**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 period ended
            December
                31, 2005




OR ̈
            TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934





For
                the transition period from
            _____________
                to _____________Commission
                file Number 0-12965




**Nestor,
                Inc**(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:NONE





Securities
                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:
            X





Indicate
                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 filing requirements 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, or a non-accelerated filer. See definition of
                “accelerated filer and large accelerated filer” in Rule 12b-2 of the
                Exchange Act. (Check one):





Large Accelerated filer:   ̈   Accelerated
      filer:   ̈   Non-accelerated
      filer: x





Indicated
                by check mark whether the registratnt is a shell company:
            Yes:
            
            No:
            XThe
                aggregate market value of the 7,471,357 shares of voting stock held
                by
                non-affiliates of the registrant on June 30, 2005, based on the closing
                price of such stock on June 30, 2005, was $44,828,142.The
                number of shares outstanding of the Registrant’s Common Stock at March 24,
                2006 was 20,364,876.**DOCUMENTS
                INCORPORATED BY REFERENCE**Sections
                of Nestor, Inc.’s definitive Proxy Statement for the 2006 Annual Meeting
                of Stockholders are incorporated by reference into Parts II and III
                of
                this report.










1




**PART
      I**







**Restatement
      of Consolidated Financial Statements**




In
      this
      Annual Report on Form 10-K we are restating our consolidated balance sheet
      as of
      December 31, 2004, and our consolidated statements of operations, stockholders’
equity, cash flows and related disclosures for the years ended December 31,
      2004
      and 2003 (the “Restatement”). We are also restating the condensed consolidated
      financial statements for: a) for the first three quarters of fiscal year ended
      December 31, 2005; and b) the four quarters of the fiscal year ended December
      31, 2004. Our Annual Reports on Form 10-K and the Quarterly Reports on Form
      10-Q
      for fiscal 2003 through the third quarter of fiscal 2005 have not been revised
      to reflect the Restatement, and the financial statements contained in those
      reports should not be relied upon. Instead, the financial statements for fiscal
      2004 and 2003 included in this Annual Report on Form 10-K should be relied
      upon.




As
      previously reported in our Current Report on Form 8-K filed with the Securities
      and Exchange Commission on December 5, 2005, the Company has been in extensive
      discussions with the Staff of the Securities and Exchange Commission concerning
      the proper accounting treatment of certain of its convertible debt, product
      sales, and unbilled revenue in current and previously reported financial
      results. The Company has settled its accounting treatment of product sales
      and
      unbilled revenue without any financial restatement necessary. However, as a
      result of these discussions, the Company’s financial statements are restated to
      bifurcate embedded derivative instruments within the Company’s debt and account
      for them separately as derivative instrument liabilities. We have also modified
      our footnote disclosure related to the debt.




Refer
      to
      Note 3 in our consolidated financial statements for additional information.




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. 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. 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. Poliscan, our speed enforcement product, uses technology developed
      by
      Vitronic GmbH. We have exclusive distribution rights to Poliscan in North
      America through February 2010, subject to meeting certain sales minimums. By
      coupling CrossingGuard and Poliscan equipment 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 200 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 court dismissal rate of
      less
      than 1%.





Poliscan
      is an automated system for digital speed detection and recording. Poliscan
      simultaneously captures multiple vehicles in multiple lanes and 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. The 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 a high-resolution
      digital camera for documentation of the speeding violation, including pictures
      of the license plate, an overview picture specifically identifying the speeding
      vehicle, and a photo of the driver where required.





2





We
      provide back office processing services for CrossingGuard and Poliscan roadside
      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.





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 February 28, 2006, we are generating revenue from 171
      CrossingGuard-equipped approaches in 29 municipalities in seven states and
      one
      Canadian province, and four mobile speed units in one municipality. As of that
      date, our active contracts with state and local governments (including the
      City
      of Los Angeles) authorize the installation of CrossingGuard at up to an
      additional 172 approaches.





**Our
      Market**




***Status
      of the CrossingGuard Market***




The
      market for automated red light enforcement is experiencing significant growth.
      We estimate that there are over 1 million approaches to signalized intersections
      in the United States. Technology solutions manage enforcement at less than
      0.5%
      of these approaches. According to the Insurance Institute for Highway Safety,
      in
      2003 red light running caused more than 200,000 crashes, nearly 176,000
      injuries, and 934 deaths. Eighty percent of respondents to a 2004 Harris Poll
      reported that the problem of drivers running red lights should receive “more
      attention”, including 57% who want it to receive “much more attention”, an
      increase of 46% since 2001. First-generation red-light camera systems gained
      early acceptance as a means of automated traffic enforcement. These systems
      generally rely on in-ground vehicle sensing loops and still photography, and
      are
      not preferred because of their intrusive roadbed installation issues, high
      maintenance requirements and general lack of functionality and accuracy.




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. Twenty-three states and the District of Columbia
      currently allow the use of automated traffic light systems, such as
      CrossingGuard ;
      and over
      the
      last year, an additional fifteen state legislatures considered bills to enable
      or expand automated traffic enforcement.




Jurisdictions
      allowing red light enforcement include:





Alaska
              Arizona
              California
              Colorado
              Delaware
              Georgia
              Illinois
              Iowa
            Maryland
              Minnesota
              Missouri
              New
                Mexico
              New
                York
              North
                Carolina
              Ohio
              Oregon
            Pennsylvania
              Rhode
                Island
              South
                Carolina
              South
                Dakota
              Tennessee
              Texas
              Washington
              Washington,
                D.C.


Recent
      studies have shown that automated red light enforcement systems are effective
      in
      reducing red light running at enforced intersections and at surrounding
      unenforced intersections. The Federal Highway Administration and other
      organizations have recently acknowledged that these systems are helpful in
      the
      reduction of red light running and correspondingly the number of accidents.
      Surveys conducted throughout many U.S. cities have found that more than 75%
      of
      drivers support red light enforcement systems. However, there remains opposition
      to these systems, largely based upon concerns regarding individual privacy
      and
      due process rights. For example, during 2005, West Virginia passed legislation
      that bans automated traffic enforcement systems. Many states and communities
      have or are considering authorization of automated traffic enforcement but
      need
      to address these concerns first.





***Status
      of the Poliscan 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. There were approximately 6.2 million reported
      crashes occurring in 2004 and the estimated economic cost of these crashes
      was
      in the tens of billions of dollars. Speeding was a factor in nearly one-third
      of
      all fatal crashes, resulting in over 13,000 deaths. In 2003, 86% of
      speeding-related fatalities occurred on roads other than interstate highways.
      Speeding was also involved in 36% of the fatal crashes that occurred in
      construction/maintenance zones. In 2004, the State of Illinois passed a bill
      allowing automated enforcement of the speed limit laws for construction zones
      to
      better protect construction zone workers.




3





Seventy-nine
      percent of respondents to a 2004 Harris poll regarding attitudes of the American
      people on highway and auto safety indicated that the issue of speeding on local
      streets needs “more attention” by public safety officials, including 59% who say
      it needs “much more attention.”





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. Currently, ten
      states, the District of Columbia and six Canadian provinces permit automated
      speed enforcement. They are:





*UNITED
                STATES*
            
            *CANADA*Arizona
            Oregon
            
            Alberta
            OntarioColorado
            Tennessee
            
            British
                Columbia
            QuebecIllinois
            Utah
            
            Manitoba
            SaskatchewanIowa
            WashingtonNew
                Mexico
            Washington,
                D.C.Ohio





***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. We offer a
      complete turnkey solution for a city’s 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 efficiencies. Our
      systems also reduce the demand for emergency resources without significantly
      increasing our customer’s administrative costs.




**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 as
      a
      wholly-owned subsidiary. In 1999 and 2000, Nestor Traffic 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 Nestor Traffic through
      a
      merger transaction with another subsidiary in which we issued common stock
      for
      the Nestor Traffic shares held by outside investors. 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 enforcement systems such
      as CrossingGuard, our current primary source of revenue.





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. We do not expect to receive future revenue from this
      license.





4





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 for certain marketing and transition
      services, we paid ReD $968,000 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 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 35 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.




**Products
      and Services**





Our
      products combine sophisticated digital and analog 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, Poliscan speed for
      mobile speed enforcement, and “speed on green” for fixed, intersection 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 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 and license
      plate, and transmits video evidence electronically 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%.




5





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 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 personal
      computer, which we install in an enclosure by the roadside link through a fiber
      optic connection, runs the intelligent software and controls camera activity.
      High-speed 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.





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 less subject to challenge 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 Profiling program, which is 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.




6





*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. However,
      throughout 2003 and 2004, there was a trend by states and municipalities towards
      a fixed monthly fee as opposed to variable per ticket fee pricing structures.
      Since fixed fees are based upon the expected level of violations over the
      contract term, the shift to monthly fixed fee contracts should result in a
      more
      stable revenue stream for these installations.





As
      of
      December 31, 2005, we had installed CrossingGuard at 202 approaches and
      Poliscan speed in
      4
      units for 35 customers throughout the United States and Canada, and our
      contracts authorize up to an additional 172 CrossingGuard approaches for
      installations and 5 speed units for deployment. Of these installed approaches,
      171 approaches are installed and generating revenues. Management believes the
      majority of the authorized approaches and units 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 $2,000 to $12,000 per approach
      for system delivery and lease and processing services.





