and Stockholders


Nestor,
Inc.


Providence,
Rhode Island





We have
audited the accompanying consolidated balance sheets of Nestor, Inc. as of
December 31, 2007 and 2006, and the related consolidated statements of
operations, stockholders’ equity and cash flows for the years then
ended.  These consolidated financial statements are the responsibility
of the Company’s management.  Our responsibility is to express an opinion
on these consolidated financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement.  The Company
is not required to have, nor were we engaged to perform, an audit of its
internal control over financial reporting.  Our audits included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting.  Accordingly, we express no
such opinion.  An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of Nestor, Inc. as of December
31, 2007 and 2006, and the results of its operations and its cash flows for the
years then ended, in conformity with accounting principles generally accepted in
the United States of America.





The
accompanying consolidated financial statements have been prepared assuming that
Nestor, Inc. will continue as a going concern.  As disclosed in Note 1
to the consolidated financial statements, Nestor, Inc. has suffered recurring
losses from operations that raise substantial doubt about Nestor, Inc.’s ability
to continue as a going concern. Management's plans in regard to these matters
are also disclosed in Note 1.  The consolidated financial statements
do not include any adjustments that might result from the outcome of this
uncertainty.










/s/ Carlin, Charron & Rosen,
LLP












Providence,
Rhode Island


April 15,
2008





-44-
 Table of Contents


NESTOR,
INC.


Consolidated Balance
Sheets


In
Thousands, Except Share Information





December
      31,2007
            
            
            December
      31, 2006ASSETSCurrent
      AssetsCash
      and cash equivalents
            
            $
            3,135
            
            
            $
            2,952Marketable
      securities
            
            
            ---
            
            
            
            58Accounts
      receivable, net
            
            
            2,806
            
            
            
            2,343Inventory,
      net
            
            
            922
            
            
            
            1,950Other
      current assets
            
            
            255
            
            
            
            197Total
      current assets
            
            
            7,118
            
            
            
            7,500Noncurrent
      assetsCapitalized
      system costs, net
            
            
            9,867
            
            
            
            8,185Property
      and equipment, net
            
            
            487
            
            
            
            789Goodwill
            
            
            5,581
            
            
            
            5,581Patent
      development costs, net
            
            
            128
            
            
            
            125Other
      long term assets
            
            
            1,865
            
            
            
            2,331Total
      Assets
            
            $
            25,046
            
            
            $
            24,511LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilitiesAccounts
      payable
            
            $
            826
            
            
            $
            1,325Accrued
      liabilities
            
            
            1,335
            
            
            
            1,493Accrued
      employee compensation
            
            
            366
            
            
            
            351Deferred
      revenue
            
            
            1,220
            
            
            
            712Asset
      retirement obligation
            
            
            330
            
            
            
            186Total
      current liabilities
            
            
            4,077
            
            
            
            4,067Noncurrent
      Liabilities:Long
      term convertible notes payable
            
            
            1,719
            
            
            
            920Long
      term notes payable
            
            
            13,295
            
            
            
            8,563Derivative
      financial instruments – debt and warrants
            
            
            2,081
            
            
            
            4,971Long
      term asset retirement obligation
            
            
            934
            
            
            
            488Total
      liabilities
            
            
            22,106
            
            
            
            19,009Commitments
      and contingencies
            
            
            ---
            
            
            
            ---Stockholders’
      Equity:Preferred
      stock, $1.00 par value, authorized 10,000,000 shares;issued
      and outstanding: Series B – 180,000 shares atDecember
      31, 2007 and December 31, 2006
            
            
            180
            
            
            
            180Common
      stock, $0.01 par value, authorized 50,000,000shares
      issued and outstanding: 28,954,219 shares atDecember
      31, 2007 and 20,386,816 shares at December 31, 2006
            
            
            290
            
            
            
            204Warrants
            
            
            ---
            
            
            
            ---Additional
      paid-in capital
            
            
            78,972
            
            
            
            73,597Accumulated
      deficit
            
            
            (76,502
            )
            
            
            (68,479
            )Total
      stockholders’ equity
            
            
            2,940
            
            
            
            5,502Total
      Liabilities and Stockholders’ Equity
            
            $
            25,046
            
            
            $
            24,511The
      Notes to the Consolidated Financial Statements are an integral part of
      this statement.


-45-
 Table of Contents


NESTOR,
INC.


Consolidated Statements of
Operations


In
Thousands, Except Share And Per Share Information








Year
      Ended December 31,2007
            
            
            2006Revenues:Lease
      and service fees
            
            $
            11,483
            
            
            $
            8,079Product
      royalties
            
            
            22
            
            
            
            8Total
      revenue
            
            
            11,505
            
            
            
            8,087Cost
      of sales:Lease
      and service fees
            
            
            7,127
            
            
            
            6,313Product
      royalties
            
            
            ---
            
            
            
            ---Total
      cost of sales
            
            
            7,127
            
            
            
            6,313Gross
      profit:Lease
      and service fees
            
            
            4,356
            
            
            
            1,766Product
      royalties
            
            
            22
            
            
            
            8Total
      gross profit
            
            
            4,378
            
            
            
            1,774Operating
      expenses:Engineering
      and operations
            
            
            4,026
            
            
            
            4,373Research
      and development
            
            
            414
            
            
            
            1,383Selling
      and marketing
            
            
            856
            
            
            
            2,180General
      and administrative
            
            
            3,481
            
            
            
            5,374Impairment
      charge for long-lived assets
            
            
            ---
            
            
            
            2,366Total
      operating expenses
            
            
            8,777
            
            
            
            15,676Loss
      from operations
            
            
            (4,399
            )
            
            
            (13,902
            )Derivative
      instrument income
            
            
            2,926
            
            
            
            16,940Debt
      discount expense
            
            
            (4,031
            )
            
            
            (8,664
            )Other
      expense, net
            
            
            (2,519
            )
            
            
            (1,865
            )Net
      loss
            
            $
            (8,023
            )
            
            $
            (7,491
            )Loss
      per share:Loss
      per share, basic and diluted
            
            $
            (0.33
            )
            
            $
            (0.37
            )Shares
      used in computing loss per share:Basic
      and diluted
            
            
            24,112,378
            
            
            
            20,277,770The Notes to the Consolidated
      Financial Statements are an integral part of this
      statement.









-46-
 Table of Contents


NESTOR,
INC.


Consolidated Statements of
Stockholders’ Equity


For
the Years Ended December 31, 2007 and 2006


In
Thousands, Except Share Information














Preferred
      Stock
                
                
                Common
      Stock
                
                
                
                
                
                
                Additional 
      Paid-In
                
                
                AccumulatedShares
                
                
                Amount
                
                
                Shares
                
                
                Amount
                
                
                Warrants
                
                
                Capital
                
                
                Deficit
                
                
                TotalBalance
      at December 31, 2005
                
                
                180,000
                
                
                $
                180
                
                
                
                19,127,065
                
                
                $
                191
                
                
                $
                9
                
                
                $
                66,015
                
                
                $
                (60,988
                )
                
                $
                5,407Issuance
      of Common Stock
                
                
                ---
                
                
                
                ---
                
                
                
                1,237,811
                
                
                
                12
                
                
                
                ---
                
                
                
                4,810
                
                
                
                ---
                
                
                
                4,822Issuance
      of Restricted Common Stock
                
                
                ---
                
                
                
                ---
                
                
                
                20,000
                
                
                
                1
                
                
                
                ---
                
                
                
                46
                
                
                
                ---
                
                
                
                47Exercise
      of incentive stock options
                
                
                ---
                
                
                
                ---
                
                
                
                1,940
                
                
                
                ---
                
                
                
                ---
                
                
                
                3
                
                
                
                ---
                
                
                
                3Variable
      warrants
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                (9
                )
                
                
                9
                
                
                
                ---
                
                
                
                ---Issuance
      of Warrants
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                208
                
                
                
                ---
                
                
                
                208Stock
      compensation expense
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                2,506
                
                
                
                ---
                
                
                
                2,506Loss
      for the year ended December 31, 2006
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                (7,491
                )
                
                
                (7,491
                )Balance
      at December 31, 2006
                
                
                180,000
                
                
                $
                180
                
                
                
                20,386,816
                
                
                $
                204
                
                
                $
                ---
                
                
                $
                73,597
                
                
                $
                (68,479
                )
                
                $
                5,502Issuance
      of Common Stock
                
                
                ---
                
                
                
                ---
                
                
                
                8,532,403
                
                
                
                85
                
                
                
                ---
                
                
                
                4,723
                
                
                
                ---
                
                
                
                4,808Issuance
      of Restricted Common Stock
                
                
                ---
                
                
                
                ---
                
                
                
                35,000
                
                
                
                1
                
                
                
                ---
                
                
                
                38
                
                
                
                ---
                
                
                
                39Stock
      compensation expense
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                614
                
                
                
                ---
                
                
                
                614Loss
      for the year ended December 31, 2007
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                ---
                
                
                
                (8,023
                )
                
                
                (8,023
                )Balance
      at December 31, 2007
                
                
                180,000
                
                
                $
                180
                
                
                
                28,954,219
                
                
                $
                290
                
                
                $
                ---
                
                
                $
                78,972
                
                
                $
                (76,502
                )
                
                $
                2,940The Notes to the Consolidated Financial
      Statements are an integral part of this statement.












-47-
 Table of Contents






NESTOR,
INC.


Consolidated Statements of
Cash Flows


In
Thousands








Years
      Ended December 31,2007
            
            
            2006Cash
      flows from operating activities:Net
      loss
            
            $
            (8,023
            )
            
            $
            (7,491
            )Adjustments to reconcile net loss
      to net cashused by operating
      activities:Depreciation and
      amortization
            
            
            3,533
            
            
            
            2,975Asset impairment
      charges
            
            
            ---
            
            
            
            2,366Stock based
      compensation
            
            
            653
            
            
            
            2,552Amortization and write-off of
      deferred financing fees
            
            
            559
            
            
            
            900Derivative instrument
      income
            
            
            (2,926
            )
            
            
            (16,940
            )Debt discount
    expense
            
            
            4,031
            
            
            
            8,664Unrealized gain on marketable
      securities
            
            
            (2
            )
            
            
            (2
            )Provision for doubtful
      accounts
            
            
            11
            
            
            
            63Provision for inventory
      reserves
            
            
            252
            
            
            
            157Increase (decrease) in cash
      arising fromchanges
      in assets and liabilities:Accounts receivable,
      net
            
            
            (474
            )
            
            
            (457
            )Inventory, net
            
            
            776
            
            
            
            (435
            )Other assets
            
            
            (237
            )
            
            
            195Accounts payable and accrued
      expenses
            
            
            (52
            )
            
            
            523Deferred revenue
            
            
            508
            
            
            
            608Net cash used for operating
      activities
            
            
            (1,391
            )
            
            
            (6,322
            )Cash
      flows from investing activities:Liquidation of marketable
      securities
            
            
            59
            
            
            
            ---Investment in capitalized
      systems
            
            
            (4,563
            )
            
            
            (6,270
            )Purchase of property and
      equipment
            
            
            (114
            )
            
            
            (339
            )Investment in patent development
      costs
            
            
            (29
            )
            
            
            (3
            )Net cash used for investing
      activities
            
            
            (4,647
            )
            
            
            (6,612
            )Cash
      flows from financing activities:Proceeds from notes
      payable
            
            
            1,413
            
            
            
            26,397Repayment of note
      payable
            
            
            ---
            
            
            
            (16,560
            )Proceeds from private stock
      placement
            
            
            4,808
            
            
            
            4,822Proceeds from issuance of common
      stock, net
            
            
            ---
            
            
            
            3Net cash provided by financing
      activities
            
            
            6,221
            
            
            
            14,662Net change in cash and cash
      equivalents
            
            
            183
            
            
            
            1,728Cash and cash equivalents –
      beginning of year
            
            
            2,952
            
            
            
            1,224Cash and cash equivalents – end of
      year
            
            $
            3,135
            
            
            $
            2,952Supplemental
      cash flows information:Interest paid
            
            $
            1,974
            
            
            $
            1,426Income taxes paid
            
            $
            ---
            
            
            $
            ---Significant non-cash
      transactions are further described in Notes 6 and
    7.The Notes to the Consolidated
      Financial Statements are an integral part of this
      statement.









-48-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information








Note
      1 -
            Nature
      of operations





A.
            Organization





Nestor,
Inc. was organized on March 21, 1983 in Delaware to acquire and develop certain
patent rights and know-how, which we acquired from our predecessor, Nestor
Associates, a limited partnership.  Our wholly-owned operating
subsidiary, Nestor Traffic Systems, Inc., (“NTS”) was formed on January 1,
1997.  CrossingGuard, Inc., a wholly-owned subsidiary of NTS, was
formed July 18, 2003 in connection with a financing.  Our principal
office is located in Providence, RI.