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 much higher resulting in lower
      per
      citation or monthly fees for systems installed in these jurisdictions. Current
      trends in the industry are towards compensating red-light program vendors on
      a
      fixed-fee basis instead of a variable-fee basis tied to ticket volumes. Actual
      results from deployment of CrossingGuard systems are expected to fluctuate
      substantially depending upon intersection selection and configuration, driver
      response to installed systems and many other factors.





***Poliscan*** ***speed*** ***Products***





*Poliscan
      Speed.* Poliscan speed ,
      an
      innovative solution for digital speed detection and recording, is the only
      multi-lane, bi-directional, scanning LiDAR mobile speed enforcement system
      in
      the industry. Unlike traditional photo speed enforcement systems, which use
      radar or conventional LiDAR, Poliscan speed 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. Poliscan 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 Poliscan speed 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 Poliscan speed system
      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




7





*Deployment
      and Set Up.* With
      outside dimensions of less than 12 inches per side and weighing less than 45
      pounds, the PoliScan speed 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, PoliScan speed 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
      PoliScan speed 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 SUV mount, tripod mount and our rugged transportable
      unit. Our proven back office integration and citation processing systems,
      coupled with PoliScan’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, PoliScan speed 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 PoliScan speed system,
      which can be operational in less than five minutes.





*Revenue
      Generation.* We
      believe ** LiDAR
      is
      rapidly becoming the industry standard and is viewed by an increasing number
      of
      police departments as the most capable technology to be used with photo speed
      enforcement. Other providers who use radar for photo enforcement are generally
      required to discard photo evidence if there is more than one car in the image
      due to the highly reflective and unpredictable nature of radar.





Enforcing
      only a single lane drastically reduces potential citation rates by 2 or 3 times.
      Poliscan 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.





***CrossingGuard
      Speed and Other Speed Products***





CrossingGuard
      Speed, our "Speed on Green" solution, is specifically designed for intersection
      applications and can be used as a complement to our CrossingGuard red light
      enforcement system. Our fixed speed solution uses two independent speed
      detection sensors to cross-reference and verify the vehicle speed, a feature
      that we believe is unique to our product. The system uses digital video in
      conjunction with either certified Ka band radar, traditional single beam LiDAR
      or the Vitronic scanning LiDAR, providing complete visual evidence of violations
      and eliminating the "multiple vehicle" uncertainty of competitors’ systems. It
      is designed to allow for upgrading CrossingGuard installations to enable
      simultaneous red light and speed intersection monitoring.  The system
      will deliver video evidence of vehicles speeding with advanced
      non-intrusive, performance similar to our CrossingGuard
      systems. The system may also be installed on a stand-alone
      basis.





***Program
      Management and Processing Services*** ****





We
      offer
      our CrossingGuard and Poliscan 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.




8





***Other
      Traffic Products***





We
      have
      two other traffic management products - Rail CrossingGuard and TrafficVision.
      We
      have chosen to focus our efforts on the automated enforcement market and are
      no
      longer marketing or developing these products. Therefore, we do not expect
      to
      receive material revenue related to them in the future.




*Rail
      CrossingGuard.* We
      developed Rail CrossingGuard, a system to monitor grade-crossing vehicles and
      train traffic, as well as signalization activity, to provide
      grade-crossing-integrity measurement, real-time crossing alert capabilities
      and
      crossing violation enforcement. This product has the potential to enhance
      rail-crossing safety by improving signal and crossing gate monitoring, alerting
      personnel to dangerous crossing situations, and enforcing train and vehicle
      safety regulations. Rail CrossingGuard may also be integrated with train
      communications systems to provide a method of alerting trains to dangerous
      rail
      crossing conditions.





*TrafficVision.* TrafficVision is a product that uses video cameras to monitor traffic flow
      and
      to send traffic data to a central Traffic Operations Center. Replacing
      short-life, high-maintenance, road-embedded copper-loop technologies from the
      1950's, TrafficVision is a non-intrusive sensor system for traffic management.
      TrafficVision uses our proprietary high-speed image-processing technology to
      analyze video content to sense and monitor traffic on highways, roadways and
      intersections in real-time. TrafficVision recognizes and classifies multiple
      vehicles continuously so that surveillance and traffic management are based
      upon
      detailed, real-time information. TrafficVision is installed at 26 locations
      in
      Rhode Island and in the state's centralized Traffic Operations Center in
      Providence.





**Sales,
      Marketing and Methods of Distribution**





We
      market
      our products and services to municipalities and governmental traffic management
      departments. As of December 31, 2005, our nationwide direct sales force had
      grown to ten individuals from four in early 2005, and our marketing support
      group consists of four people. 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.





We
      obtain
      product inquiries from customer referrals, product mailings, attendance at
      trade
      shows, trade press coverage and our Internet site. Most CrossingGuard 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 2005, we submitted 43 **** proposals
      to state and local governments. As of December 31, 2005, as a result of bids
      submitted in 2004 and 2005, we were awarded 10 contracts and we have been
      selected as the provider by, but not entered into a contract with, 5
      municipalities. No provider has been selected with respect to 7 of the RFPs
      to
      which we responded in 2005.





Our
      2006
      marketing and sales plan includes state-specific marketing, comprehensive
      municipal coverage by our expanded sales team and consultant and lobbyist
      engagements.





**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.




9





We
      have
      recently completed development of two new 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;
                and


·
            Our
                CrossingGuard Speed system, which can utilize any of three speed
                detection
                systems - Ka band radar, single beam traditional LiDAR and Vitronic’s
                scanning LiDAR. The integration of all known types of non-intrusive
                speed
                sensors into our product allows us to deliver a full array of solutions
                to
                the customer while maintaining the advantage of full motion digital
                video.





We
      have
      begun development of a high-speed enforcement detection system for the
      CrossingGuard fixed speed platform. This system will allow accurate speed
      detection and measurement using a video tracking system. This will allow for
      an
      inexpensive and non-detectible sensor system to enforce speed through
      intersections and at fixed speed locations.





We
      spent
      $1,737,000, $157,000, and $122,000 in the years ended December 31, 2005, 2004
      and 2003 respectively, on research and development. The more significant 2005
      research and development expenditures are attributable to development of the
      CrossingGuard all digital video solution and, to a larger degree, the US
      commercialization and back office integration of the PoliScan speed product .
      We
      expect these costs to decrease in 2006.





**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 it’s 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.





During
      2005, we received one patent relative to the CrossingGuard product line. The
      patent recognizes the use of a virtual violation line for detecting red light
      violations. During 2004, we received two patents relative to the CrossingGuard
      product line. The first patent recognizes the transmission of video as part
      of
      the user interface in our CitationComposer software for ticket processing and
      issuance. The second patent recognizes the invention of a traffic sensor. During
      2003, we received two patents relative to the CrossingGuard product line. One
      of
      the patents recognizes our method of predicting and recording a red light
      violation with a video-based system including the use of violation probability
      scores. The other patent defines a system and method of detecting and filtering
      non-violations in a traffic light enforcement system employing a video camera
      to
      improve the effectiveness of the system.





As
      of
      December 31, 2005, we own 13 U.S. patents and 2 foreign patents. We have two
      foreign patent applications pending. We also have one pending U.S. patent
      application acquired from Transol. Seven of our U.S. patents, both of our
      foreign patents and all of our patent applications have relevance to our traffic
      enforcement business. The foreign patents correspond to one or more of the
      U.S.
      patents. Our patents expire at various times from 2006 to 2021. 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.




10




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 ACS, which has the greatest
      number of red-light and speed camera systems installed, and Redflex Traffic
      Systems, Inc. Among others are Laser Craft, Mulvihill/ATS, Peek Traffic (Quixote
      Corp.), 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. Because
      these contracts are generally self-funded from ticket fees collected from
      red-light violators and some contracts contain termination fee provisions,
      we do
      not expect termination to be a significant risk. We retain all patent and other
      proprietary rights from products developed and delivered under
      government-supported contracts.





**Employees**





As
      of
      March 15, 2006, we had 102 **** full-time
      employees, comprising 17 in software engineering and product development, 23
      in
      processing and system support, 38 in program management and field
      services, **** 12
      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.




11





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, 2005, 2004, and 2003,
      our net losses have been approximately $6,764,000, $6,178,000, **** and
      $5,325,000, respectively. As of December 31, 2005 we had an accumulated deficit
      of $60,988,000. We expect to incur continuing 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
      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, 2005, we had approximately $13.7 million of outstanding debt,
      at
      par value. We will need to raise additional funds in the near 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 may 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 unless we raise the additional financing.




If
      we
      raise additional funds by issuing equity securities, 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. If we raise
      additional funds through a debt financing, the terms and conditions of the
      debt
      financing may result in restrictions on our operations or require that we grant
      a security interest in some or all of the assets for which such debt financing
      would be used. Any debt that we incur could have significant additional negative
      consequences, including:




·
            Increasing
                our vulnerability to general adverse economic and industry
                conditions;




·
            Limiting
                our ability to obtain additional
                financing;




·
            Requiring
                the dedication of a substantial portion of our cash flow from operations
                to service our debt, thereby reducing the amount of expected cash
                flow
                available for other purposes, such as sustaining our operations,
                capital
                expenditures and research and
                development;




·
            Limiting
                our flexibility in planning for, or reacting to, changes in our business
                and the industry in which we compete;
                and




12




·
            Placing
                us at a possible competitive disadvantage to competitors with less
                debt
                and to competitors that have better access to capital
                resources.




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.




***Substantially
      all of our current revenue is from a single product and related services.***




Currently,
      substantially all of our revenue is from our red light enforcement systems
      and
      services. While we have recently begun to deploy the speed enforcement products,
      there can be no assurance that we will be able to generate significant revenue
      from this product or that we will be able to develop other sources of revenue.
      Because our revenue depends substantially on a single product, any decrease
      in
      the market share held by CrossingGuard, unless offset by other revenue sources,
      would have a substantial adverse effect on our business, financial condition
      and
      results of operations. If we fail to meet our expectations for the growth in
      sales of CrossingGuard and Poliscan or if we are not able to expand our speed
      enforcement business or develop other sources of revenue, we will not be able
      to
      generate the significantly higher revenue that we believe we must generate
      to
      achieve profitability.




***We
      have limited experience in the speed enforcement market.***




We
      have
      limited experience in the speed enforcement market. Currently, we are only
      party
      to two speed enforcement contracts, one of which is a pilot program that we
      expect will run through the end of the current school year, and thereafter
      be
      replaced by a longer term program with a vendor selected through an RFP. There
      can be no assurance that we will obtain additional speed enforcement contracts.
      Furthermore, since we have only limited experience in deploying the Poliscan
      automated enforcement system, we cannot assure you that this product will be
      profitable, new customers will be obtained, or that any revenue from the sale
      of
      these systems will be sustainable.




***We
      may not maintain our rights to market Poliscan.***




Under
      our
      contract with Vitronic, if we fail to generate specific sales volume during
      each
      year of the contract beginning with the year ending June 30, 2006, Vitronic
      can
      elect to terminate our exclusivity or the entire contract. There can be no
      assurance that we will meet the performance targets under the contract. Because
      the growth of our speed business, namely the increased deployment of Poliscan
      systems, is such a key component of our growth strategy, the termination of
      the
      Vitronic contract would adversely affect our business and results of
      operations.




***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, 2005, our active contracts with state and local governments
      authorized the installation of CrossingGuard at up to an additional 172
      approaches. In many cases, we cannot proceed with these installations until
      the
      sites 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 or generate revenue associated
      therewith. We cannot assure you that all approaches under contract will
      ultimately be installed.




***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.




13




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




Currently,
      23 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. For example, last year
      the Virginia General Assembly declined to extend authorization for automated
      red
      light enforcement beyond the sunset date of June 30, 2005 in the enabling
      legislation. We had two revenue-producing red light enforcement contracts with
      municipalities in Virginia. We anticipate no material revenues from the 14
      approaches covered by these contracts unless there is a change in Virginia
      law.
      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 very
      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.




***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;




14




·
            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.




***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.




***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 all 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;




15




·
            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;




·
            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; and




·
            The
                mix of revenue from our products and
                services.




***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;




16




·
            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.




Any
      delay
      or failure to complete sales 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 sales 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.




17




***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.




***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;




18




·
            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.




**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.




***Our
      President and Chief Executive Officer beneficially owns a significant amount
      of
      our common stock and, accordingly, exercises significant control over our
      business and affairs, including the approval of change in control transactions.***




As
      of
      December 31, 2005, our President and Chief Executive Officer beneficially owns
      approximately 50.1% of our common stock, which includes shares of common stock
      held by Silver Star Partners I, LLC (Silver Star), of which he serves as the
      managing director. Based on the number of shares of common stock outstanding
      as
      of February 28, 2006, our President and Chief Executive Officer will be able
      to
      exert substantial influence over all matters requiring approval by our
      stockholders. These matters include the election and removal of directors and
      any merger, consolidation or sale of all or substantially all of our assets.
      This concentration of ownership may have the effect of delaying, deferring
      or
      preventing a change in control, or impeding a merger, consolidation, takeover
      or
      business combination even if the transaction might be beneficial to our
      stockholders.




In
      addition, Section 203 of the General Corporation Law of the State of Delaware
      restricts business combinations with any “interested stockholder” as defined by
      the statute. The statute may have the effect of delaying, deferring or
      preventing a change in control of our company.




***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.




19




***We
      have a significant number of options, warrants and convertible securities
      outstanding, which could result in substantial dilution to the purchasers of
      shares in this offering.***




As
      of
      December 31, 2005, we have issued and outstanding warrants and options to
      purchase up to approximately 3,044,358 shares of our common stock, preferred
      stock convertible into 18,000 shares of our common stock and debt convertible
      into approximately 1,924,399 shares of our common stock. The exercise of such
      warrants and options and conversion of convertible securities may dilute the
      interests of all stockholders. 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 $4.40 per share. Possible future resale of common stock issuable
      from such warrants and options or conversion of such convertible securities
      could adversely affect the prevailing market price of our common
      stock.




***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 approximately 20,364,876 **** shares
      of
      our common stock outstanding as of February 28, 2006, of which approximately
      9,047,742 shares **** were
      freely tradable without restrictions or further registration under the
      Securities Act. Silver Star, our majority stockholder, has the right to require
      us to register under the Securities Act their resale of all 9,589,941 shares
      of
      common stock that it owns, as soon as practicable after Silver Star requests
      that registration. We are also obligated to register for resale the 1,237,811
      shares we sold to accredited investors on January 31, 2006 and 203,774 shares
      held by Laurus Master Fund, Ltd.




20








ITEM
              2.
            Properties.





In
      October 2005, we relocated our corporate headquarters from 400 Massasoit Avenue,
      East Providence, Rhode Island to 42 Oriental Street, Third Floor, Providence,
      Rhode Island. We are party to a five-year lease for 12,700 square feet of office
      space and 11,000 square feet of warehouse space at this new location with lease
      payments of approximately $7,400 per month for the office space, subject to
      increase for renewal terms. The warehouse space is rent-free until the first
      anniversary of the lease, at which time annual rent for the warehouse space
      will
      adjust to $4.00 per square foot. We are still the lessee of 4,800 square feet
      of
      our former corporate headquarters in East Providence, at a monthly rent of
      $6,141, for which we are attempting to find a sublessee. Our obligations under
      that lease expire on May 31, 2007.




We
      also
      maintain a local field office in San Diego, California on a two-year lease
      dated
      July 2004, and pay approximately $2,600 per month. In addition, we maintain
      a
      local field office in Placentia, California on a two-year lease dated February
      2004, and pay approximately $1,400 per month. We are planning on relocating
      our
      San Diego offices to the Los Angeles area to improve the support for our
      customers located in and around the Los Angeles. We may consolidate the
      Placentia field office with the Los Angeles office, depending on facility layout
      and availability.




ITEM
              3.
            Legal
                Proceedings.





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. No decision has been made by the
      judge on that motion. The judge stayed all discovery pending the outcome of
      that
      motion.




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, nusiance, 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. No decision has been made by the judge on that motion.
      The judge stayed all discovery pending the outcome of that motion.




Sherrod
      Vans of Jacksonville, Inc., a former vendor that provided van customization
      services to us, has filed suit against us in the Circuit Court (Duval County,
      Florida), alleging that we failed to pay for some of the services that they
      provided. Sherrod is seeking payment from us of $114,075. Among the items for
      which they are seeking payment are items that have not been delivered to us.
      If
      Sherrod delivers those items, the amount in dispute is less than $20,000.




In
      addition, from time to time, we are involved in legal proceedings arising in
      the
      ordinary course of business. We do not currently have any pending litigation
      other than that described above.




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




No
      matters were submitted to a vote of security holders during the fourth quarter
      of the year ended December 31, 2005.





21





**PART
      II**





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





The
      Company’s common stock is traded on the Nasdaq National Market under the symbol
“NEST.” The following table reflects the range of the reported high and low last
      sale prices on the Nasdaq National Market for the periods
      indicated:





Low
            
            HighYear
                Ended December 31, 20051st
                Quarter
            
            $
            4.50
            
            $
            7.432nd
                Quarter
            
            $
            5.05
            
            $
            7.003rd
                Quarter
            
            $
            4.40
            
            $
            6.754th
                Quarter
            
            $
            4.80
            
            $
            9.17Year
                Ended December 31, 20041st
                Quarter
            
            $
            2.85
            
            $
            4.002nd
                Quarter
            
            $
            3.16
            
            $
            4.103rd
                Quarter
            
            $
            4.05
            
            $
            5.004th
                Quarter
            
            $
            4.75
            
            $
            7.85




*Holders
      of Common Stock*


At
      March
      24, 2006, the number of holders of record of the issued and outstanding common
      stock of the Company was 404.





*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.




22





ITEM
              6.
            Selected
                Financial Data.