We are a
leading provider of innovative, automated traffic enforcement systems and
services to state and local governments throughout the United States and
Canada.  We are the only provider of both a fully video-based
automated red light enforcement system and a multi-lane, bi-directional scanning
light detection and ranging, or LiDAR, speed enforcement system.  We
also offer a newly developed ViDARTM speed detection and imaging system as a
complement to our other products or as a stand-alone speed enforcement system.
CrossingGuard, our red light enforcement product, uses our patented image
processing technology to predict and record the occurrence of a red light
violation, and manages the process of issuing and processing a
citation.  Poliscanspeed, one
of our speed enforcement products, uses technology developed by Vitronic
GmbH.  ViDARTM uses average speed over distance calculations to detect
and record evidence of speeding vehicles.  Because ViDARTM was
developed by in-house talent, there are no purchase minimums.  By
combining CrossingGuard, Poliscanspeed and
ViDARTM with Citation Composer, our proprietary citation preparation and
processing software, we are able to provide fully integrated, turnkey red light
and speed enforcement solutions.





B.
            Liquidity and management’s
      plans





The
accompanying consolidated financial statements have been prepared assuming we
will continue as a going concern, which contemplates continuity of operations,
realization of assets and the satisfaction of liabilities and commitments in the
normal course of business. We have incurred significant losses since inception
and have an accumulated deficit of $76,502 through December 31, 2007. These
circumstances raise substantial doubt about our ability to continue as a going
concern. Our consolidated financial statements do not include any adjustments
relating to the recoverability and classification of recorded assets or the
amounts and classification of liabilities that might be necessary in the event
we cannot continue in existence.





Management
believes that given its liquidity at December 31, 2007, its current levels of
cash being used by operations, and capital requirements necessary to deliver on
current contracts with municipalities, we will be required to raise additional
capital in the near term.  Even if we obtain the capital desired,
there can be no assurance that our operations will be profitable in the future,
that our product development and marketing efforts will be successful, or that
the additional capital will be available on terms acceptable to us, if at
all.








Note
      2 -
            Summary
      of significant accounting policies:





A.
            Principles of
      Consolidation





The
consolidated financial statements include the accounts of Nestor, Inc. and our
wholly-owned subsidiary, NTS.  All intercompany transactions and
balances have been eliminated upon consolidation.





B.
            Cash
      equivalents





The
Company considers all highly liquid debt instruments purchased with an original
maturity of 90 days or less to be cash equivalents.


-49-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


C.
            Marketable  securities





The
Company’s marketable securities consist of investments in closed-end insured
municipal bond funds.   The securities are classified as “trading
securities” and accordingly are reported at fair value with unrealized gains and
losses included in other income (expense).





D.
            Accounts
      receivable





Accounts
receivable represents balances due from customers, net of a $227 reserve for
doubtful accounts at December 31, 2007 and 2006.  In determining the
need for an allowance, objective evidence that a single receivable is
uncollectible as well as a historical pattern of collections of accounts
receivable that indicate that the entire face amount of a portfolio of accounts
receivable may not be collected is considered at each balance sheet
date.





E.
            Inventory





Inventory
      is valued at the lower of cost or market, with cost determined by the
      first-in, first-out basis and consists mostly of equipment to be installed
      as capitalized system costs.  The inventory balances are
      presented net of inventory reserves of  $686 and $542 as of
      December 31, 2007 and 2006,
respectively.





F.
            Property and equipment &
      depreciation and
amortization





Property
      and equipment are recorded at cost.  Depreciation and
      amortization are calculated using the straight-line method at rates
      sufficient to write off the cost of the assets over their estimated useful
      lives.





G.
            Goodwill





Goodwill
represents the excess of cost over the fair value of net assets
acquired.  Statement of Financial Accounting Standards (SFAS) No. 142,
“Goodwill and Other Intangible Assets,” requires that goodwill be tested for
impairment at least annually and whenever events or changes in circumstances
indicate that the carrying amount of the asset may not be
recoverable.  Goodwill is reviewed for impairment using the Company’s
quoted stock price as a measurement of the Company’s fair value of assets,
including goodwill, and liabilities.  Any resulting goodwill
impairment will be charged to operations.





H.
            Product and patent development
      costs





The costs
of development of the Company’s software, which consist primarily of labor and
outside consulting, and costs of research and development are expensed until
technological feasibility has been established for the
product.  Thereafter, all software production costs are capitalized
and subsequently reported at the lower of unamortized cost or net realizable
value in accordance with American Institute of Certified Public Accountants
(“AICPA”) Statement of Position 98-1, “Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use”.  Capitalized costs
are amortized on a straight-line basis over the estimated economic life of the
product.  The Company currently has no costs eligible for
capitalization.





Patent-development
      costs are expensed or capitalized, as appropriate.  Amortization
      of capitalized costs is on a straight-line basis over the shorter of the
      estimated economic life, or statutory life, of the
  patent.





I.
            Revenue
      recognition





In
accordance with Staff Accounting Bulletin 104, “Revenue Recognition in Financial
Statements,” (“SAB 104”) revenue is generally recognized and earned when all of
the following criteria are satisfied: (a) persuasive evidence of a sales
arrangement exists, (b) delivery of products and/or services has occurred, (c)
the sales price is fixed or determinable, and (d) collectability is reasonably
assured.  In those cases where all four criteria are not met, we defer
recognition of revenue until the period these criteria are
satisfied.


-50-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


The
majority of our revenue is derived from three types of customer
arrangements:





a)
            We
      provide hardware and equipment and related third party embedded software
      (“roadside systems”).  The third party embedded software is
      considered incidental to the system as a whole.  In these
      arrangements, we typically sell or lease the system as a stand-alone
      roadside system.  For direct sales of roadside systems, we
      recognize revenue upon shipment.  We account for one of our
      leasing arrangements as a sales-type lease, as it meets the criteria in
      accordance with Statement of Financial Accounting Standards (SFAS) No. 13,
      “Accounting for Leases.”  In this instance, we recognized
      revenue upon inception of the transaction; interest income related to
      payments against the lease is recognized ratably over the term of the
      lease.  All other leasing arrangements are operating
      leases.  We recognize revenue on these leases on a monthly basis
      over the life of the contract with the
customer.





b)
            We
      provide services, which typically include citation processing, back office
      and hosting services. Software is more than incidental to the services as
      a whole, but 1) is used by us to capture and internally process the
      violations, and 2) customers do not have the right to and do not take
      possession of our detection and tracking, citation processing and back
      office software.  For these services, we typically recognize
      revenue on a fixed monthly fee or a per citation fee
      basis.  Revenue usually commences for these service arrangements
      upon the first month after inception of
  operations.





c)
            For
      two current customers who process their own citations, we lease our
      detection and tracking and citation processing and back office software
      and provide monthly customer support on the software. For these
      arrangements, we recognize revenue in accordance with AICPA Statement of
      Position 97-2, “Software Revenue Recognition.”  Although all
      software deliverables are complete in the initial month of operations, and
      the monthly customer support is the only undelivered element, we recognize
      revenue on a monthly basis as the citations are
  issued.





Some
contracts include penalty provisions relating to timely performance and delivery
of systems and services by us. Penalties are charged to operations in the period
the penalty is determinable.





J.
            Deferred
      Revenue





In some
cases, a customer may pay an upfront, non-refundable mobilization fee for the
Company to install our technology in addition to fees on a per ticket basis over
the life of a contract. The Company records the non-refundable mobilization fee
as deferred revenue and amortizes it over the life of the contract. Deferred
revenue for December 31, 2007 and 2006 was $1,220 and $712,
respectively.





K.
            Shipping and handling
      costs





Shipping
and handling costs are capitalized if such costs comprise a material part of a
leased system.  All other shipping and handling costs are recorded to
engineering and operations expense as incurred.





L.
            Research and
      development





Research
and development costs associated with the Company’s products consist principally
of payroll and related costs, facilities costs and the cost of prototype
components.





M.
            Impairment of long lived
      assets





We assess
potential impairment of our long-lived assets on an annual basis or more
frequently as events or circumstances indicate that an asset may be impaired.
Our long-lived assets are primarily capitalized systems, property and equipment,
and our identifiable intangibles such as goodwill and customer contracts. We
determine such impairment by measuring the estimated undiscounted future cash
flow generated by the assets, comparing the result to the asset carrying value
and adjust the asset to the lower of its carrying value or fair value and
charging current operations for the measured impairment.  The
determination of the asset fair value is subject to significant
judgment.  No impairment charges were taken in 2007.  In the
second quarter of 2006, the Company recorded a $175 impairment charge relating
to two of our red-light contracts. In the fourth quarter of 2006, the Company
recorded a $2,191 impairment charge of which $1,737 related to long-lived assets
associated with the contracts we acquired from Transol, Inc. in
2005.   The components of the $2,366 charge taken in 2006 were
$1,364 to capitalized systems, $893 to customer contracts, and $109 to accrued
liabilities.






-51-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information







N.
            Income
      taxes





The
Company accounts for income taxes using the liability method.  Under
this method, deferred tax assets and liabilities are determined based on
differences between the financial reporting and the tax bases of assets and
liabilities, and are measured using enacted tax rates and tax laws that will be
in effect when the differences are expected to reverse.   The
primary component of the deferred tax asset, which is fully reserved, is net
operating loss carry forwards.





Although
the Company reports consolidated results and balances for financial reporting
purposes, the individual companies file separate tax returns.  Due to
operating losses throughout the reporting periods, no provision for income tax
has been made.





O.
            Earnings (loss) per share and
      common stock





The
Company reports its earnings (loss) per share (“EPS”) in accordance with the
provisions of Statement of Financial Accounting Standards No. 128, Earnings Per
Share (“SFAS 128”). Basic EPS is calculated by dividing the net income (loss) by
the weighted average number of common shares outstanding for the period, without
consideration for common stock equivalents.  Diluted earnings (loss)
per share is computed using the weighted average number of common shares
outstanding during the period plus the dilutive effect of potential future
issues of common stock relating to the Company’s stock option program,
convertible debt and other potentially dilutive securities.  Because
the Company incurred net losses for the years ended December 31, 2007 and 2006,
the effect of potentially dilutive securities was not calculated because to do
so would have been anti-dilutive.





P.
            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 and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period.  Actual results could differ from those
estimates.





Q.
            Concentrations of credit
      risk





The
Company’s financial instruments that are exposed to concentrations of credit
risk consist primarily of cash and cash equivalents, marketable equity
securities and trade accounts receivable.  The Company places its cash
and temporary cash investments with high credit quality
institutions.  Such investments may be in excess of amounts insured by
the FDIC.  Senior management continually reviews the financial
stability of these financial institutions.  The Company’s marketable
equity securities (primarily cash reserves and an insured municipal bond fund)
are exposed to market risk due to changes in U.S. interest rates and
fluctuations in foreign currency exchange rates. The securities are classified
as “trading securities” and accordingly are reported at fair value with
unrealized gains and losses included in other income (expense).  The
Company routinely assesses the financial strength of its customers, most of
which are municipalities, and, as a result, believes that its trade accounts
receivable credit risk exposure is limited.  The Company does not
require collateral from its customers.





Three
customers accounted for 44% of the Company’s total revenues in fiscal 2007, and
two customers accounted for 32% of the Company’s total revenues in fiscal
2006.  Two customers accounted for 51% of net accounts receivable at
December 31, 2007, and three customers accounted for 52% of net accounts
receivable at December 31, 2006.


-52-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




R.
            Stock options
      plans





Effective
January 1, 2006, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 123(R), “Share-Based Payment,” (“SFAS 123(R)”), which
establishes accounting for equity instruments exchanged for employee
services.  Under the provisions of SFAS 123(R), share-based
compensation cost is measured at the grant date, based on the fair value of the
award, and is recognized as an expense over the employee’s requisite service
period (generally the vesting period of the equity grant).  The
Company elected to adopt the modified prospective transition method as provided
by SFAS 123(R).  Under this application, we are required to record
compensation cost for all share-based payments granted after the date of
adoption based on the grant date fair value estimated in accordance with the
provisions of SFAS 123(R) and for the unvested portion of all share-based
payments previously granted that remain outstanding which were based on the
grant date fair value estimated in accordance with the original provisions of
SFAS 123.  The majority of our share-based compensation arrangements
vest over either a four or five year graded vesting schedule.  The
Company expenses its share-based compensation under the ratable method, which
treats each vesting tranche as if it were an individual grant.





S.
            Asset retirement
      obligations





The
Company’s fixed red light and speed enforcement systems are installed at traffic
intersections under three to five year customer contracts. At the end of many
contracts, the Company is required to remove all aboveground structures and
restore the site. As required by Statement of Financial Accounting Standards No.
143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”), the Company
records an obligation for the cost to remove its systems and remediate the site,
if contractually required.





Upon
installation, a liability for the asset retirement obligation is initially
recorded at its present value.  Over time, the liability is accreted
to its present value each period.   Upon settlement of the
liability, a gain or loss is recorded.  A reconciliation of the net
carrying value of the asset retirement obligations (ARO) is as
follows:





December
      31,2007
            
            
            2006Balance
      at beginning of year
            
            $
            674
            
            
            $
            194ARO incurred
            
            
            535
            
            
            
            423Accretion expense
            
            
            55
            
            
            
            57ARO settled
            
            
            ---
            
            
            
            ---Revisions to ARO
      estimates
            
            
            ---
            
            
            
            ---Balance
      at the end of year
            
            $
            1,264
            
            
            $
            674





T.
            Deferred
      Rent





The
Company accounts for escalating rental payments on a straight-line basis over
the term of the lease.  The balance of deferred rent was $22 and $49
at December 31, 2007 and 2006, respectively, and is included in accrued
liabilities in the balance sheet.