The
      following data includes the accounts of Nestor, Inc. for all periods presented
      and NTS for the years 2004, 2003, and 2002 and for the period September 13,
      2001
      through December 31, 2001. The Company’s investment in NTS was recorded on the
      equity method prior to September 13, 2001. 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)2005
            
            2004
            
            2003
            
            2002
            
            2001Revenue
            
            $
            7,769
            
            $
            6,035
            
            $
            2,706
            
            $
            2,122
            
            $
            3,521Operating
                loss
            
            
            (9,277
            )
            
            (4,647
            )
            
            (4,261
            )
            
            (15,127
            )
            
            (1,297
            )Gain
                on debt extinguishment, net
            
            
            ---
            
            
            508
            
            
            ---
            
            
            ---
            
            
            ---Loss
                on debt refinancing
            
            
            (509
            )
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---Contract
                termination reserve
            
            
            ---
            
            
            ---
            
            
            (125
            )
            
            ---
            
            
            ---Gain
                on royalty assignment
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            2,812
            
            
            ---Loss
                from investment in affiliate
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (81
            )Other
                expense
            
            
            (704
            )
            
            (334
            )
            
            (504
            )
            
            (319
            )
            
            (187
            )Derivative
                instrument expense, net
            
            
            3,726
            
            
            (1,705
            )
            
            (435
            )
            
            ---
            
            
            ---Net
                loss
            
            $
            (6,764
            )
            $
            (6,178
            )
            $
            (5,325
            )
            $
            (12,634
            )
            $
            (1,565
            )Loss
                per share:Weighted
                number of outstanding shares -basic
                and diluted
            
            
            18,826,966
            
            
            18,223,609
            
            
            12,964,498
            
            
            5,047,611
            
            
            2,881,877Loss
                per share
            
            $
            (0.36
            )
            $
            (0.34
            )
            $
            (0.41
            )
            $
            (2.50
            )
            $
            (0.54
            )SELECTED
                BALANCE SHEET DATA:Total
                assets
            
            $
            19,215
            
            $
            18,847
            
            $
            16,299
            
            $
            9,201
            
            $
            22,035Working
                capital (deficit)
            
            $
            (2,097
            )
            $
            6,786
            
            $
            3,294
            
            $
            (1,572
            )
            $
            1,775Long-term
                liabilities
            
            $
            6,420
            
            $
            7,812
            
            $
            3,322
            
            $
            2,849
            
            $
            2,830




(Note:
      Earnings per share information as previously reported for fiscal years ended
      December 31, 2002 and 2001 have been adjusted to a post-reverse split
      basis.)




23





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.”**





The
      following discussion and analysis gives effect to the restatement described
      in
      Note 3 in the Notes to the Consolidated Financial Statements. For this reason,
      the data in this section may not be comparable to discussions and data in our
      previously filed annual and quarterly reports.





**Executive
      Summary**





We
      are a
      leading provider of innovative, automated traffic enforcement systems and
      services to state and local governments throughout the United States. 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. CrossingGuard, our red light enforcement product,
      uses
      our patented image processing technology to predict and record the occurrence
      of
      a red light violation, manages the process of issuing and processing a citation.
      PoliScan *speed* ,
      our new
      speed enforcement product, uses technology developed by Vitronic. We have
      exclusive marketing rights to Poliscan in North America through February 2010,
      subject to meeting certain sales minimums. By coupling CrossingGuard and
      Poliscan equipment with Citation Composer, our proprietary citation preparation
      and processing software, we 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. Essentially all of our
      revenue prior to September 30, 2005 was generated through contracts for our
      CrossingGuard system as explained below. Beginning in the fourth quarter of
      2005, we started generating revenue from our PoliScan system. 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 such systems. Throughout 2003 and 2004, there was a trend by customers
      towards a fixed monthly fee as opposed to variable per ticket fee pricing
      structures for CrossingGuard systems. Because fixed fees are based upon the
      expected level of violations over the contract term, the shift to monthly fixed
      fee contracts should result in a more stable revenue stream for these
      installations. Many of our initial CrossingGuard 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 $2,000 to $12,000 per approach
      for
      system delivery and processing services.





State
      statutes providing for automated red light 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 are generally in the western
      part
      of the US, and 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. We delivered 11 and 20 systems to Delaware DOT in
      2004 and 2005, respectively, and have completed deliveries of units under the
      current contract terms.




24





Our
      existing CrossingGuard contracts with government entities typically authorize
      the installation of systems at a specified number of approaches. As of December
      31, 2005, our existing active contracts authorized the installation of our
      CrossingGuard product at up to an additional 172 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
                31,2005
            
            2004
            
            2003Number
                of Approaches and Units:Installed,
                operational and revenue-generating:CrossingGuard
                red light approaches
            
            
            171
            
            
            111
            
            
            88PoliscanspeedUnits
            
            
            4
            
            
            0
            
            
            0Additional
                Authorized Approaches:CrossingGuard
                red light approaches
            
            
            172
            
            
            128
            
            
            47PoliscanspeedUnits
            
            
            5
            
            
            0
            
            
            0Total
            
            
            352
            
            
            239
            
            
            135






On
      October 26, 2005, we deployed the first of four approved Poliscan systems in
      the
      City of Akron, Ohio. As of December 31, 2005, we had contracts with two
      municipalities authorizing the installation of up to 9 speed enforcement
      systems, including Akron. Our agreement with Akron is a pilot program that
      had
      an initial 90-day term followed by automatic monthly renewals. The program
      is
      still operating under those renewals. We expect that it will run until the
      end
      of the school year, and that, thereafter, Akron will seek a longer term program
      through an RFP. We will receive a fee of $19 to $23 per ticket paid under the
      agreement with Akron. We expect that our PoliScan speed contracts will compensate us on a per ticket paid basis **** in
      return
      for both equipment lease and citation processing and customer support services.
      We anticipate that we will generally receive fees from $10 to $25 per ticket
      under our future Poliscan contracts depending on factors including number of
      units ordered, length of contract, service levels provided, and
      competition. ****





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 costs related to customization of our products and services;
      announcements or introductions of new products and services by our competitors;
      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; equipment 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; 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; and the mix of revenue from our products and services.




25




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.





***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 sales
      arrangements exist, (b) delivery 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 and account
                for
                it either as a direct sale, in one instance as a sales type lease,
                as it
                met the criteria of a sales type lease in Financial Accounting Standards
                Board (FASB) Statement of Financial Accounting Standards (FAS) No.
                13 -
                Accounting for Leases, or in most other cases as an operating lease
                accounted for on a monthly basis. For each arrangement, usually upon
                delivery for the sales type lease or monthly for operating type leases,
                revenue is recognized as there exists evidence that an arrangement
                exists,
                the system is delivered, the price is fixed or determinable, and
                collectability is reasonably assured in accordance with SAB 104;





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, or our 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, as there exists evidence that an arrangement
                exists, services have been rendered or delivered (citations and other
                services are delivered), the price is fixed or determinable, and
                collectability is reasonably assured;
                and




26





c.
            For
                two current customers who want to process their own citations, we
                lease
                them our detection and tracking and citation processing and back
                office
                software and provide monthly customer support on the software. For
                this
                arrangement, we recognize revenue in accordance with 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.





***Unbilled
      contract revenue***





Unbilled
      contract revenue represents revenue earned by us in advance of being billable
      under customer contract terms. Under the terms of some current contracts, we
      cannot bill the municipality until the court has collected the citation fine.
      Through September 30, 2005, management recorded unbilled contract revenue in
      these situations at a net amount, based upon a historical pattern of collections
      by the courts for the municipalities. The pattern of collections on these
      citations was periodically reviewed and updated by management.





Based
      upon review of this policy during discussions with the Securities and Exchange
      examining division, management decided to defer recognition of income on these
      contracts until the municipality has collected the applicable citation to which
      we are entitled to a portion. Management implemented this change in the fourth
      quarter of 2005 and recorded a cumulative adjustment to reflect the change
      including a reduction of lease and service revenue and unbilled contract
      revenues of $149,000.





***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 uncollectable. 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 or not such
      equipment to be installed 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.





***Derivative
      Instruments***





In
      connection with the sale of debt or equity instruments, we 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 as 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.





The
      identification of, and accounting for, derivative instruments is complex.
      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.




27





***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.





***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. At times such investments may be in
      excess of the FDIC limit. However, 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 $1,280,000 at December
      31, 2005 compared with $6,422,000 at December 31, 2004. At December 31, 2005,
      we
      had a working capital deficit of $2,097,000 compared with working capital of
      $6,785,000 at December 31, 2004.





The
      $5,142,000 decline in cash is primarily due to the use of $7,782,000 in
      operating activities that generated our net loss and the use of $5,537,000
      in
      investing activities, primarily to install additional red light and mobile
      speed
      technology and acquire assets from a bankrupt competitor. These uses of cash
      were partially offset by $8,500,000 of net funding obtained during the year
      through the private placement of notes payable to accredited
      investors.





Our
      net
      worth at December 31, 2005 was $5,407,000 compared with $9,184,000 at December
      31, 2004. The decrease in net worth was primarily the result of our twelve
      month
      net loss of $6,764,000, partially offset by conversions to common stock by
      certain holders of our senior convertible notes in the principal amount of
      $800,000, an increase in additional paid-in capital resulting from the $419,000
      ascribed value of warrants issued relating to the issuance of a convertible
      note
      in May 2005, and a $1,078,000 increase in additional capital resulting from
      the
      ascribed value of stock issued related to our December 28, 2005 debt
      refinancing. We continue to seek additional sources of equity and debt financing
      to fund operations 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.





Historically,
      we have raised capital by/through a series of privately placed debt. **** See
      notes
      7 and 8 to the consolidated financial statements.





On
      May
      16, 2005, we sold a convertible note in the principal amount of $6,000,000
      to an
      accredited institutional investor, and issued 100,000 warrants at a per share
      exercise price ranging from $6.69 to $8.43 and expiring on May 16,
      2010.





On
      August
      30, 2005 and October 26, 2005, we issued secured promissory notes, each in
      the
      principal amount of $1,250,000, to two different accredited investors for the
      purpose of financing the purchase of mobile speed units.





On
      December 28, 2005, we sold a new note payable to Laurus Funds for an aggregate
      principal amount of $6,000,000, and issued common stock equal to 18% of the
      new
      financing, or 203,774 shares. The proceeds were used to retire the convertible
      note issued to Laurus in May 2005.




28





In
      January 2006, we sold 1,237,811 shares of common stock in a private placement
      at
      $4.42 per share raising $4,822,000, net of expenses, and issued 371,339 warrants
      at a per share exercise price of $4.91 that expire on January 31, 2009. We
      used
      $1,250,000 of the proceeds to retire a note payable and the remainder is being
      used for general corporate purposes


.