U.
            Derivative
      Instruments





In
connection with the sale of debt or equity instruments, the Company may issue
warrants to purchase our common stock.  In certain circumstances,
these warrants may be classified as derivative liabilities rather than
equity.  Additionally, the debt or equity instruments may contain
embedded derivative instruments such as variable conversion options, which in
certain circumstances may be required to be bifurcated from the host instrument
and accounted for separately as a derivative instrument
liability.


-53-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


Derivative
instrument liabilities are re-valued at the end of each reporting period, with
changes in fair value of the derivative liability recorded as charges or credits
to income in the period in which the changes occur.  For options,
warrants and bifurcated conversion options that are accounted for as derivative
instrument liabilities, we determine the fair value of these instruments using
the Black-Sholes option pricing model, binomial stock price probability trees,
or other valuation techniques, sometimes with the assistance of a certified
valuation expert. These models require assumptions related to the remaining term
of the instruments and risk-free rates of return, our current common stock price
and expected dividend yield, and the expected volatility of our common stock
price based on not only the history of our stock price but also the experience
of other entities considered comparable to us.  The identification of,
and accounting for, derivative instruments and the assumptions used to value
them can significantly affect our financial statements.





V.
            Advertising





The
Company charges advertising costs to operations as
incurred.   Advertising expense was $120 and $114 for the years
ended December 31, 2007 and 2006, respectively.





W.
            Reclassification





Certain
prior year balances have been reclassified to conform to the current year
presentation.  These reclassifications had no effect on the net loss
as previously reported.








Note
      3 -
            Capitalized
      system costs:





Equipment,
installation, and other costs related to operating lease contracts with our
customers are capitalized.  After acceptance by the customer, these
costs (net of residual value) are depreciated over the term of the contract,
generally either three or five years.





Capitalized
system costs were comprised of the following:





December
      31,2007
            
            
            2006Equipment
      under operating leases:Work-in-process
            
            $
            1,379
            
            
            $
            3,312Installed
      and accepted
            
            
            19,833
            
            
            
            13,23221,212
            
            
            
            16,544Less:  Accumulated
      depreciation
            
            
            (11,345
            )
            
            
            (8,359
            )Net
      investment in leased equipment
            
            $
            9,867
            
            
            $
            8,185





The
Company recorded an impairment charge of $1,364 related to capitalized system
costs in 2006.  See Note 2 for further details.





Revenues
realized from these operating leases, generally in the form of per-citation or
monthly fees, are expected to be adequate to cover the capitalized and future
costs related to these agreements.  Future minimum payment
requirements under these leases are as follows:





Payments
      due in:2008
            
            $
            8,5342009
            
            
            3,6962010
            
            
            2,2552011
            
            
            1,0752012
            
            
            754Thereafter
            
            
            ---$
            16,314





-54-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


Management
expects that these annual amounts could increase and extend to future years, as
additional intersections are installed or decrease based on cost-neutral
contract adjustment provisions.







Note  4
      -
            Property
      and equipment - net:


December
      31,Depreciable
      Life
            
            2007
            
            
            2006Office
      furniture and equipment
            3
      years
            
            $
            479
            
            
            $
            478Computer
      equipment and software
            1-5
      years
            
            
            2,487
            
            
            
            2,389Demonstration
      equipment
            3
      years
            
            
            129
            
            
            
            127Leasehold
      improvements
            5
      years
            
            
            357
            
            
            
            5923,452
            
            
            
            3,586Less:  Accumulated
      depreciation
            
            
            
            (2,965
            )
            
            
            (2,797
            )$
            487
            
            
            $
            789





Depreciation
and amortization expense on the above assets was $415 and $475 for the years
ended December 31, 2007 and 2006, respectively.





In 2007,
the Company disposed of certain leasehold improvement costs related to its
former corporate headquarters.  Amounts disposed in 2007 totaled $246;
these assets were fully depreciated at the time of disposal.  The
Company did not dispose of any property and equipment in 2006.








Note
      5 -
            Goodwill
      and other intangible assets, net:





Under
SFAS 142, the Company tests goodwill for impairment on an annual basis or
whenever indicators of impairment are identified.  Management
considers the Company’s quoted stock price to be the best indicator of fair
value for purposes of performing these analyses.





Other
intangible assets were comprised of the following as of December 31,
2007:







Identified
      Intangible Asset
            
            
            Useful
      Life In Years
            
            
            
            Gross
      Carrying Amount
            
            
            
            Accumulated
      Amortization
            
            
            
            Net
      Carrying AmountPatents
            
            
            7
            
            
            $
            235
            
            
            $
            (107
            )
            
            $
            128Customer
      contracts and related customer relationships (included in Other
      Assets)
            
            
            1-5
            
            
            
            1,337
            
            
            
            (1,330
            )
            
            
            7Total
            
            
            
            
            
            $
            1,572
            
            
            $
            (1,437
            )
            
            $
            135





Amortization
expense related to identified intangible assets was $30 for the year ended
December 31, 2007 and was included in cost of sales.  Amortization
expense related to identified intangible assets was $321 and impairment charges
of $893 for the year ended December 31, 2006.





-55-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


The
following is the estimated future amortization expense related to other
intangible assets as of December 31:







Fiscal
      Year
            
            Estimated
      Amortization Expense2008
            
            $
            282009
            
            
            262010
            
            
            192011
            
            
            72012
            
            
            3Thereafter
            
            
            52Total
            
            $
            135








Note
      6 -
            Long
      Term Obligations:





The
Company considers its long-term convertible notes payable, long term notes
payable and derivative financial instruments to be its long-term
obligations.





Long-term
obligations consisted of the following at December 31:





2007
            
            
            2006Senior
      Convertible NotesPrincipal
            
            $
            2,850
            
            
            $
            2,850Debt
      discount
            
            
            (1,131
            )
            
            
            (1,930
            )FMV
      of embedded derivatives
            
            
            ---
            
            
            
            164Senior
      Secured Convertible NotesPrincipal
            
            
            22,840
            
            
            
            22,840Debt
      discount
            
            
            (11,045
            )
            
            
            (14,277
            )FMV
      of embedded derivatives, including warrants
            
            
            2,081
            
            
            
            4,807Variable
      Rate Senior Notes
            
            
            1,500
            
            
            
            ---Foundation
      Partners Secured Promissory Note
            
            
            ---
            
            
            
            ---Heil
      Secured Promissory Note
            
            
            ---
            
            
            
            ---Fourth
      Laurus Note
            
            
            ---
            
            
            
            ---17,095
            
            
            
            14,454Less
      current portion
            
            
            ---
            
            
            
            ---Total
            
            $
            17,095
            
            
            $
            14,454








Aggregate
maturities of long-term obligations for the years ending after December 31, 2007
are as follows:





2009
            
            
            2011
            
            
            TotalSenior
      Secured Convertible Notes
            
            $
            ---
            
            
            $
            22,840
            
            
            $
            22,840Variable
      Rate Senior Notes
            
            
            ---
            
            
            
            1,500
            
            
            
            1,500Senior
      Convertible Notes
            
            
            2,850
            
            
            
            ---
            
            
            
            2,850Total
            
            $
            2,850
            
            
            $
            24,340
            
            
            $
            27,190





-56-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


Variable
Rate Senior Notes





In April
2007, the Company completed the sale of $1,500 of the Company’s Variable Rate Senior Notes due May 25, 2011 (the “Speed
Notes”) in a private placement.  The Company received $1,413 of note
proceeds after $87 of placement fees.  These placement fees were paid
to Danzell Investment Management, Ltd., an affiliate of the
Company.  The Speed Notes are secured by a first priority security
interest in all of the Company’s assets which are directly and exclusively used
for the implementation and performance of existing (entered into after October
1, 2006) and future contracts for fixed and mobile automated speed enforcement
units.  Among the purchasers of these Speed Notes is Silver Star
Partners, an affiliate of the Company, and Foundation Partners I,
LLC.  The managing member of Foundation Partners is Danzell Investment
Management, Ltd.  William B. Danzell is the President and sole
stockholder of Danzell Investment Management, Ltd. and the former Chief
Executive Officer, President, and a former director of the
Company.





Speed
Note holders receive interest payments equal to (a) $5.00 per paid citation
issued with the Equipment (for “as issued” contracts), (b) $6.00 per paid
citation (for “as paid” contracts) and (c) 17% of amounts collected (for “fixed
fee” contracts), subject to a minimum return of 10% per annum, payable quarterly
in arrears.  The interest rate as of December 31, 2007 was
10%.  Payments will be made based upon citations issued from 16 speed
units per $1,500 in aggregate outstanding principal on all
Notes.  Once the Company has entered into contracts for the operation
of 16 speed units, the Company may, but is not obligated to, sell an additional
$1,500 of Speed Notes.





The Speed
Notes mature on May 25, 2011, at which time the Company will pay all unpaid
principal together with all accrued but unpaid interest.  The Company
may redeem the Speed Notes at any time at 110% of face value plus
accrued  interest.





The
proceeds from the Speed Notes will be used, either prospectively or
retrospectively, to fund the purchase price or cost of design, engineering,
installation, construction, configuring, maintenance, or operation or
improvement of property or equipment used in contracts signed after October 1,
2006 at a customer site, including without limitation, costs of site analysis
and preparation.





Senior
Secured Convertible Notes





On May
24, 2006, the Company entered into a Securities Purchase Agreement (the
“Agreement”) with several institutional and accredited investors to sell $28,550
of Units consisting of five-year, senior secured convertible promissory notes
(the “Secured Notes”), convertible into shares of the Company’s common stock
(the “common stock”), and five-year warrants to purchase 1,982,639 shares of
common stock at an exercise price of $4.35 per share (the “Warrants”), in a
private placement pursuant to Regulation D under the Securities Act of 1933 (the
“Transaction”).  The Transaction was closed on May 25,
2006.





The
Secured Notes, which rank pari
passu with the Company’s existing Senior Convertible Notes (the “Senior
Notes”), are secured by a first priority security interest in all corporate
assets, except contracts entered into by the Company after October 1, 2006 and
all assets related thereto and all proceeds thereof.   Interest
is payable quarterly in arrears, and an amount equal to two years’ interest on
the Secured Notes is secured by an irrevocable letter of credit.  In
order to obtain the irrevocable letter of credit from a bank, the Company needed
to establish a restricted cash account as collateral.  The letter of
credit expires once drawn down, but no later than May 25, 2008; and the bank fee
is one and one-quarter percent on the open balance, annually.





The
interest rate was subject to adjustment effective July 1, 2007 for certain
changes in the Company’s consolidated EBITDA (defined as earnings before
interest, taxes, depreciation and amortization, any derivative instrument gain
or loss or any employee stock option expense under SFAS 123R, “Share-Based
Payment”).  If consolidated EBITDA as reported on the Company’s
Quarterly Report on Form 10-Q (“Form 10-Q”) for the fiscal quarter ending June
30, 2007 was less than $1,250, the interest rate would increase to
9%.  If consolidated EBITDA as reported on the Form 10-Q for the
fiscal quarter ending June 30, 2007 was greater than $2,500, the interest rate
would decrease to 5%.  Because the Company reported consolidated
EBITDA of less than $1,250 on its Quarterly Report on Form 10-Q for the fiscal
period ended June 30, 2007, the interest rate on the Secured Notes increased to
9%, effective July 1, 2007.  The interest rate is subject to further
adjustment effective January 1, 2009.  If consolidated EBITDA for the
year ended December 31, 2008 as reported on the Company’s Annual Report on Form
10-K (the “Form 10-K”) is greater than $14,000, the interest rate currently in
effect at that time will decrease by 2%.  In the event of default on
the Secured Notes, the interest rate will be 13.5% during the period of
default.






-57-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




All
outstanding principal and interest on the Secured Notes is due on May 25,
2011.  The principal of the Secured Notes is convertible into the
Company’s common stock at a conversion price of $3.60 per share.  The
conversion price is subject to full ratchet anti-dilution protection for any
equity issuances within three years and standard weighted-average anti-dilution
protection thereafter in addition to other customary adjustment
events.





The
Secured Notes contain restrictive covenants, which, among other things, restrict
the Company’s ability to incur additional indebtedness, repay indebtedness
including the secured notes before maturity, grant security interests on its
assets or make distributions on or repurchase its common stock.





The
holders of the Secured Notes had the right to require the Company to redeem up
to 20% of the outstanding principal by written notice to the Company at least
five trading days prior to December 29, 2006.  In addition, the
holders have the right to require the Company to redeem all or any portion of
the outstanding balance of the Secured Notes on May 25, 2009, provided that
this right will be forfeited if, among other things, the Company’s consolidated
EBITDA for the twelve-month period ended December 31, 2008 as reported on the
Form 10-K exceeds $14,000.  The Secured Note holders also have the
right to redeem some or all of their Secured Notes in the event of a change of
control of the Company or an event of default under the
Notes.   On December 29, 2006, the Secured Noteholders exercised
their right to require the Company to redeem 20% of the outstanding principal,
or $5,710.





If, prior
to May 25, 2009, a holder elects to convert its Secured Notes into shares
of the Company’s common stock, or in the event of a “Mandatory Conversion”
(defined below) by the Company, such Secured Note holder will receive a
“make-whole” payment in cash equal to 21% of the face value of the Secured Notes
so converted, less any interest paid.  Beginning on May 25, 2008,
if the average closing bid price of the common stock exceeds 165% of the
conversion price for any 20 trading days during a 30 consecutive trading day
period, the Company can force conversion of the Secured Notes (a “Mandatory
Conversion”), subject to certain notice and other requirements.  The
number of shares of common stock issuable to all Secured Note holders in such
Mandatory Conversion cannot exceed the total daily trading volume of the common
stock for the 20 consecutive trading days immediately preceding the conversion
date.  Furthermore, the Company can require a Mandatory Conversion
only once in any 60 consecutive trading-day period.





Under the
Agreement, the Company has agreed that until 180 days following the effective
date of the Registration Statement covering the shares issuable upon conversion
of the Secured Notes and exercise of the Warrants, it will not, directly or
indirectly, offer, sell grant any option to purchase, or otherwise dispose of
(or announce any offer, sale, grant or any option to purchase or other
disposition of) any of its or its subsidiaries' equity or equity equivalent
securities, including any debt, preferred stock or other instrument or security
that is convertible into or exchangeable or exercisable for shares of its common
stock without the prior written approval of the holders of at least 75% of the
aggregate principal amount of the Secured Notes. In addition, until the first
anniversary of the effective date of such Registration Statement, and provided
that at least 30% of the principal face amount of the Secured Notes remain
outstanding,  holders of the Secured Note have the right to purchase
up to 30% of any equity or equity-linked financings, subject to certain
conditions.  Furthermore, if at any time the Company grants, issues or
sells any options, convertible securities or rights to purchase stock, warrants,
securities or other property pro rata to the record holders of any class of its
common stock, each holder will be entitled to acquire, upon the terms applicable
to such purchase rights, the aggregate purchase rights a holder could have
acquired if the holder had held the number of shares of common stock acquirable
upon complete conversion of such holder’s Secured Note.





The
Warrants are subject to standard weighted average anti-dilution protection for
the life of the Warrants, and expire on May 25, 2011.  In the
event of a change of control, unless the closing sale price of the common stock
on the first trading day immediately following the public announcement of the
change of control exceeds $6.00 per share, the Warrant holder may require the
Company to purchase all or any portion of a Warrant (the “redeemed portion”) for
cash at a price equal to the value of the redeemed portion of the Warrant
determined using the Black-Scholes option pricing model. The Warrants also
contain a “cashless exercise” provision.  In conjunction with the
private placement of common stock in July 2007, (see Note 7) the Company issued
565,410 additional warrants to the Secured Note holders, and the exercise price
of the Warrants was reduced from $4.35 per share to $3.38 per
share.


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 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


The
Company used the net proceeds from the sale of the Units (after expenses and
placement agent fees) to repay the outstanding principal and interest, totaling
$5,670, of a non-convertible promissory note dated December 28, 2005 issued to
Laurus Master Fund, Ltd., the outstanding principal and interest, totaling
$1,270, of a secured promissory note dated August 30, 2005 issued to Foundation
Partners I, LLC, and $2,420 was used to repurchase approximately $2,350
principal amount of the Company’s Senior Notes at a price of 102.5% of face
amount plus accrued interest.  The remaining funds were used for
capital expenditures, including the installation of automated traffic
enforcement systems pursuant to existing contracts, for general corporate
purposes and working capital.





In
connection with the Transaction, the Company and the holders of the Senior Notes
entered into a Written Consent and Waiver and Amendment to Note Agreement (the
“Senior Noteholder Agreement”) pursuant to which the holders of the Senior Notes
consented to the Company granting a security interest in its assets to the
holders of the Secured Notes and waiving their right to redeem the balance of
their Senior Notes.  In addition, the Senior Note holders agreed to
extend the maturity of the $2,850 remaining Senior Notes from October 31, 2007
to May 25, 2009, and received warrants to purchase an aggregate 163,793
shares of common stock at an exercise price of $4.35 per share (the “Senior
Warrants”).  The Senior Warrants expire on May 25,
2009.  The Senior Notes contain full-ratchet anti-dilution
protection.  As a result of the Transaction, the remaining Senior
Notes are now convertible into shares of common stock at a conversion price of
$3.60 per share.





In
connection with the Transaction, we entered into a registration rights agreement
with the holders of the Secured Notes, pursuant to which the Company agreed to
file a Registration Statement on Form S-3 registering for resale a number of
common shares sufficient to allow for full conversion of the Secured Notes and
exercise of the Warrants.  The Registration Statement was filed on
July 14, 2006. Penalties are imposed on the Company if the registration
statement is not declared effective by the SEC within 60 days of filing (or 90
days if subject to SEC review) up to a maximum of 10% of the purchase price of
the Secured Notes.  In addition, the Company is obligated to register
for resale shares of common stock issuable upon exercise of the Senior Warrants
issued to the Senior Note holders.  The Registration Statement was
declared effective by the SEC on September 14, 2006.





The
Company was required by the terms of the Transaction documents to seek
stockholder approval of the Transaction (as required by NASDAQ Rule 4350(i)) and
stockholder approval of an amendment to its certificate of incorporation
increasing the number of shares of authorized common stock sufficient to allow
for conversion in full of the Secured Notes and exercise in full of the
warrants.  No conversions or exercises into common stock was effected
by the Company to the extent that such issuance would exceed 19.99% of the
currently outstanding common stock, until such approvals were
obtained.  The Company obtained such approval on July 6, 2006,
the date of the Annual Meeting of Stockholders.  In connection with
the Transaction, the Company entered into Voting Agreements with stockholders
who hold, in the aggregate, 10,351,048 shares, or 50.83%, of the outstanding
common stock of the Company, pursuant to which they have agreed to vote in favor
of the Transaction and the increase in the number of shares of authorized common
stock.





Cowen &
Co. LLC (“Cowen”) acted as exclusive placement agent for the offering and was
paid $1,485 at closing.  In addition, the Company reimbursed Cowen for
its out-of-pocket expenses and issued Cowen warrants to purchase 198,264 shares
of common stock at an exercise price of $3.60 per share and 49,566 shares of
common stock at an exercise price of $4.35 per share.  These warrants
generally have the same terms as the warrants issued to the Secured Note holders
in the Transaction.  The Company issued additional warrants in
conjunction with the private placement of common stock in July
2007.  As a result, Cowen holds warrants to purchase 252,496 shares of
common stock at an exercise price of $2.82 per share and 63,701 shares of common
stock at an exercise price of $3.38 per share.






-59-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




The
Company is required to maintain its listing on a national securities exchange,
automated quotation system or electronic bulletin board on which shares of its
stock are currently listed as part of the covenants entered into as part of the
Agreement.  The Company has been out of compliance with the Nasdaq Capital
Market’s continued listing minimum bid price requirement.  The Company
remains listed on the Nasdaq Capital Market pursuant to a grace period that
expires on April 21, 2008.  The Company has not taken any action to cure
the minimum stock price requirement.  Because of this, the Company’s stock
is subject to delisting from the Nasdaq Capital Market upon expiration of the
grace period.  If the Company’s stock is suspended from trading or fails to
be listed on a national stock exchange or stock market for a period of five
consecutive days or for more than an aggregate of ten days in any 365-day
period, the Company would not be in compliance with its debt covenants, and this
suspension or delisting would trigger an event of default on the Secured
Notes.  As such, the Company could be subject to the remedies available to
the holders of these notes, including acceleration of the repayment of the
indebtedness.  The Company is currently seeking to obtain covenant default
waivers from each of the noteholders in regard to the potential delisting of its
stock.
 Fourth
Laurus Note
 
 On
December 28, 2005, Laurus issued a new non-convertible note to the Company in
the face amount of $6,000.  The note was used to retire the
unamortized portion of the May 2005 Laurus convertible note (having a remaining
principal balance of $5,273 on December 28, 2005), plus unpaid interest on the
closing date.  The Company received a net cash balance of $603 on the
closing.  In consideration of repaying the note and eliminating
conversion rights, prepayment penalty rights, registration rights, and other
rights under the third Laurus convertible note, the Company issued 203,774
shares of common stock to Laurus with a market value of $1,078 at the date of
close and recorded the transaction as a discount to the non-convertible note and
a credit to Additional Paid in Capital.  The principal amount of the
Note was repayable at rates commencing in April 2006 of $181 per month through
the end of the Note term in December 2008.  The Note bore interest at
the coupon rate of the prime rate plus 2% and was subject to a floor interest
rate of 7%.   The Note contained certain non-financial operating
covenants.




The
Company also entered into a registration rights agreement covering the common
stock issued to Laurus with this non-convertible note, and the Warrants from the
May 2005 Laurus Note.  The agreement required the Company to use its
best efforts to file for registration of the shares within 120 days after
closing of the transaction, and obtaining an effective registration within 180
days.  No specific damages are provided for in the agreement in the
event a registration statement is not filed or effective within the proposed
time periods.





This Note
was paid in full in May 2006 with proceeds received from the Senior Secured
Convertible Notes.





Heil
Secured Promissory Note





On
October 26, 2005, we gave a secured promissory note to Edward F. Heil in the
principal amount of $1,250 with a maturity date of October 25,
2006.  The note bore interest at the rate of one percent per month
until the note was paid in full.  The due date of the principal and
all accrued interest could be accelerated if we defaulted on the
note.  The note could be prepaid in full or in part on the last
calendar day of any month during the term.  The note was secured by
ten mobile speed enforcement units including all associated speed detection
systems and all rights to operate said systems.  If Mr. Heil
foreclosed on the units, we would provide citation processing services for Mr.
Heil with respect to violation data generated by the units at commercially
reasonable prices and Mr. Heil would have all rights and licenses necessary to
so operate the units for their intended uses.  If we were unable to
provide Mr. Heil with citation processing services, then Mr. Heil may obtain
such services from any person or entity, including our
competitors.  In connection with the loan that the secured promissory
note evidences, we paid an origination fee of $25, and we agreed to pay Mr.
Heil’s legal fees related to the loan.  We amortized the origination
fee and any legal fees over the note term.





The Heil
Secured Promissory Note was paid in full in January 2006 from the proceeds of
the private placement of the company’s common stock.  Mr. Heil
invested $1,250 in the equity transaction.


-60-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




Foundation
Partners Secured Promissory Note
 
 On
August 30, 2005 we gave a secured promissory note to Foundation Partners I, LLC
in the principal amount of $1,250 with a maturity date of August 29,
2006.  The note bore interest at the rate of 10% per
year.  Interest was payable monthly and the principal was payable in
full on the maturity date.  The due date of the principal and all
accrued interest could be accelerated if we defaulted on the
note.  The note could be prepaid in full or in part on the last
calendar day of any month during the term.  The note was secured by
ten mobile speed enforcement units including all associated speed detection
systems and all rights to operate said systems.  If Foundation
Partners foreclosed on the units, we would provide citation processing services
for Foundation Partners with respect to violation data generated by the units at
commercially reasonable prices and Foundation Partners would have all rights and
licenses necessary to so operate the units for their intended
uses.  If we were unable to provide Foundation Partners with citation
processing services, then Foundation Partners may obtain such services from any
person or entity, including our competitors, and Foundation Partners would have
all rights and licenses necessary to so operate the units for their intended
uses.  The managing member of Foundation Partners is Danzell
Investment Management, Ltd.  William B. Danzell is the President and
sole stockholder of Danzell Investment Management, Ltd. and the former Chief
Executive Officer, President, and a former director of Nestor.  In
connection with the loan that the secured promissory note evidences, we paid an
origination fee of $25, of which $13 was paid to Foundation Partners and $13 was
paid to Danzell Investment Management, Ltd.  We amortized the
origination fee over the term of the note.
  This
Note was paid in full in May 2006 with proceeds received from the Senior Secured
Convertible Notes.


Senior
Convertible Notes





In
November 2004, the Company completed the sale of $6,000 aggregate principal
amount of its Senior Convertible Notes due October 31, 2007 (the "Senior
Convertible Notes") in a private placement.  The Company received
$5,555 of note proceeds after $445 of placement fees and related
expenses.  The Senior Convertible Notes are convertible into Nestor
common stock at the option of the investors at $5.82 per share and accrue
interest at 5% per year.  The Company must make quarterly
interest-only payments until the Senior Convertible Notes are either paid in
full or are converted into common stock.  At the option of the
holders, all amounts due may be accelerated upon certain events of default,
including failures to pay principal or interest when due, breach of covenants
that remain uncured after notice, bankruptcy of the Company or certain similar
events and defaults under other material credit arrangements.  The
Notes contain certain non-financial operating covenants.





The
Company may, at its option, redeem the Senior Convertible Notes in whole or in
part, at a redemption price of 105% before November 1, 2005, 102.5% before
November 1, 2006, and 101% thereafter, plus unpaid interest, upon 30 to 60 days
prior written notice.  The Company is obligated to offer to repurchase
the Senior Convertible Notes at


the
then-current redemption price in the event of a change in control of the Company
or upon the occurrence certain financing events, as defined.  In
connection with the Senior Convertible Notes, the Company issued a warrant to a
placement agent for the purchase of 60,000 shares of common stock at $5.21 per
share exercisable through October 31, 2009.