***Commitments,
      Contractual Obligations and Off-Balance Sheet
      Arrangements***





The
      following table summarizes the Company’s contractual obligations at December 31,
      2005, and the effect such obligations are expected to have on its cash flow
      in
      future periods:




**Payments
                due in:**
            
            **Operating
                Leases**
            
            **Heil
                Secured Promissory Note**
            
            **Foundation
                Partners Secured Promissory Note**
            
            **Senior
                Convertible Notes**
            
            **Fourth
                Laurus Note**
            
            **Debt
                Interest**
            
            **Total****2006**
            
            $
            205,000
            
            $
            1,250,000
            
            $
            1,250,000
            
            $
            **---**
            
            $
            1,636,000
            
            $
            1,120,000
            
            $
            5,461,000**2007**
            
            
            166,000
            
            
            **---**
            
            
            **---**
            
            
            5,200,000
            
            
            2,182,000
            
            
            799,000
            
            
            8,347,000**2008**
            
            
            135,000
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            2,182,000
            
            
            431,000
            
            
            2,748,000**2009**
            
            
            135,000
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            135,000**2010
                &**
            
            
            90,000
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            90,000**Thereafter**
            
            
            ---
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**
            
            
            **---**$
            731,000
            
            $
            1,250,000
            
            $
            1,250,000
            
            $
            5,200,000
            
            $
            6,000,000
            
            $
            2,350,000
            
            $
            16,781,000





As
      of
      December 31, 2005, we have no off balance sheet arrangements.





***Future
      Commitments***





For
      the
      twelve months ended December 31, 2005, we invested $3,680,000 in capitalized
      systems for CrossingGuard and speed units and $1,253,000 in roadside system
      costs expensed under a sales-type lease compared to $1,519,000 invested in
      capitalized systems and $333,000 in roadside system costs expensed in the
      comparable period last year. Management expects that we will make significant
      future commitments for systems related to our CrossingGuard contracts (currently
      for an additional 172 approaches) and our speed enforcement unit contracts
      (currently for an additional 5 units).





In
      November 2005, the Company signed a purchase agreement with one of its vendors.
      This agreement commits the Company to purchase a minimum of $750,000 over
      eighteen months expiring in May 2007.





29





**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**2005
            
            %
            
            2004
            
            %
            
            2003
            
            %(As
                Restated)
            
            
            
            (As
                Restated)Lease
                & Service Fees
            
            $
            5,975,000
            
            
            77
            %
            $
            5,118,000
            
            
            85
            %
            $
            2,677,000
            
            
            99
            %Sales
                & Royalty Revenue
            
            
            1,794,000
            
            
            23
            %
            
            917,000
            
            
            15
            %
            
            29,000
            
            
            1
            %Total
                Revenue
            
            
            7,769,000
            
            
            100
            %
            
            6,035,000
            
            
            100
            %
            
            2,706,000
            
            
            100
            %Cost
                of sales
            
            
            5,732,000
            
            
            74
            %
            
            3,932,000
            
            
            65
            %
            
            1,791,000
            
            
            66
            %Gross
                profit
            
            
            2,037,000
            
            
            26
            %
            
            2,103,000
            
            
            35
            %
            
            915,000
            
            
            34
            %Operating
                expenses
            
            
            11,315,000
            
            
            146
            %
            
            6,750,000
            
            
            112
            %
            
            5,176,000
            
            
            191
            %Loss
                from operations
            
            
            (9,277,000
            )
            
            119
            %
            
            (4,647,000
            )
            
            77
            %
            
            (4,261,000
            )
            
            157
            %(Loss)
                Gain on Debt
            
            
            (509,000
            )
            
            7
            %
            
            508,000
            
            
            8
            %
            
            ---
            
            
            0
            %Other
                income (expense)
            
            
            (704,000
            )
            
            9
            %
            
            (334,000
            )
            
            6
            %
            
            (629,000
            )
            
            23
            %Derivative
                instrument expense, net
            
            
            3,726,000
            
            
            48
            %
            
            (1,705,000
            )
            
            28
            %
            
            (435,000
            )
            
            16
            %Net
                loss
            
            $
            (6,764,000
            )
            
            87
            %
            $
            (6,178,000
            )
            
            102
            %
            $
            (5,325,000
            )
            
            197
            %








***Analysis
      of the Years Ended December 31, 2005 and December 31,
      2004***




*Revenue*




During
      the year ended December 31, 2005, revenue increased $1,734,000, or 29%, to
      $7,769,000 from $6,035,000 in the comparable period in 2004. The increase in
      overall revenue was primarily the result of an increase in lease and service
      fees and product sales.




Lease
      and
      service fee revenues totaled $5,975,000 in 2005, as compared with $5,118,000
      in
      2004, an increase of $857,000, or 17%, primarily due to additional revenue
      generating approaches. For the 2005 year, we began the year with 111 revenue
      generating approaches and ended with 171 revenue generating approaches. During
      the 2005 year we 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. In 2004, we started the year
      with
      88 revenue generating approaches, installed 23 approaches, and ended the year
      with 111 revenue generating approaches. Additionally, average monthly revenue
      generated from approaches installed in 2004 and before, decreased in 2005 as
      violation rates declined, which typically occurs due to modified driver
      behavior.





Product
      sales recognized from sales-type leases for CrossingGuard roadside systems,
      totaled $1,600,000 in the 2005 period, compared with $880,000 in the 2004
      period, an increase of $720,000 or 82%. This primarily represents delivery
      of 20
      roadside systems in the 2005 year, compared to delivery of 11 roadside systems
      in the 2004 year. Additionally, we recognized $158,000 in direct product sales
      of our CrossingGuard roadside systems in 2005, while in the 2004 period we
      did
      not have direct product sales. Residual royalty streams from two customers
      relating to technology licenses to IBM and NCS accounted for product royalty
      revenues of $36,000 and $37,000 in 2005 and 2004, respectively.





30





*Cost
      of Sales*




For
      the
      year ended December 31, 2005, cost of sales totaled $5,732,000, an increase
      of
      $1,800,000, or 46%, compared to $3,932,000 in 2004. The increase in cost of
      sales is primarily due to the cost of 9 more roadside systems installed under
      sales-type leases ($1,253,000 in 2005 as compared to $607,000 in 2004),
      increased amortization of more installed capitalized systems, other direct
      processing and support costs due to the increase in citation volumes processed,
      accelerated amortization of capitalized systems in the amount of $201,000 due
      to
      the red light enforcement law expiring in Virginia, and because we also recorded
      a $330,000 charge in 2005 to reserve for obsolete and excess inventory relating
      to the conversion and upgrade of certain installations from old to new
      technology to improve violation capture capability.





*Gross
      Profit*




For
      the
      year ended December 31, 2005, gross profit declined $66,000, or 3%, to
      $2,037,000 from $2,103,000 in 2004, while gross margin decreased by 9 percentage
      points to 26% for the year ended December 31, 2005 from 35% for the year ended
      December 31, 2004. The decline in gross profit is primarily attributable to
      a
      higher mix of lower margin sales-type leases in 2005 versus 2004, the $201,000
      of accelerated depreciation due to the shutdown of our Virginia customers as
      a
      result of the expiration of the red light enforcement law, and the $330,000
      of
      additional excess and obsolete inventory costs related to the conversion and
      upgrade of certain installations from old to new technology to improve violation
      capture capability.





*Operating
      Expenses*




Total
      operating expenses amounted to $11,315,000 in 2005, an increase of $4,565,000,
      or 68%, over total operating expenses of $6,750,000 in 2004. The increase is
      primarily due to increased engineering and operating expenses from growth in
      installed CrossingGuard systems and the development of our speed enforcement
      program, along with increased investments in our sales and marketing
      efforts.





Engineering
      and operations expenses totaled $4,050,000 in the year ended December 31, 2005,
      an increase of $586,000, or 17%, compared to $3,465,000 in 2004. The increase
      in
      engineering and operations expenses are primarily attributable to increased
      personnel and related field support costs driven by our increased installed
      base
      as well as an increase in design and engineering consultant
      expenses.





Research
      and development expenses totaled $1,737,000 in the year ended December 31,
      2005,
      an increase of $1,579,000 compared with $157,000 in the comparable year of
      2004.
      The increase in research and development expenses primarily resulted from
      increased spending in salary and related personnel costs and development
      consultants attributable to projects advancing our CrossingGuard product
      technology and development and commercialization of our mobile speed enforcement
      system.





Selling
      and marketing expenses totaled $2,057,000 in the year ended December 31, 2005,
      an increase of $1,183,000, or 135%, compared with $874,000 in 2004. Selling
      and
      marketing expenses increases in 2005 are primarily attributable to a larger
      sales force and support personnel with related increases in sales commissions
      and travel expenses, as well as due to the strategic use of consultants and
      marketing activities during the year.





General
      and administrative expenses totaled $3,470,000 for the year ended December
      31,
      2005, an increase of $1,216,000, or 54%, compared with $2,254,000 in 2004.
      The
      increase in general and administrative expenses for the year ended December
      31,
      2005 compared to 2004 is primarily related to (i) an increase in payroll and
      related costs, (ii) an increase in accounting and related costs, (iii) an
      increase in legal expenses for the prosecution of patent infringement cases,
      which were concluded in June 2005, (iv) an increase in financing fees due to
      note conversions and a new financing arrangement, and (v) increased costs
      associated with shareholder communication and meetings.