The
Securities and Exchange Commission declared the Registration Statement on Form
S-2 (SEC File No. 333-121015) for the resale of these shares effective on
January 28, 2005.   Pursuant to the terms of the warrant, the
Company has agreed to include the resale of the shares of the Company's common
stock underlying the warrant in future registration statements upon the request
of such holder.





During
February 2005, two noteholders converted an aggregate $600 note face value into
103,092 shares of Nestor stock at $5.82 per share.  During May 2005,
one note holder converted an aggregate $200 note face value into 34,364 shares
of Nestor stock at $5.82 per share.  Any unamortized deferred
financing costs associated with the converted notes was expensed upon
conversion.





In
January 2006, the Company issued additional common stock at a price of $4.20 per
share.  In accordance with anti-dilution rights contained in the SMH
notes, the conversion price of the outstanding notes decreased from $5.82 per
share  to $4.20 per share on the date of the January
transaction.





-61-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


In May
2006, in connection with the Senior Secured Convertible Notes, $2,350 was repaid
at a price of 102.5% of face value plus accrued interest. In connection with the
Transaction, the Company and the holders of the Senior Notes entered into a
Written Consent and Waiver and Amendment to Note Agreement (the “Senior
Noteholder Agreement”) pursuant to which the holders of the Senior Notes
consented to the Company granting a security interest in its assets to the
holders of the Secured Notes and waiving their right to redeem the balance of
their Senior Notes.  In addition, the Senior Note holders agreed to
extend the maturity of the $2.85 million remaining Senior Notes from October 31,
2007 to May 25, 2009, and received warrants to purchase an aggregate
163,793 shares of common stock at an exercise price of $4.35 per share (the
“Senior Warrants”).  The Senior Warrants expire on May 25,
2009.  The Senior Notes contain full-ratchet anti-dilution
protection.  As a result of the Transaction, the remaining Senior
Notes are now convertible into shares of common stock at a conversion price of
$3.60 per share.





Embedded
Derivatives and Debt Discounts





The
Senior Convertible Notes and the Secured Notes included a variety of conversion
options, variable interest rate features, events of default, and certain
variable liquidated damage clauses, that may be considered embedded derivative
financial instruments.





The
accounting treatment of the derivatives require that the Company record the
derivatives at their relative fair value as of the inception date of the
agreement, and at fair value as of each subsequent balance sheet date. Any
change in fair value is recorded as derivative instrument expense at each
reporting date, which is a non-operating, non-cash income or
expense.









·
            Principal
      Conversion Options


·
            Monthly
      Payment Conversion Options


·
            Interest
      Rate Adjustment provisions





As of
December 31, 2007 and 2006, these derivatives were valued at $2,081 and $4,971,
respectively. The principal's conversion option on the senior convertible note
was valued using the Binomial Option Pricing Model with the following
assumptions: dividend yield of 0%, annual volatility of 60%; and risk free
interest rate of 3.07% as of December 31, 2007.





As of
December 31, 2007 and 2006, the derivatives and warrants were recorded as
discounts to the notes and are amortized over the expected term of the
debt.  The unamortized discount on the notes was $12,176 and $16,207
for 2007 and 2006, respectively.









Note 7
      -
            Common
      and Preferred Stock:


Private
Stock Placements





On
July 27, 2007, the Company sold 8,532,403 shares of the Company’s common
stock to certain accredited investors at $0.5802 per share, raising $4,808 net
of expenses.  Among the purchasers was Edward Heil, a director of the
Company, who purchased 4,739,745 shares; L-J Holdings, Inc., an affiliate of the
Company, who purchased 646,329 shares; and Kuekenhof Equity Fund, L.P., an
affiliate of the Company, who purchased 430,886 shares.





To allow
for this placement, the Company entered into agreements (“Waivers”) with the
holders of the Company’s Senior Secured Convertible Notes and Senior Convertible
Notes to waive the anti-dilution provisions that would have been triggered by
this placement.  These Waivers did not affect certain Warrants related to
the Senior Secured Convertible Notes, which were adjusted in accordance with
their original terms.  As a result of this placement, Warrants to
purchase 2,032,205 shares with an exercise price of $4.35 and 198,264 shares
with an exercise price of $3.60 were modified to 2,611,750 warrants with an
exercise price of $3.38 and 252,496 warrants with an exercise price of $2.82,
respectively.






-62-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




We
entered into a registration rights agreement to file a Registration Statement on
Form S-3, registering the shares purchased in this placement for
resale.  The Registration Statement must be filed no later than 30
business days after the earlier of (a) the date the Company files its Annual
Report on Form 10-K for the fiscal year ending December 31, 2007 or (b) the last
day on which the Company could timely file such Annual Report on Form 10-K in
accordance with SEC rules, with penalties imposed on the Company if such filing
deadline is not met, or if the Registration Statement is not declared effective
by the SEC within 60 days of filing (or 90 days if subject to SEC
review).
 
 On
January 31, 2006, the Company sold 1,237,811 shares of its common stock to
fifteen accredited investors at $4.42 per share raising $4,822, net of expenses
and issued warrants to purchase 371,339 shares of its common stock exercisable
at $4.91 per share expiring on January 31, 2009. The Company used $1,250 of the
proceeds to immediately retire the Heil Secured Promissory Note. Among the
purchasers was Silver Star Partners, an affiliate of the Company, which
purchased 220,589 shares and a warrant to purchase an additional 66,176 shares
and Kuekenhof Equity Fund, L.P. an affiliate of the Company, which purchased
56,561 shares and a warrant to purchase an additional 16,968
shares.
 
 Preferred
      Stock
 
 Series
      B Convertible Preferred Stock is convertible into Common Stock of the
      Company at any time on a share-for-share basis.  Series B
      Convertible Preferred Stock has the same rights with respect to voting and
      dividends as the Common Stock, except that each share of Series B
      Convertible Preferred Stock has the right to receive $1.00 in liquidation
      before any distribution is made to holders of the Common
      Stock.  The liquidation value of Series B Preferred was $180 at
      December 31, 2007 and 2006.









Note
      8 -
            Options
      and warrants:





On May 6,
1997, the Company adopted the 1997 Stock Option Plan under which the Board of
Directors granted incentive or non-qualified stock options to employees,
directors and consultants to purchase shares of the Company’s common stock at a
price equal to the market price of the stock at the date of grant.  In
June 2001, the 1997 Stock Option Plan was amended to increase the aggregate
number of options authorized to 500,000 shares (post-reverse split) of the
Company’s common stock.  Options vest over four years and are
exercisable for up to ten years from the date of grant, although most options
currently outstanding expire eight years from the date of grant.  The
options are not transferable except by will or domestic relations
order.  No further grants may be made under this Plan pursuant to the
adoption of the 2004 Stock Incentive Plan.





On June
24, 2004, the Company adopted the 2004 Stock Incentive Plan, which provides for
the grant of awards to employees, officers and directors.  Subject to
adjustments for changes in the Company’s common stock and other events, the
stock plan is authorized to grant up to 4,500,000 shares, either in the form of
options to purchase Nestor common stock or as restricted stock
awards.  The Board of Directors will determine the award amount,
price, (usually equal to the market price of the stock on the date of the grant)
vesting provisions and expiration period (not to exceed ten years) in each
applicable agreement. The awards are not transferable except by will or domestic
relations order.





Effective
January 1, 2006, the Company adopted the provisions of Statement of Financial
Accounting Standards No. 123(R) (“SFAS 123(R)”), “Share-Based Payment,”which
establishes accounting for equity instruments exchanged for employee
services.  Under the provisions of SFAS 123(R), share-based
compensation cost is measured at the grant date, based on the fair value of the
award, and is recognized as an expense over the employee’s requisite service
period (generally the vesting period of the equity grant).  The
Company elected to adopt the modified prospective transition method as provided
by SFAS 123(R).  Under this application, we are required to record
compensation cost for all share-based payments granted after the date of
adoption based on the grant date fair value estimated in accordance with the
provisions of SFAS 123R and for the unvested portion of all share-based payments
previously granted that remain outstanding which were based on the grant date
fair value estimated in accordance with the original provisions of SFAS
123.  The majority of our share-based compensation arrangements vest
over either a four or five year graded vesting schedule.  The Company
expenses its share-based compensation under the ratable method, which treats
each vesting tranche as if it were an individual grant.





-63-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




The
following table presents share-based compensation expenses for continuing
operations included in the Company’s consolidated statements of operations for
the years ended December 31, 2007 and 2006:
 
 2007
              
              
              2006Cost
      of sales
              
              $
              19
              
              
              $
              25Engineering
      and operations
              
              
              260
              
              
              
              291Research
      and development
              
              
              37
              
              
              
              119Selling
      and marketing
              
              
              10
              
              
              
              79General
      and administrative
              
              
              288
              
              
              
              1,992Share-based
      compensation expense before tax
              
              
              614
              
              
              
              2,506Provision
      for income tax
              
              
              ---
              
              
              
              ---Net
      share-based compensation expense
              
              $
              614
              
              
              $
              2,506
 
 The
Company estimates the fair value of stock options using the Black-Scholes
valuation model.  Key input assumptions used to estimate the fair
value of stock options include the exercise price of the award, the expected
option term, the expected volatility of the Company’s stock over the option’s
expected term, the risk-free interest rate over the option’s expected term, and
the Company’s expected annual dividend yield.  The Company believes
that the valuation technique and the approach utilized to develop the underlying
assumptions are appropriate in calculating the fair values of the Company’s
stock options granted in 2007.  Estimates of fair value are not
intended to predict actual future events of the value ultimately realized by
persons who receive equity awards.




The fair
value of each option grant was estimated on the grant date using the
Black-Scholes option-pricing model with the following assumptions:








2007
            
            
            2006Expected
      option term (in years) (1)
            
            
            5.25
      - 5.50
            
            
            
            5.25Expected
      volatility factor (2)
            
            
            158%
      - 165
            %
            
            
            164%
      - 169
            %Risk-free
      interest rate (3)
            
            
            4.3%
      - 5.0
            %
            
            
            4.3%
      - 5.0
            %Expected
      annual dividend yield (4)
            
            
            0
            %
            
            
            0
            %





(1)
            The
      option life was determined using the simplified method for estimating
      expected option life, which qualify as “plain-vanilla”
      options.





(2)
            The
      stock volatility for each grant is determined based on the review of the
      experience of the weighted average of historical weekly price changes of
      the Company’s common stock over the expected option
  term.





(3)
            The
      risk-free interest rate for periods equal to the expected term of the
      share option is based on the U. S. Treasury yield curve in effect at the
      time of grant.




(4)
              The
      Company has not paid a dividend historically nor plans to declare a
      dividend in the near
future.


The total
grant date fair value of stock options that vested during the year ended
December 31, 2007 was approximately $735 with a weighted average remaining
contractual term of 5.6 years.





As of
December 31, 2007, there was $1,398 of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under the
Company’s stock option plans.  That cost is expected to be recognized
over a weighted-average period of 2.9 years.  The Company amortizes
stock-based compensation on the straight-line method.








-64-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information





The
following table presents the activity of the Company’s Stock Option Plans for
the years ended December 31, 2007 and 2006.
  Years
      Ended December 31,2007
              
              2006Shares
              
              Weighted
      Av. Ex. Price
              
              Shares
              
              Weighted
      Av. Ex. PriceOutstanding
      beginning of year
              2,953,853
              
              $
              4.55
              
              2,866,027
              
              $
              4.87Granted
              744,500
              
              
              0.84
              
              559,000
              
              
              3.11Exercised
              ---
              
              
              ---
              
              1,940
              
              
              1.80Canceled
              511,600
              
              
              4.36
              
              469,234
              
              
              4.80Outstanding
      end of year
              3,186,753
              
              
              3.72
              
              2,953,853
              
              
              4.55Options
      exercisable at year end
              2,224,328
              
              $
              4.39
              
              1,884,028
              
              $
              4.77


The
following table presents weighted average price and life information about
significant option groups outstanding at December 31, 2007.






Options
      Outstanding
            
            
            
            Options
      ExercisableRange
      of Exercise Price
            
            
            Outstanding
            
            
            Weighted
      Average Remaining Contractural
              Life
      (Years)
            
            
            
            Weighted
      Average Exercise Price
            
            
            
            Exercisable
            
            
            
            Weighted
      Averaged Exercisable Price$
            0.00
            
            -
            
            1.99
            
            
            759,150
            
            
            7.3
            
            
            $
            0.84
            
            
            
            198,800
            
            
            $
            0.842.00
            
            -
            
            2.99
            
            
            177,000
            
            
            6.7
            
            
            
            2.38
            
            
            
            59,250
            
            
            
            2.323.00
            
            -
            
            3.99
            
            
            231,000
            
            
            3.7
            
            
            
            3.59
            
            
            
            174,750
            
            
            
            3.654.00
            
            -
            
            4.99
            
            
            1,835,775
            
            
            0.9
            
            
            
            4.86
            
            
            
            1,640,450
            
            
            
            4.865.00
            
            -
            
            6.99
            
            
            183,828
            
            
            3.0
            
            
            
            5.63
            
            
            
            151,078
            
            
            
            5.643,186,753
            
            
            3.0
            
            
            $
            3.72
            
            
            
            2,224,328
            
            
            $
            4.39





Warrants





The
Company, at the discretion of the Board of Directors, has granted warrants from
time to time, generally in conjunction with the sale of equities.  The
Company issued 60,000 warrants in connection with the private placement in
November 2004, and 100,000 warrants in connection with the private placement in
May 2005.  In 2006, the Company issued 371,339 warrants in connection
with the January 2006 Private Stock Placement and 2,394,262 warrants in
connection with the May 2006 Private Debt Placement.  In 2007, as
discussed in Note 7, the Company issued 633,778 warrants to holders of the
Senior Secured Convertible Notes in connection with the July 2007 Private Stock
Placement.





The
following table presents warrants outstanding after adjusting to a post-reverse
split basis:





Years
      Ended December 31,2007
            
            
            2006Eligible,
      end of year for exercise, currently
            
            
            3,559,379
            
            
            
            2,925,601Warrants
      issued
            
            
            633,778
            
            
            
            2,765,601Low
      exercise price
            
            $
            2.82
            
            
            $
            3.60High
      exercise price
            
            $
            8.43
            
            
            $
            8.43





-65-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




The
warrants outstanding as of December 31, 2007 are currently exercisable and
expire at various dates through May 2011. The outstanding warrants entitle the
owner to purchase one share of common stock for each warrant, at prices ranging
from $2.82 to $8.43 per share.
 
 NTS
Investors, LLC (the “Group”) received a warrant right in January 2001 to acquire
up to 298,071 additional shares of common stock exercisable at the same price at
which the then outstanding warrants of Nestor, Inc. were exercisable, but only
in the event the then outstanding warrants were exercised, so as to maintain
their initial ownership interest percentage.  This warrant right
decreased by 125,000 shares on March 1, 2002 with the expiration of TSAI’s
warrant on that date.  The Group exercised 124,952 warrants on a
cashless basis during 2004 at prices of $3.98 to $4.63 per share, resulting in
59,898 shares of Nestor stock being issued.  Warrants outstanding at
December 31, 2005 includes 18,331 warrants belonging to the Group.  In
addition, the Group received a warrant to acquire 100,000 shares of the
Company’s common stock at $12.80 per share for three years as dilution
protection against both the Company’s and NTS’s converted employee stock options
outstanding at closing.  This warrant expired on September 12,
2004.  All such remaining warrants expired in January
2006.






Note
      9
            Segment
      and geographic information:





Operating
segments are identified as components of an enterprise about which separate
discrete financial information is available to the chief operating decision
maker, or decision-making group, in assessing performance and allocating
resources. The Company’s decision-making group, its executive team, views the
Company’s operations and manages its business principally as one segment.
Therefore, the financial information presented in these financial statements
represents all the material financial information related to the Company’s
principal operating segment.  The Company principally operates in the
United States where its long lived assets are located.








Note
      10
            Master
      lease assignment:





The State
of Delaware Department of Transportation (“DelDOT”) executed a Master Lease
Agreement with NTS in February 2004 whereby lease financing for equipment
installed under this CrossingGuard contract would be financed under lease terms
offered by GE Capital Public Finance, Inc. (“GE”).  Under this
sales-type lease agreement, NTS received $1,600 in 2005 from GE and $880 in 2004
from GE on behalf of DelDOT pursuant to its Assignment and Security Agreement
with GE.  NTS retains a first priority interest in the equipment and
assigned its interest in the DelDOT lease and right to receive rental payments
thereunder to GE.  As a matter of convenience, NTS monthly billings to
DelDOT include their GE repayment of principal and interest, which NTS then
remits to GE on their behalf.






Note
      11
            Other
      expense – net:







Other
expense as reflected in the consolidated statements of operations consists of
the following:





Years Ended December
      31,2007
            
            
            2006Interest
      and dividend income
            
            $
            126
            
            
            $
            392Interest
      expense
            
            
            (2,086
            )
            
            
            (1,925
            )Expense
      relating to financing operations
            
            
            (559
            )
            
            
            (330
            )Unrealized
      gain/(loss)
            
            
            2
            
            
            
            8Other
      income/(expense)
            
            
            (2
            )
            
            
            (10
            )$
            (2,519
            )
            
            $
            (1,865
            )








-66-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


Note
      12
              Income
      taxes:
 
 The
Company and its subsidiaries file income tax returns in the United States and
various states.  With few exceptions, the Company and its subsidiaries
are no longer subject to U.S. federal, state and local income tax examinations
by tax authorities for years before 2001.
 
 The
Company adopted the provisions of FASB Interpretation No, 48, “Accounting for
Uncertainty in Income Taxes” (“FIN 48”) on January 1, 2007.  As a
result of this adoption, the Company was not required to record any liabilities
for unrecognized tax benefits.
 
 During
2007 and 2006, the Company recorded deferred tax assets primarily for the
benefit of net operating losses in the amount of $1,540 and $5,053,
respectively.  The cumulative amount of these assets, which is $28,116
and $26,576 at December 31, 2007 and 2006, respectively, is fully
reserved.  Due to the Company’s history of operating losses,
management has concluded that realization of the benefit is not
likely.
 
 The
Company has $64,426 and $34,294 of net operating loss carryforwards available
for federal and state purposes, respectively, at December 31, 2007.
Approximately $13,318 of these federal net operating loss carryforwards were
acquired as part of the merger with NTS.  These loss carryforwards may
be applied against future taxable income and expire at various points through
the year 2027.


The
Company’s effective income tax rate differs from the statutory federal income
tax rate for the years ended December 31, 2007 and 2006 as follows:




U.S.
      federal statutory rate
              
              34
              %State
      tax, net of federal tax benefit
              
              5
              %Provision
      for valuation allowance
              
              (39
              )%Effective
      income tax rate
              
              0
              %


Pursuant
to Section 382 of the Internal Revenue Code, annual use of the tax loss
carryforwards may be limited if there is a change in ownership. This limitation
applies to the losses incurred by Nestor, Inc., as well as to the losses
incurred by NTS.   The use of state net operating losses may be
limited in the future due to the apportionment of net operating losses among
different states and varying net operating loss utilization requirements by
state. The Company has not determined the effect of these
limitations.






Note
      13 -
            Related
      party transactions:  On
January 1, 1999, Nestor, Inc. entered into an exclusive license with NTS through
the expiration date of the underlying patents protecting the technologies used
in NTS’s products.  The license provides for royalties, as defined, to
be paid to Nestor, Inc. that are eliminated in consolidation.





See Note
6 and Note 7 for transactions with Silver Star Partners, Danzell Investment
Management, Ltd., Foundation Partners I, LLC, L-J Holdings, Inc. and Kuekenhof
Equity Fund, L.P.






Note
      14-
            Employee
      savings plan:







The
Company has a 401(k) savings plan for all employees pursuant to which
eligible employees may voluntarily contribute up to $15,000 subject to statutory
limitations.  The Company may, at its discretion, make matching
contributions on behalf of its employees.  The Company did not make
any matching contributions in 2007 and 2006.  Administrative fees paid
by the Company related to the plan totaled $1 in 2007 and 2006.




-67-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share
Information


Note
      15 -
              Commitments
      and contingencies:
 
 The
following table summarizes the Company’s non-cancelable operating lease
obligations at December 31, 2007:
 
 Payments
      due in:
              
              Non-Cancelable
      Operating Leases (1)2008
              
              $
              3572009
              
              
              3572010
              
              
              3132011
              
              
              1132012
              
              
              ---Thereafter
              
              
              ---$
              1,140
 
 (1)
              Primarily
      facility lease obligations in Providence, RI and North Hollywood,
      CA.
 
 As of
December 31, 2007, the Company has no off balance sheet
arrangements.
 
 Rent
expense was approximately $331 and $330 for the years ended December 31, 2007
and 2006, respectively.




NTS
entered into an operating lease dated June 21, 2000 for office and warehouse
facilities in East Providence, Rhode Island.  The Company relocated to
new office and warehouse space in September 2005, and as a result, has recorded
a reserve for lease termination costs in the amount of $159 as of December 31,
2007 and 2006.  This reserve is include in accrued
liabilities.





In
September 2005, the Company entered into an operating lease for its corporate
headquarters in Providence, RI, which calls for monthly lease payments ranging
from  $8 to $11 through September 2010.





In June
2006, the Company entered into an operating lease for office and warehouse
facilities in North Hollywood, California. The lease calls for monthly rent of
$19 through the lease term expiration in June 2011.








Note
      16 -
            Litigation:





On April
13, 2007, the Company filed suit against Place Motor, Inc. and Clair Ford,
Lincoln Mercury, Inc.  (Nestor Traffic Systems, Inc.
Plaintiff, vs. Place Motor, Inc., et al., Rhode Island Superior Court, C.A. No.
PC-07-1963).  Place Motor, Inc. and Clair Ford, Lincoln
Mercury, Inc. are in possession of title for eight vans for which Nestor has
paid in full.  Nestor has alleged that it paid for these vans by
making payment to the defendants’ agent, Northeast Conversions,
LLC.  Although Northeast Conversions never forwarded our payment to
the defendants, Nestor believes that it satisfied its obligation to pay for the
vans when it delivered payment to the defendants’ agent.  Accordingly,
Nestor seeks declaratory judgment in favor stating that the Defendants’ must
take any action necessary to deliver the vans together with valid title
certificates to Nestor Traffic Systems.  The defendants have answered
the complaint with general denials of the basis for Nestor’s claims and
asserting certain affirmative defenses.  Neither party asserted any
counterclaims.  At present, discovery is ongoing with Clair Ford,
Lincoln Mercury, Inc. and a default is pending with respect to Place Motor, Inc.
for its failure to respond to discovery.




Two suits
have been filed against us and the City of Akron seeking to enjoin the City of
Akron speed program and damages.  These cases have been consolidated
in the U.S. District Court for the Northern District of Ohio.  These
cases are:


-68-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information




Mendenhall v. The City of
Akron, et al., United States District Court, Northern District of Ohio,
Eastern Division, No. 5:06CV0139, in which plaintiff filed a complaint and class
action for declaratory judgment, injunctive relief and for a money judgment in
an unspecified amount against City of Akron and all of its City Council members
in their official capacity and us alleging federal and state constitutional
violations.  The action was filed in the Summit County Court of Common
Pleas and was removed to federal court.  On February 17, 2006, we and
the other defendants filed a joint motion for judgment on the
pleadings.  Plaintiff filed an opposition to that motion on March 24,
2006.  On May 19, 2006, the court ruled that the Akron ordinance
permitting photo enforcement of speeding laws was a proper exercise of municipal
power under the Ohio Constitution, but deferred ruling on the alleged due
process violations pending an opportunity for discovery by the plaintiff, which
was completed on October 20, 2006.   The plaintiff amended her
complaint on August 8, 2006 to include equal protection violations among her
federal constitutional claims.  We filed an answer to that amended
complaint on August 18, 2006 and all dispositive motions in the case were filed
by November 22, 2006.
 
 Sipe, et al. v. Nestor
Traffic Systems, Inc., et al., United States District Court, Northern
District of Ohio, Eastern Division, No. 5:06CV0139, in which plaintiffs filed a
complaint and class action for declaratory judgment, injunctive relief and for a
money judgment in an unspecified amount against us, various past and present
employees of ours and the City of Akron and alleging fraud, civil conspiracy,
common plan to commit fraud, violations of the Consumer Sales Practices Act,
nuisance, conversion, invasion of privacy, negligence, and federal
constitutional violation. The action was filed in the Summit County Court of
Common Pleas and was removed to federal court.  On February 17, 2006,
we and the other defendants filed a joint motion for judgment on the
pleadings.  Plaintiff filed an opposition to that motion on March 24,
2006.  On May 19, 2006, the court ruled that the Akron ordinance
permitting photo enforcement of speeding laws was a proper exercise of municipal
power under the Ohio Constitution, but deferred ruling on the alleged due
process violations pending an opportunity for discovery by the plaintiff, which
was completed on October 20, 2006 and all dispositive motions in the case were
filed by November 22, 2006.




With
respect to both of the above cases, on January 31, 2008, the Ohio Supreme Court
determined in the affirmative the following certified question:





Whether a
municipality has the power under home rule to enact civil penalties for the
offense of violating a traffic signal light or for the offense of speeding, both
of which are criminal offenses under the Ohio Revised Code.





On
February 7, 2007, the Ohio Supreme Court accepted the case for determination of
the question presented.  The Ohio Supreme Court has received briefs
from all parties, and oral arguments were heard on September 18,
2007.  On January 31, 2008, the Ohio Supreme Court unanimously ruled
that the municipality does have power under home rule to enact civil penalties
for violating a traffic signal light and speeding.  This ruling will
permit the Federal District Court to resolve any remaining Constitutional issues
raised by the plaintiffs, including issues related to due process.





We do not
currently have any pending material litigation other than that described
above.