*Gain
      on Debt Extinguishment*




During
      the year ended December 31, 2004, obligations to Electronic Data Systems, or
      EDS, under a lease payable and obligations to Laurus under a convertible note
      originally issued in July 2003 were fully satisfied, resulting in a net gain
      of
      $508,000. An early payment on the lease payable resulted in a gain of $681,000,
      which was partially offset by a prepayment penalty of $173,000 incurred in
      the
      repayment of the convertible note.




31





*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 $704,000 in the year ended December 31, 2005, an increase
      of $370,000, or 111%, compared with other expense, net of $334,000 in 2004.
      In
      the year ended December 31, 2005, we incurred increased interest expense as
      a
      result of higher debt levels, which was partially offset by earnings on
      investments.





*Derivative
      instrument income/expense, net*





For
      the
      year ended December 31, 2005, derivative instrument income, net was $3,726,000
      as compared to derivative instrument expense, net of $1,705,000 for the year
      ended December 31, 2004. The change was attributable to changes in the fair
      market value of embedded derivatives issued with convertible debt as well as
      for
      the amortization of the related debt discount established at the time the
      derivative was bifurcated from the debt when the debt was issued. 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
      time to maturity of the outstanding debt at different points in time. The major
      factors contributing to the change for the year ended December 31, 2005 were
      due
      to the decline in the fair market value of our derivative instrument liabilities
      relating to our senior convertible note due to the passage of time partially
      offset by related debt discount amortization. The major factor contributing
      to
      the change for the year ended December 31, 2004 was attributable to the increase
      in the fair market value of our derivative instrument liabilities relating
      to
      the increase in our stock price.





*Net
      Loss*




For
      the
      year ended December 31, 2005, we incurred a net loss of $6,764,000, or $0.36
      per
      share, an increase of $586,000, compared with a net loss of $6,178,000, or
      $0.34
      per share, in 2004. The increase in the net loss was a result of (i) substantial
      investment in operating activities during 2005 of $7,782,000 to improve the
      CrossingGuard technologies, introduce and integrate the Poliscan speed technology,
      deliver the increased revenues, and to support overall expansion of the
      companies business; (ii) additional financing and interest costs, related to
      our
      debt and financing arrangements, and; (iii) offset by the change in fair market
      value of the embedded derivatives in our senior convertible notes.





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, 2005, there were 18,826,966 basic and diluted
      weighted average shares outstanding compared with 18,223,609 for the year ended
      2004.





***Analysis
      of the Years Ended December 31, 2004 and 2003***




*Revenue*




During
      the year ended December 31, 2004, revenue increased $3,329,000, or 123%, to
      $6,035,000 from $2,706,000 in 2003. The increase in overall revenue was
      primarily the result of an increase in lease and service fees and product sales.




Lease
      and
      service fees totaled $5,118,000 in 2004, as compared with $2,677,000 in 2003,
      an
      increase of $2,441,000, or 91%. The increase in lease and service fees were
      largely attributable to an entire year of revenue from 88 installed approaches
      during 2004 compared to an entire year of revenue from 42 installed approaches
      during 2003 and the installation of an additional 23 approaches during 2004.





Product
      sales, which are recognized from capital sales-type leases for certain
      CrossingGuard systems sold to Delaware DOT, totaled $880,000 in 2004, as
      compared with $0 in 2003, an increase of $880,000. Product sales for 2004
      represent six CrossingGuard systems sold to Delaware DOT that were financed
      through GE Capital. Product royalties totaled $37,000 in 2004, as compared
      with
      $29,000 in 2003, an increase of $8,000, or 28%. Residual royalty streams from
      two customers relating to technology licenses to IBM and NCS accounted for
      all
      product royalty.




32





*Costs
      of Sales*




Cost
      of
      sales totaled $3,932,000 in 2004 as compared to $1,791,000 in 2003, an increase
      of $2,141,000, or 120%. The increase in cost of sales in 2004 was primarily
      due
      to an increase in amortization in the amount of $990,000 because of more
      installed approaches in 2004 compared to 2003, including $184,000 of accelerated
      amortization on certain installed approaches that were not renewed, and $558,000
      of amortization under sales-type lease accounting for the CrossingGuard systems
      sold to Delaware DOT.





*Gross
      Profit*




For
      the
      year ended December 31, 2004, gross profit increased $1,188,000, or 130%, to
      $2,103,000 from $915,000 in the prior year, while gross margin increased by
      1%
      to 35% for the year ended December 31, 2005 from 34% for 2003. The increase
      in
      gross profit is primarily attributable to an average of 100 installed approaches
      operating during 2004 as compared to an average of 64 approaches in
      2003.





*Operating
      Expenses*




Total
      operating expenses amounted to $10,682,000 in the year ended December 31, 2004,
      an increase of $3,715,000, or 53%, over total operating expenses of $6,967,000
      in 2003. The primary changes in 2004 include increased amortization on a greater
      number of installed approaches, an increase in cost of sales as a result of
      the
      sales-type lease accounting for the CrossingGuard systems sold to Delaware
      DOT,
      a significant increase in sales consulting expenses and $381,000 of additional
      patent lawsuit defense expenses. Additionally, headcount increased 33% in 2004
      compared 2003, which caused an increase in salaries and fringe benefits and
      related travel expenses.





Engineering
      and operations expenses totaled $3,464,000 in 2004, as compared with $2,578,000
      in 2003, an increase of $886,000, or 34%. The increase in engineering and
      operations expenses in 2004 reflected the additional internal and field-based
      expenses, including expenses for travel, tools and supplies, to support the
      growing number of installed approaches. Engineering and operations staff growth
      in 2004 included redeployment of five people from other departments to field
      support in addition to the hiring of six new employees.





Research
      and development expenses totaled $157,000 in the year ended December 31, 2004,
      as compared with $121,000 in 2003, an increase of $36,000, or 30%. The increase
      in research and development expenses in 2004 was directly attributable to
      materials purchased in support of on-going research activities.





Selling
      and marketing expenses increased $519,000 to $874,000, or 146%, in the year
      ended December 31, 2004, from $355,000 in 2003. The increase in 2004 costs
      reflected the hiring of a nationwide sales force and the use of outside
      consultants to support sales activity in strategic markets.





General
      and administrative expenses totaled $2,254,000 in 2004, as compared with
      $2,121,000 in 2003, an increase of $133,00, or 6%. The increase in general
      and
      administrative expenses was largely the net result of $381,000 for patent
      lawsuit defense costs in 2004, offset by a $124,000 decrease in financing fees
      for 2004 and a $180,000 expense for an employee settlement agreement in
      2003.





*Gain
      on Debt Extinguishment*




Obligations
      to EDS under a lease payable and obligations to Laurus under a convertible
      note
      issued in July 2003 were fully satisfied in January 2004, resulting in a net
      gain of $508,000. An early payment on the lease payable resulted in a gain
      of
      $681,000, which was partially offset by a prepayment penalty of $173,000
      incurred in the repayment of the convertible note. There were no corresponding
      gains or prepayment penalties during 2003.




33





*Contract
      Termination Reserve*




A
      significant customer contract in our former Rail line of business was terminated
      by mutual agreement prior to its completion as a result of our decision to
      focus
      our resources on CrossingGuard systems and services. We accrued $125,000 of
      estimated contract termination fees in June 2003, the entire amount of which
      was
      paid in December 2004.





*Other
      Expense - Net*




For
      2004,
      other expense, net was $334,000, as compared with other expense, net of $504,000
      in 2003, a decrease of $170,000, or 34%. In 2004, other expense included $80,000
      of interest expense accrued as a result of a 2004 sales and use tax audit,
      a
      decrease of $144,000 in interest expense associated with notes payable, a
      $96,000 realized loss on marketable equity securities and a decrease of $44,000
      in warrant amortization as warrants were fully amortized in July 2004.
      Non-recurring 2003 items included $164,000 of interest expense paid to EDS
      offset by a $64,000 favorable vendor settlement.





*Derivative
      instrument income/expense, net*





For
      the
      year ended December 31, 2004, derivative instrument expense, net was $1,705,000
      as compared to derivative instrument expense, net of $435,000 for the year
      ended
      December 31, 2003. The change was attributable to changes in the fair market
      value of embedded derivatives issued with convertible debt as well as for the
      amortization of the related debt discount established at the time the derivative
      was bifurcated from the debt when the debt was issued. 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 time
      to
      maturity of the outstanding debt at different points in time. The major factor
      contributing to the change for the year ended December 31, 2003 was attributable
      to the increase in the fair market value of our derivative instrument
      liabilities relating to the increase in our stock price.





*Net
      Loss*




During
      2004, we recorded a net loss of $6,178,000, as compared with a loss of
      $5,325,000 in 2003, an increase of $853,000, or 16%. For the year ended December
      31, 2004, net loss per share was $0.34 compared to a net loss per share of
      $0.41
      in 2003.





ITEM
              7A.
            Quantitative
                and Qualitative Disclosure about Market
                Risk




The
      following discussion of our market risk includes forward looking statements
      that
      involve risk and uncertainty. Actual results could differ materially from those
      projected in the forward looking statements. Market risk represents risk of
      changes in value of a financial instrument caused by fluctuations in interest
      rates, foreign exchange rates and equity and bond prices.