Note
      17-
            Recent
      accounting pronouncements:





In
September 2006, the SEC staff issued SAB No. 108, “Considering the
Effects of Prior Year Misstatements when Quantifying Misstatements in Current
Year Financial Statements” (“SAB 108”).  SAB 108 was issued
in order to eliminate the diversity of practice surrounding how public companies
quantify financial statement misstatements.  SAB 108 requires
registrants to quantify the impact of correcting all misstatements using both
the “rollover” method, which focuses primarily on the impact of a misstatement
on the income statement and is the method the Company currently uses, and the
“iron curtain” method, which focuses primarily on the effect of correcting the
period-end balance sheet.  The use of both of these methods is
referred to as the “dual approach” and should be combined with the evaluation of
qualitative elements surrounding the errors in accordance with
SAB No. 99, “Materiality.”  The adoption of SAB 108 in 2007
did not have a material impact on the Company’s consolidated financial
statements.





-69-
 Table of Contents
 NESTOR,
INC.
 Notes
to the Consolidated Financial Statements
 In
Thousands, Except Share and per Share Information


In
September 2006, the FASB issued Statement of Financial Accounting Standards No.
157,“Fair Value
Measurements” (“SFAS 157”).  SFAS 157 prescribes a single definition
of fair value as the price that would be received to sell an asset or paid to
transfer a liability in an orderly transaction between market participants at
the measurement date.  SFAS 157 is effective for the fiscal year
beginning January 1, 2008.  The Company is still evaluating the impact
of this pronouncement.
 
 In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option
for Financial Assets and Financial Liabilities—including an amendment of
FAS 115” (“SFAS 159”).  SFAS159 allows entities to choose,
at specific election dates, to measure eligible financial assets and liabilities
at fair value that are not otherwise required to be measured at fair
value.  If a company elects the fair value option for an eligible
item, changes in that item’s fair value in subsequent reporting periods must be
recognized in current earnings.  SFAS 159 is effective for the
fiscal year beginning January 1, 2008.  The Company is still
evaluating the impact of this pronouncement.
 
 In
December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in
Consolidated Financial Statements”. (“SFAS 160”)  SFAS 160 amends
ARB 51 to establish accounting and reporting standards for the noncontrolling
(minority) interest in a subsidiary and for the deconsolidation of a subsidiary.
 It clarifies that a noncontrolling interest in a subsidiary is an
ownership interest in the consolidated entity that should be reported as equity
in the consolidated financial statements. SFAS No. 160 is effective for the
fiscal year beginning January 1, 2009.  The Company is still evaluating the
impact of this pronouncement.


In
December 2007, the FASB issued SFAS No. 141(R), “Business
Combinations”. (“SFAS 141(R)”)  This Statement replaces SFAS No.
141, “Business Combinations.” SFAS 141(R) retains the fundamental
requirements in Statement 141 that the acquisition method of accounting (which
Statement 141 called the purchase method) be used for all business combinations
and for an acquirer to be identified for each business combination. This
Statement also establishes principles and requirements for how the acquirer: a)
recognizes and measures in its financial statements the identifiable assets
acquired, the liabilities assumed, and any noncontrolling interest in the
acquiree; b) recognizes and measures the goodwill acquired in the business
combination or a gain from a bargain purchase and c) determines what information
to disclose to enable users of the financial statements to evaluate the nature
and financial effects of the business combination. SFAS 141(R) will apply
prospectively to business combinations for which the acquisition date is on or
after the Company’s fiscal year beginning July 1, 2009. While the Company is
still evaluating the impact of this pronouncement, the Company will be required
to expense costs related to any acquisitions after June 30, 2009.





In March
2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments
and Hedging Activities - an Amendment of FASB Statement 133” (“SFAS 161”). 
SFAS 161 enhances required disclosures regarding derivatives and hedging
activities, including enhanced disclosures regarding how: (a) an entity uses derivative
instruments; (b)
derivative instruments and related hedged items are accounted for under FASB
Statement No. 133, “Accounting for Derivative Instruments and Hedging
Activities”; and (c) derivative instruments and
related hedged items affect an entity's financial position, financial
performance and cash flows. Specifically, SFAS 161 requires disclosure of the
objectives for using derivative instruments be disclosed in terms of underlying
risk and accounting designation; disclosure of the fair values of derivative
instruments and their gains and losses in a tabular format; disclosure of
information about credit-risk-related contingent features; and cross-reference
from the derivative footnote to other footnotes in which derivative-related
information is disclosed.  SFAS 161 is effective for fiscal years and
interim periods beginning after November 15, 2008.  Early application is
encouraged.  The
Company is still evaluating the impact of this
pronouncement.




Note
      18-
              Subsequent
      Event:


-70-
 Table of Contents


ITEM
      9.
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure




None.








ITEM
      9A.
            Controls and
Procedures





We
maintain disclosure controls and procedures, as defined in Exchange Act Rule
13a-15(e) and 15d-15(e), that are designed to ensure that information required
to be disclosed in reports that we file or submit under the Securities Exchange
Act of 1934 is recorded, processed, summarized, and reported within the time
periods specified in the Securities and Exchange Commission’s rules and forms,
and that such information is accumulated and communicated to our management,
including our Chief Executive Officer and Chief Financial Officer, as
appropriate to allow timely decisions regarding the required disclosures. Our
disclosure controls and procedures are designed to provide reasonable assurance
that their objectives are met.





The
management of Nestor, Inc., including the Chief Executive Officer and Chief
Financial Officer, conducted an evaluation of the effectiveness of the design
and operation of our disclosure controls and procedures as of December 31,
2007.





Based
upon that evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that as of December 31, 2007, our disclosure controls and procedures
were effective, in that they provide reasonable assurance (i) that information
required to be disclosed by us in the reports we file or submit under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms and (ii) that information
required to be disclosed in reports that we file or submit under the Exchange
Act is accumulated and communicated to our management including our Chief
Executive Officer and Chief Financial Officer, to allow timely decisions
regarding required disclosure.





No change
in our internal control over financial reporting (as defined in Rules 13a-15(f)
and 15d-15(f) under the Exchange Act) occurred during the quarter ended December
31, 2007 that has materially affected, or is reasonably likely to materially
affect, the Company’s internal control over financial reporting.





Management’s
Report on Internal Control Over Financial Reporting





Management
of the Company is responsible for establishing and maintaining adequate internal
control over financial reporting.  Internal control over financial
reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act
as a process designed by, or under the supervision of, the Company’s principal
executive and principal financial officers and effected by the Company’s board
of directors, management and other personnel to provide reasonable assurance
regarding the reliability of financial reporting and the preparation of
financial statements for external purposes in accordance with U.S. generally
accepted accounting principles and includes those policies and procedures
that:




·
            pertain
      to the maintenance of records that in reasonable detail accurately and
      fairly reflect the transactions and dispositions of the assets of the
      company;


·
            provide
      reasonable assurance that transactions are recorded as necessary to permit
      preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the company
      are being made only in accordance with authorizations of management and
      directors of the company; and


·
            provide
      reasonable assurance regarding prevention or timely detection of
      unauthorized acquisition, use or disposition of the company’s assets that
      could have a material effect on the financial
  statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Projections of any evaluation of effectiveness
to future periods are subject to the risks that controls may become inadequate
because of changes in conditions, or that the degree of compliance with the
policies or procedures may deteriorate.


-71-
 Table of Contents


Management
assessed the effectiveness of the company’s internal control over financial
reporting as of December 31, 2007.  In making this assessment,
management used the criteria established in Internal Control-Integrated
Framework, issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  Based on this assessment, our management
concluded that, as of December 31, 2007, our internal control over
financial reporting is effective based on those criteria.








ITEM
      9B.
            Other
      Information





None.





-72-
 Table of Contents


PART
      III





ITEM
      10.
            Directors, Executive Officers and Corporate
      Governance





The
information concerning directors and executive officers required by this item,
including the Audit Committee and the Audit Committee financial expert, is
incorporated herein by reference to the sections entitled “Election of
Directors,” “Audit Committee” and “Audit Committee Financial Expert” in the
Company’s Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders
to be filed with the SEC.




The
Company has adopted a written code of ethics that applies to all employees,
including but not limited to, its principal executive officer, principal
financial officer, principal accounting officer or controller, or persons
performing similar functions.  A copy of Nestor’s code of ethics is
available without charge by writing to: Nestor, Inc., 42 Oriental Street,
Providence, Rhode Island 02908, Attention: Teodor Klowan, Jr.  The
Company has posted the Code of Ethics on the Company's web site at
www.nestor.com under Investor
Information and intends to disclose any amendment to its Code of Ethics
on its web site.  In addition, any waiver of a provision of the Code
of Ethics for the CEO, CFO, Controller or persons performing similar functions
shall be disclosed by the filing of a Form 8-K as required by the rules of the
NASDAQ Capital Market.








ITEM
      11.
            Executive
Compensation





The
information required by this item is incorporated herein by reference to the
sections entitled “Compensation of Directors”, “Compensation Discussion and
Analysis”, ‘Compensation Committee Interlocks and Insider Participation,”
“Compensation Committee Report” and “Executive Compensation” in the Company’s
Definitive Proxy Statement for the 2008 Annual Meeting of Shareholders to be
filed with the SEC.





The
information set forth under the heading “Compensation Committee Report” in the
Company’s Definitive Proxy Statement is furnished and shall not be deemed as
filed for purposes of Section 18 of the Securities Exchange Act of 1934, as
amended, and is not deemed incorporated by reference in any filing under the
Securities Act of 1933, as amended.








ITEM
      12.
            Security Ownership of Certain Beneficial Owners and
      Management





The
information required by this item is incorporated herein by reference to the
Sections entitled “Securities Authorized for Issuance Under Equity Compensation
Plans” and “Security Ownership of Certain Beneficial Owners and Management” in
the Company’s Definitive Proxy Statement for the 2008 Annual Meeting of
Shareholders to be filed with the SEC.








ITEM
      13.
            Certain
      Relationships, Related Transactions and Director
      Independence





The
information required by this item is incorporated herein by reference to the
sections entitled “Certain Relationships and Related Transactions” and “Election
of Directors” in the Company’s Definitive Proxy Statement for the 2008 Annual
Meeting of Shareholders to be filed with the SEC.








ITEM
      14.
            Principal Accountant Fees and
    Services





The
information required by this item is incorporated herein by reference to the
Section entitled “Principal Accountant Fees and Services” in the Company’s
Definitive Proxy Statement for the 2007 Annual Meeting of Shareholders to be
filed with the SEC.





-73-
 Table of Contents





PART
      IV





ITEM
      15.
            Exhibits and Financial Statement
      Schedules


(a)
            The
      following documents are filed as part of this
  report:





(1)
            The
      financial statements of the Company and accompanying notes, as set forth
      in the contents to the financial statements annexed hereto, are included
      in Part II, Item 8.





(2)
            All
      financial statement schedules are omitted, as the Company has elected to
      follow the reduced disclosure requirements as a smaller reporting company,
      as defined in Rule 12b-2 of the Exchange
Act.


(3)
            Exhibits
      numbered in accordance with Item 601 of Regulation S-K and filed
      herewith.





See
      Exhibit Index.








-74-
 Table of Contents


SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused the report to be signed on its behalf by
the undersigned, thereunto duly authorized.





NESTOR,
      INC.(Registrant)April 15, 2008
            /s/
      Clarence A. DavisClarence
      A. Davis, Chief Executive OfficerApril 15, 2008
            /s/
      Teodor Klowan, Jr.Teodor
      Klowan, Jr., Chief Financial Officer








Signatures
              Title
              Date/s/
      George L. Ball
              Chairman
      of the Board of Directors
              April
      15, 2008George
      L. Ball/s/
      Harold E. Ford
              Director
              April
      15, 2008Harold
      E. Ford/s/
      Edward F. Heil
              Director
              April
      15, 2008Edward
      F. Heil/s/
      Michael C. James
              Director
              April
      15, 2008Michael
      C. James/s/
      David N. Jordan
              Director
              April
      15, 2008David
      N. Jordan/s/
      Nina R. Mitchell
              Director
              April
      15, 2008Nina
      R. Mitchell/s/
      Theodore Petroulas
              Director
              April
      15, 2008Theodore
      Petroulas/s/
      Daryl Silzer
              Director
              April
      15, 2008Daryl
      Silzer


-75-
 Table of Contents
 INDEX
OF EXHIBITS





Exhibit
      No.
            Description
      of Exhibits3.1
            Third
      Amended and Restated Certificate of Incorporation.3.2
            Amended
      and Restated By-Laws.10.1
            Asset
      Purchase Agreement and License Agreement between the Company and National
      Computer Systems, Inc., filed as an Exhibit to the Company's Current
      Report on Form 8-K dated June 11, 1996, is hereby incorporated by
      reference.10.2
            PRISM
      Non-Exclusive License Agreement between the Company and Applied
      Communications, Inc., filed as an Exhibit to the Company's Current Report
      on Form 8-K dated September 19, 1996, is hereby incorporated by
      reference.  Portions of the Exhibit omitted, pursuant to a grant
      of confidential treatment.10.4
            Amendment
      to the PRISM Non-Exclusive License Agreement dated as of April 18, 1997,
      between Nestor, Inc. and Applied Communications, Inc., filed as an Exhibit
      to the Company's Current Report on Form 8-K dated April 30, 1997, is
      hereby incorporated by reference.  Portions of the Exhibit
      omitted pursuant to a grant of confidential treatment.10.5
            Exclusive
      License Agreement between Nestor, Inc. and Nestor Traffic Systems, Inc.
      dated January 1, 1999, filed as an Exhibit to the Company's Current Report
      on Form 8-K dated March 25, 1999, is hereby incorporated by
      reference.10.6
            Secured
      Note Agreement by and among Nestor, Inc., Nestor Traffic Systems, Inc. and
      NTS Investors LLC dated January 9, 2001, filed as an Exhibit to the
      Company's Current Report on Form 8-K dated January 18, 2001, is hereby
      incorporated by reference.10.7
            License
      Agreement between Nestor, Inc. and ACI Worldwide, Inc. dated February 1,
      2001, filed as an Exhibit to the Company's Current Report on Form 8-K
      dated February 9, 2001, is hereby incorporated by reference.10.8
            License
      Agreement between Nestor, Inc. and Retail Decisions, Inc. dated May 18,
      2001, filed as an Exhibit to the Company's Current Report on Form 8-K
      dated May 18, 2001, is hereby incorporated by reference.


10.17
            Nestor,
      Inc. 1997 Incentive Stock Option Plan, as amended, filed as an Exhibit to
      the Company's Registration Statement on Form S-8 filed May 16, 1997, is
      hereby incorporated by reference.10.24
            Registration
      Rights Agreement dated December 31, 2003 among Nestor, Inc., Sanders
      Morris Harris, Inc., and Barrett & Company, Inc., filed as an Exhibit
      to the Company's Registration Statement on Form S-2, as amended (File No.
      333-108432), is hereby incorporated by reference.10.25
            Nestor,
      Inc. 2004 Stock Incentive Plan, filed as an Exhibit to the Company’s
      Current Report on Form 8-K dated June 24, 2003 and filed as an Exhibit to
      the Company's Registration Statement on Form S-8 filed January 21, 2005,
      is hereby incorporated by reference.10.27
            Employment
      Agreement dated October 13, 2004 between Nestor, Inc. and Nigel P.
      Hebborn, filed as an Exhibit to the Company’s Current Report on Form 8-K
      dated October 13, 2004, is hereby incorporated by reference.10.28
            Note
      Purchase Agreement dated November 5, 2004 between Nestor, Inc. and the
      purchasers named therein, filed as an Exhibit to the Company’s Current
      Report on Form 8-K dated November 5, 2004, is hereby incorporated by
      reference.10.29
            Registration
      Rights Agreement dated November 5, 2004 among Nestor, Inc. and the
      purchasers named therein, filed as an Exhibit to the Company’s Current
      Report on Form 8-K dated November 5, 2004, is hereby incorporated by
      reference.10.30
            Warrant
      to Purchase Common Stock, issued by Nestor, Inc. to Sanders Morris Harris,
      Inc. dated November 5, 2004, filed as an Exhibit to the Company’s Current
      Report on Form 8-K dated November 5, 2004, is hereby incorporated by
      reference.





-76-
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Exhibit
      No.
            Description
      of Exhibits10.34
            Incentive
      Stock Option Agreement by and between Nestor, Inc. and Nigel P. Hebborn
      dated October 13, 2004, filed as an Exhibit to the Company’s Quarterly
      Report on Form 10-Q for the quarter ended September 30, 2004, is hereby
      incorporated by reference.10.35
            Incentive
      Stock Option Agreement by and between Nestor, Inc. and Nigel P. Hebborn
      dated October 13, 2004, filed as an Exhibit to the Company’s Quarterly
      Report on Form 10-Q for the quarter ended September 30, 2004, is hereby
      incorporated by reference.10.36
            Employment
      Agreement dated March 29, 2005 between Nestor, Inc. and Tadas A. Eikinas,
      filed as an Exhibit to the Company’s Annual Report on Form 10-K for the
      year ended December 31, 2004, is hereby incorporated by
      reference.10.38
            Incentive
      Stock Option Agreement by and between Nestor, Inc. and Tadas A. Eikinas
      dated March 29, 2005, filed as an Exhibit to the Company’s Annual Report
      on Form 10-K for the year ended December 31, 2004, is hereby incorporated
      by reference.10.41
            Bonus
      Targets Letter to Nigel P. Hebborn dated March 29, 2005, filed as an
      Exhibit to the Company’s Annual Report on Form 10-K for the year ended
      December 31, 2004, is hereby incorporated by reference.10.42
            Lease
      Agreement between Nestor Traffic Systems, Inc. and Admiral Associates
      dated May 27, 2005, filed as an Exhibit to the Company’s Current Report on
      Form 8-K dated May 27, 2005, is hereby incorporated by
      reference.10.46
            Common
      Stock Purchase Warrant dated May 16, 2005 by Nestor, Inc. to Laurus Master
      Fund, Ltd., filed as an Exhibit to the Company’s Registration Statement on
      Form S-2 (File No. 333-126047), is hereby incorporated by
      reference.10.49
            Purchase
      and Sale Agreement dated August 31, 2005 by and among Transol Holdings Pty
      Limited (CAN 100 078 046) (receivers and managers appointed), Transol PTY
      Limited (ABN 65 095 538 828) (receivers and managers appointed), Transol
      Corporation Limited (ABN 73 089 224 402) (receivers and managers
      appointed), Alleasing Finance Australia Limited (ABN 94 003 421 136) and
      Nestor Traffic Systems, Inc., filed as an Exhibit to the Company’s
      Quarterly Report on Form 10-Q for the quarter ended September 30, 2005, is
      hereby incorporated by reference.10.55
            Letter
      agreement from Nigel P. Hebborn to Nestor, Inc. dated March 6, 2006, filed
      as an Exhibit to the Company’s Current Report on Form 8-K dated March 6,
      2006, is hereby incorporated by reference.10.56
            Letter
      agreement from Tadas A. Eikinas to Nestor, Inc. dated March 6, 2006, filed
      as an Exhibit to the Company’s Current Report on Form 8-K dated March 6,
      2006, is hereby incorporated by reference.10.59
            Securities
      Purchase Agreement dated January 31, 2006 by and among Nestor, Inc. and
      the investors named therein, filed as an Exhibit to the Company’s Annual
      Report on Form 10-K for the year ended December 31, 2005, is hereby
      incorporated by reference.10.60
            Form
      of Common Stock Warrant dated January 31, 2006, filed as an Exhibit to the
      Company’s Annual Report on Form 10-K for the year ended December 31, 2005,
      is hereby incorporated by reference.10.61
            Incentive
      Stock Option Grant Agreement between Nestor and Teodor Klowan, Jr., dated
      May 5, 2006, filed as an Exhibit to the Company’s Current Report on Form
      8-K dated May 1, 2006, is hereby incorporated by reference.10.62
            Securities
      Purchase Agreement by and among Nestor, Inc. and the Purchasers signatory
      thereto (the “Purchasers”) dated May 24, 2006 (including exhibits
      thereto), filed as an Exhibit to the Company’s Current Report on Form 8-K
      dated May 26, 2006, is hereby incorporated by
  reference.





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Exhibit
      No.
            Description
      of Exhibits10.63
            Form
      of Restricted Stock Agreement dated July 3, 2006, filed as an Exhibit to
      the Company’s Current Report on Form 8-K dated July 3, 2006, is hereby
      incorporated by reference.10.64
            Schedule
      of Director Payments, filed as an Exhibit to the Company’s Current Report
      on Form 8-K dated July 3, 2006, is hereby incorporated by
      reference.10.65
            Form
      of Senior Convertible Notes dated May 25, 2006, filed as Exhibit 10.1 (at
      Exhibit A thereto) to the Company’s Current Report on Form 8-K dated May
      26, 2006, is hereby incorporated by reference.10.66
            Form
      of Warrants dated May 25, 2006, filed as Exhibit 10.1 (at Exhibit B
      thereto) to the Company’s Current Report on Form 8-K dated May 26, 2006,
      is hereby incorporated by reference.10.67
            Warrants
      in favor of Cowen & Co., LLC dated May 25, 2006, filed as an Exhibit
      to the Company’s Quarterly Report on Form 10-Q for the quarter ended June
      30, 2006, is hereby incorporated by reference.10.68
            Security
      Agreement by and among U.S. Bank National Association, Nestor, Inc.,
      Nestor Traffic Systems, Inc. and CrossingGuard, Inc. dated May 25, 2006,
      filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q for the
      quarter ended June 30, 2006, is hereby incorporated by
      reference.10.69
            Guaranty
      and Suretyship Agreement by and among U.S. Bank National Association,
      Nestor, Inc., Nestor Traffic Systems, Inc. and CrossingGuard, Inc. dated
      May 25, 2006, filed as an Exhibit to the Company’s Quarterly Report on
      Form 10-Q for the quarter ended June 30, 2006, is hereby incorporated by
      reference.10.70
            Borrower/Subsidiary
      Pledge Agreement by and among U.S. Bank National Association, Nestor,
      Inc., Nestor Traffic Systems, Inc. and CrossingGuard, Inc. dated May 25,
      2006, filed as an Exhibit to the Company’s Quarterly Report on Form 10-Q
      for the quarter ended June 30, 2006, is hereby incorporated by
      reference.10.71
            Security
      Agreement -- Trademarks, Patents and Copyrights, by and between U.S. Bank
      National Association and Nestor, Inc. dated May 25, 2006, filed as an
      Exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter
      ended June 30, 2006, is hereby incorporated by reference.10.72
            Registration
      Rights Agreement by and among Nestor, Inc. and the buyers named therein
      dated May 25, 2006, filed as Exhibit 10.1 (at Exhibit F thereto) to the
      Company’s Current Report on Form 8-K filed May 26, 2006, is hereby
      incorporated by reference.10.73
            Form
      of Amended & Restated 5% Senior Convertible Notes dated May 25, 2006,
      filed as Exhibit 10.1 (at Exhibits B through J thereto) to the Company’s
      Current Report on Form 8-K filed May 26, 2006, is hereby incorporated by
      reference.10.74
            Form
      of Common Stock Warrants dated May 25, 2006, filed as Exhibit 10.1 (at
      Exhibits C through J thereto) to the Company’s Current Report on Form 8-K
      filed May 26, 2006, is hereby incorporated by reference.10.75
            Form
      of Incentive Stock Option Agreement dated November 1, 2006, filed as an
      Exhibit to the Company’s Current Report on Form 8-K dated November 1,
      2006, is hereby incorporated by reference.10.76
            Incentive Stock Option Agreement
      between Nestor, Inc. and Tadas A. Eikinas dated September 8, 2006, filed
      as an Exhibit to the Company’s Quarterly Report on Form 10-Q for
      the quarter ended September 30, 2006, is hereby incorporated by
      reference.10.77
            Employment
      Agreement between Nestor, Inc. and Teodor Klowan, Jr. dated February 1,
      2007, filed as an Exhibit to the Company’s Current Report on Form 8-K
      dated February 1, 2007, is hereby incorporated by
    reference.





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Exhibit
      No.
            Description
      of Exhibits10.78
            Employment
      Agreement between Nestor, Inc. and Brian R. Haskell dated February 7,
      2007, filed as an Exhibit to the Company’s Current Report on Form 8-K
      dated February 1, 2007, is hereby incorporated by reference.10.79
            Consulting
      Letter Agreement between Nestor, Inc. and Clarence A. Davis dated February
      7, 2007, filed as an Exhibit to the Company’s Current Report on Form 8-K
      dated February 1, 2007, is hereby incorporated by reference.10.80
            Form
      of Restricted Stock Agreement dated February 1, 2007, filed as an Exhibit
      to the Company’s Current Report on Form 8-K dated February 1, 2007, is
      hereby incorporated by reference.10.81
            Note
      Purchase Agreement by and among Nestor Traffic Systems, Inc. and the
      Purchasers signatory thereto (the “Purchasers”) dated April 1, 2007, filed
      as an Exhibit to the Company’s Annual Report on Form 10-K for the year
      ended December 31, 2006, is hereby incorporated by reference.10.82
            Securities
      Purchase Agreement by and among Nestor, Inc. and the Purchasers signatory
      thereto (the “Purchasers”) dated July 23, 2007, filed as an Exhibit to the
      Company’s Quarterly Report on Form 10-Q for the quarter ended June 30,
      2007, is hereby incorporated by reference.10.83
            Employment
      Agreement between Nestor, Inc. and Clarence A. Davis dated July 30, 2007,
      filed as Exhibit 10.1 to the Company’s Current Report on Form 8-K dated
      August 3, 2007, is hereby incorporated by reference.23.01
            Consent
      of Carlin, Charron & Rosen, LLP dated April 15, 2008.31.1
            Certification
      of principal executive officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as amended.31.2
            Certification
      of principal financial officer pursuant to Rule 13a-14(a)/15d-14(a) of the
      Securities Exchange Act of 1934, as amended.32
            Statement
      Pursuant to 18 U.S.C. §1350*.











*
            Certification
      is not deemed “filed” for purposes of Section 18 of the Exchange Act, or
      otherwise subject to the liability of that section.  Such
      certification is not deemed to be incorporated by reference into any
      filing under the Securities Act or the Exchange Act, except to the extent
      that the registrant specifically incorporates it by
    reference.





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