Interest
      Rates





Our
      marketable securities, an insured municipal bond fund, valued at $56,000 at
      December 31, 2005, are exposed to market risk due to changes in U.S. interest
      rates. The primary objective of our investment activities is the preservation
      of
      principal while maximizing investment income. Our exposure to this market risk
      is moderately high in the short-term. During the year ended December 31, 2005,
      we had an unrealized loss of $14 on securities held at December 31, 2005. The
      securities are classified as “trading securities” and accordingly are reported
      at fair value with unrealized gains and losses included in other expense,
      net.





We
      have a
      senior convertible note payable with interest fixed at 5% through its October
      2007 maturity. We have a secured promissory note with a fixed interest rate
      of
      approximately 10% that matures in November 2006. Management assesses the
      exposure to market risk for these obligations as minimal. In addition, we have
      a
      non-convertible note payable with a principal amount of $6,000,000 with a
      variable interest rate, currently the prime rate plus 2%. This three year note
      begins monthly principal amortization payments in April 2006. Our exposure
      to
      this interest rate risk is moderately high in the intermediate term. Management
      assesses the exposure to market risk for these obligations as minimal.





34




ITEM
              8.
            Financial
                Statements and Supplementary Data





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, 2005**





35




NESTOR,
      INC.





CONTENTS





Page
                No.Report
                of Independent Registered Public Accounting Firm
            37Consolidated
                Balance Sheets -December
                31, 2005 and 2004 (as restated)
            38Consolidated
                Statements of Operations -For
                the Years Ended December 31, 2005, 2004 (as restated) and 2003 (as
                restated)
            39Consolidated
                Statements of Stockholders' Equity -For
                the Years Ended December 31, 2005, 2004 (as restated) and 2003 (as
                restated)
            40Consolidated
                Statements of Cash Flows -For
                the Years Ended December 31, 2005, 2004 (as restated) and 2003 (as
                restated)
            41Notes
                to the Consolidated Financial Statements
            42





36




**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, 2005 and 2004, and the related consolidated statements of
      operations, stockholders’ equity and cash flows for each of the years in the
      three-year period ended December 31, 2005. Our audit also included the financial
      statement schedule for the year ended December 31, 2005 listed in the index
      at
      Item 15(a)(2). These consolidated financial statements and schedule are the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on these consolidated financial statements and schedule 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 audit 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.




As
      discussed in Note 3 to the consolidated financial statements, the Company
      restated its 2004 and 2003 consolidated financial statements.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of Nestor, Inc.
      as
      of December 31, 2005 and 2004, and the consolidated results of its operations
      and its cash flows for each of the years in the three-year period ended December
      31, 2005, in conformity with accounting principles generally accepted in the
      United States of America. Also, in our opinion, the related financial statement
      schedule, when considered in relation to the basic consolidated financial
      statements taken as a whole, presents fairly, in all material respects, the
      information set forth therein.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      Nestor, Inc. will continue as a going concern. As disclosed in the consolidated
      financial statements, Nestor, Inc. has an accumulated deficit at December 31,
      2005 and has suffered substantial net losses in recent years, which raise
      substantial doubt about Nestor, Inc.’s ability to continue as a going concern.
      Management's plans in regard to these matters are disclosed in Note 1. The
      financial statements do not include any adjustments that might result from
      the  outcome
      of this uncertainty.




/s/
      Carlin, Charron, & Rosen, LLP.


Westborough,
      Massachusetts


April
      12,
      2006




37





**NESTOR,
      INC.**


**Consolidated
      Balance Sheets**


IN
        THOUSANDS, EXCEPT SHARE AND PER SHARE INFORMATION





**DECEMBER
                31, 2005******
            
            **DECEMBER
                31, 2004****(As
                Restated)****ASSETS****CURRENT
                ASSETS:**Cash
                and cash equivalents
            
            $
            1,224
            
            $
            5,850Marketable
                securities
            
            
            56
            
            
            572Accounts
                receivable, net
            
            
            1,949
            
            
            763Unbilled
                contract revenue
            
            
            ---
            
            
            111Inventory,
                net
            
            
            1,671
            
            
            1,032Other
                current assets
            
            
            391
            
            
            308Total
                current assets
            
            
            5,291
            
            
            8,636**NONCURRENT
                ASSETS:**Capitalized
                system costs, net
            
            
            5,379
            
            
            3,749Property
                and equipment, net
            
            
            925
            
            
            357Goodwill
            
            
            5,581
            
            
            5,581Patent
                development costs, net
            
            
            146
            
            
            162Other
                long term assets
            
            
            1,893
            
            
            362**TOTAL
                ASSETS**
            
            $
            19,215
            
            $
            18,847**LIABILITIES
                AND STOCKHOLDERS’ EQUITY****CURRENT
                LIABILITIES:**Current
                portion of notes payable
            
            $
            4,136
            
            $
            ---Accounts
                payable
            
            
            1,071
            
            
            620Accrued
                liabilities
            
            
            1,470
            
            
            644Accrued
                employee compensation
            
            
            478
            
            
            461Deferred
                revenue
            
            
            103
            
            
            92Leases
                payable
            
            
            1
            
            
            23Asset
                retirement obligation
            
            
            129
            
            
            11Total
                current liabilities
            
            
            7,388
            
            
            1,851**NONCURRENT
                LIABILITIES:**Long
                term convertible notes payable
            
            
            1,650
            
            
            514Long
                term notes payable
            
            
            3,286
            
            
            ---Derivative
                financial instruments
            
            
            1,419
            
            
            7,081Long
                term asset retirement obligation
            
            
            65
            
            
            147Long
                term, other
            
            
            ---
            
            
            70Total
                liabilities
            
            
            13,808
            
            
            9,663Commitments
                and contingencies
            
            
            ---
            
            
            ---**STOCKHOLDERS’
                EQUITY:**Preferred
                stock, $1.00 par value, authorized 10,000,000 shares; issued and
                outstanding: Series B - 180,000 shares at December 31, 2005 and December
                31, 2004
            
            
            180
            
            
            180Common
                stock, $0.01 par value, authorized 30,000,000 shares; issued and
                outstanding: 19,127,065 shares at December 31, 2005 and 18,673,498
                shares
                at December 31, 2004
            
            
            191
            
            
            187Warrants
            
            
            9
            
            
            66Additional
                paid-in capital
            
            
            66,015
            
            
            62,975Accumulated
                deficit
            
            
            (60,988
            )
            
            (54,224
            )Total
                stockholders’ equity
            
            
            5,407
            
            
            9,184**TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY**
            
            $
            19,215
            
            $
            18,847





***See*** ***Notes*** ***to the Consolidated Financial Statements.***





38





**NESTOR,
      INC.**


**Consolidated
      Statements of Operations**


In
      Thousands, Except Share And Per Share Information




**Year
                Ended December 31,****2005**
            
            **2004**
            
            **2003****(As
                Restated)**
            
            **(As
                Restated)**Revenues:Lease
                and service fees
            
            $
            5,975
            
            $
            5,118
            
            $
            2,677Product
                sales
            
            
            1,758
            
            
            880
            
            
            ---Product
                royalties
            
            
            36
            
            
            37
            
            
            29Total
                revenue
            
            
            7,769
            
            
            6,035
            
            
            2,706Cost
                of sales:Lease
                and service fees
            
            
            4,341
            
            
            3,323
            
            
            1,791Product
                sales
            
            
            1,391
            
            
            609
            
            
            ---Product
                royalties
            
            
            ---
            
            
            ---
            
            
            ---Total
                cost of sales
            
            
            5,732
            
            
            3,932
            
            
            1,791Gross
                profit:Lease
                and service fees
            
            
            1,634
            
            
            1,795
            
            
            886Product
                sales
            
            
            367
            
            
            271
            
            
            ---Product
                royalties
            
            
            36
            
            
            37
            
            
            29Total
                gross profit
            
            
            2,037
            
            
            2,103
            
            
            915Operating
                expenses:Engineering
                and operations
            
            
            4,050
            
            
            3,465
            
            
            2,578Research
                and development
            
            
            1,737
            
            
            157
            
            
            122Selling
                and marketing
            
            
            2,057
            
            
            874
            
            
            355General
                and administrative
            
            
            3,470
            
            
            2,254
            
            
            2,121Total
                operating expenses
            
            
            11,314
            
            
            6,750
            
            
            5,176Loss
                from operations
            
            
            (9,277
            )
            
            (4,647
            )
            
            (4,261
            )Gain
                on debt extinguishment, net
            
            
            ---
            
            
            508
            
            
            ---(Loss)
                on debt refinancing
            
            
            (509
            )
            
            ---
            
            
            ---Other
                (expense) income, net
            
            
            (704
            )
            
            (334
            )
            
            (629
            )Derivative
                instrument income (expense), net
            
            
            3,726
            
            
            (1,705
            )
            
            (435
            )Net
                loss
            
            $
            (6,764
            )
            $
            (6,178
            )
            $
            (5,325
            )Loss
                per share:Loss
                per share, basic and diluted
            
            $
            (0.36
            )
            $
            (0.34
            )
            $
            (0.41
            )Shares
                used in computing loss per share:Basic
                and diluted
            
            
            18,826,966
            
            
            18,223,609
            
            
            12,964,498





***See*** ***Notes*** ***to the Consolidated Financial Statements.***








39





**NESTOR,
      INC.**


**Consolidated
      Statements of Stockholders’ Equity**


**For
      the Years Ended December 31, 2005, 2004 and 2003**


In
      Thousands, Except Share And Per Share Information




Preferred
                Stock
            
            Common
                StockShares
            
            Amount
            
            Shares
            
            Amount
            
            Warrants
            
            Additional
                Paid-inCapital
            
            Stock
                PendingIssuance
            
            AccumulatedDeficit
            
            Total**Balance
                at December 31, 2002**
            
            
            **235,000**
            
            **$**
            **235**
            
            
            **5,024,111**
            
            **$**
            **50**
            
            **$**
            **1,073**
            
            **$**
            **45,228**
            
            **$**
            **---**
            
            **$**
            **(42,721**
            **)**
            **$**
            **3,865**Issuance
                of Common Stock
            
            
            ---
            
            
            ---
            
            
            8,968,627
            
            
            90
            
            
            ---
            
            
            3,998
            
            
            ---
            
            
            ---
            
            
            4,088Conversion
                of Preferred Stock to Common Stock
            
            
            (45,000
            )
            
            (45
            )
            
            4,500
            
            
            ---
            
            
            ---
            
            
            45
            
            
            ---
            
            
            ---
            
            
            ---Stock
                issuance outstanding
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            6,336
            
            
            ---
            
            
            6,336Issuance
                of warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            158
            
            
            ---
            
            
            ---
            
            
            158Accretion
                value of warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            106
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            106Variable
                warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            198
            
            
            (198
            )
            
            ---
            
            
            ---
            
            
            ---Loss
                for the year ended December 31, 2003
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (5,325
            )
            
            (5,325
            )**Balance
                at December 31, 2003 - Restated**
            
            
            **190,000**
            
            **$**
            **190**
            
            
            **13,997,238**
            
            **$**
            **140**
            
            **$**
            **1,377**
            
            **$**
            **49,231**
            
            **$**
            **6,336**
            
            **$**
            **(48,046**
            **)**
            **$**
            **9,228**Issuance
                of Common Stock
            
            
            ---
            
            
            ---
            
            
            3,519,384
            
            
            35
            
            
            ---
            
            
            9,721
            
            
            (6,336
            )
            
            ---
            
            
            3,420Conversion
                of notes payable
            
            
            ---
            
            
            ---
            
            
            865,761
            
            
            9
            
            
            ---
            
            
            2,605
            
            
            ---
            
            
            ---
            
            
            2,614Exercise
                of cashless warrants
            
            
            ---
            
            
            ---
            
            
            262,115
            
            
            3
            
            
            ---
            
            
            (3
            )
            
            ---
            
            
            ---
            
            
            ---Exercise
                of incentive stock options
            
            
            ---
            
            
            ---
            
            
            28,000
            
            
            ---
            
            
            ---
            
            
            38
            
            
            ---
            
            
            ---
            
            
            38Conversion
                of Preferred Stock to Common Stock
            
            
            (10,000
            )
            
            (10
            )
            
            1,000
            
            
            ---
            
            
            ---
            
            
            10
            
            
            ---
            
            
            ---
            
            
            ---Accretion
                value of warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            62
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            62Expired
                warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (1,225
            )
            
            1,225
            
            
            ---
            
            
            ---
            
            
            ---Variable
                warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (148
            )
            
            148
            
            
            ---
            
            
            ---
            
            
            ---Loss
                for the year ended December 31, 2004
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (6,178
            )
            
            (6,178
            )**Balance
                at December 31, 2004 - Restated**
            
            
            **180,000**
            
            **$**
            **180**
            
            
            **18,673,498**
            
            **$**
            **187**
            
            **$**
            **66**
            
            **$**
            **62,975**
            
            **$**
            **---**
            
            **$**
            **(54,224**
            **)**
            **$**
            **9,184**Issuance
                of Common Stock
            
            
            ---
            
            
            ---
            
            
            203,774
            
            
            2
            
            
            ---
            
            
            1,078
            
            
            ---
            
            
            ---
            
            
            1,080Conversion
                of notes payable
            
            
            ---
            
            
            ---
            
            
            137,456
            
            
            1
            
            
            ---
            
            
            799
            
            
            ---
            
            
            ---
            
            
            800Exercise
                of incentive stock options
            
            
            ---
            
            
            ---
            
            
            100,844
            
            
            1
            
            
            ---
            
            
            226
            
            
            ---
            
            
            ---
            
            
            227Exercise
                of warrants
            
            
            ---
            
            
            ---
            
            
            11,493
            
            
            ---
            
            
            ---
            
            
            5
            
            
            ---
            
            
            ---
            
            
            5Variable
                warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (57
            )
            
            57
            
            
            ---
            
            
            ---
            
            
            ---Issuance
                of Warrants
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            705
            
            
            ---
            
            
            ---
            
            
            705Issuance
                of Laurus Note beneficial conversion features
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            38
            
            
            ---
            
            
            ---
            
            
            38Issuance
                of Stock Options for sales commissions
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            132
            
            
            ---
            
            
            ---
            
            
            132Loss
                for the year ended December 31, 2005
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            (6,764
            )
            
            (6,764
            )**Balance
                at December 31, 2005**
            
            
            **180,000**
            
            **$**
            **180**
            
            
            **19,127,065**
            
            **$**
            **191**
            
            **$**
            **9**
            
            **$**
            **66,015**
            
            **$**
            **---**
            
            **$**
            **(60,988**
            **)**
            **$**
            **5,407**




***See
      Notes to the Consolidated Financial Statements.***





40





**NESTOR,
      INC.**


**Consolidated
      Statements of Cash Flows**


In
      Thousands, Except Share And Per Share Information


**YEARS
                  ENDED DECEMBER 31,****2005**
              
              **2004**
              
              **2003****(AS
                  RESTATED)**
              
              **(AS
                  RESTATED)****CASH
                  FLOWS FROM OPERATING ACTIVITIES:**Net
                  loss
              
              $
              (6,764
              )
              $
              (6,178
              )
              $
              (5,325
              )Adjustments
                  to reconcile net loss to net cash used by operating activities:Depreciation
                  and amortization
              
              
              2,398
              
              
              2,037
              
              
              1,012Derivative
                  instrument expense, net
              
              
              (3,726
              )
              
              1,705
              
              
              435Loss
                  on disposal of fixed assets
              
              
              ---
              
              
              5
              
              
              5(Gain)
                  on extinguishment of debt, net
              
              
              ---
              
              
              (508
              )
              
              ---Loss
                  on debt refinancing
              
              
              509
              
              
              ---
              
              
              ---Unrealized
                  loss on marketable securities
              
              
              14
              
              
              10
              
              
              ---Realized
                  loss on marketable securities
              
              
              ---
              
              
              96
              
              
              ---Dividends
                  reinvested
              
              
              (89
              )
              
              (35
              )
              
              ---Expenses
                  charged to operations relating to options, warrants and capital
                  transactions
              
              
              367
              
              
              62
              
              
              265Provision
                  for doubtful accounts
              
              
              80
              
              
              34
              
              
              84Provision
                  for inventory reserves
              
              
              317
              
              
              50
              
              
              ---Increase
                  (decrease) in cash arising from changes in assets and
                  liabilities:Accounts
                  receivable, net
              
              
              (1,258
              )
              
              (276
              )
              
              (465
              )Unbilled
                  contract revenue
              
              
              111
              
              
              48
              
              
              (36
              )Inventory,
                  net
              
              
              (752
              )
              
              (650
              )
              
              (178
              )Other
                  assets
              
              
              (276
              )
              
              (496
              )
              
              82Accounts
                  payable and accrued expenses
              
              
              1,329
              
              
              163
              
              
              (137
              )Deferred
                  income
              
              
              (42
              )
              
              125
              
              
              20Restructuring
                  reserve
              
              
              ---
              
              
              (147
              )
              
              (219
              )Net
                  cash used for operating activities
              
              
              (7,782
              )
              
              (3,955
              )
              
              (4,457
              )**CASH
                  FLOWS FROM INVESTING ACTIVITIES:**Investment
                  in marketable securities
              
              
              ---
              
              
              (1,500
              )
              
              ---Liquidation
                  of marketable securities
              
              
              591
              
              
              857
              
              
              ---Purchase
                  of Transol assets
              
              
              (1,760
              )
              
              ---
              
              
              ---Investment
                  in capitalized systems
              
              
              (3,562
              )
              
              (1,829
              )
              
              (2,341
              )Purchase
                  of property and equipment
              
              
              (799
              )
              
              (232
              )
              
              (86
              )Investment
                  in patent development costs
              
              
              (7
              )
              
              (7
              )
              
              (31
              )Net
                  cash used for investing activities
              
              
              (5,537
              )
              
              (2,711
              )
              
              (2,458
              )**CASH
                  FLOWS FROM FINANCING ACTIVITIES:**Repayment
                  of obligations under capital leases
              
              
              (39
              )
              
              (2,260
              )
              
              (293
              )Proceeds
                  from notes payable
              
              
              14,500
              
              
              6,098
              
              
              4,000Repayment
                  of note payable
              
              
              (6,000
              )
              
              (195
              )
              
              ---Proceeds
                  from issuance of common stock, net
              
              
              232
              
              
              3,463
              
              
              4,002Proceeds
                  from stock pending issuance
              
              
              ---
              
              
              ---
              
              
              4,307Net
                  cash provided by financing activities
              
              
              8,693
              
              
              7,106
              
              
              12,016Net
                  change in cash and cash equivalents
              
              
              (4,626
              )
              
              440
              
              
              5,101Cash
                  and cash equivalents - beginning of year
              
              
              5,850
              
              
              5,410
              
              
              309Cash
                  and cash equivalents - end of year
              
              $
              1,224
              
              $
              5,850
              
              $
              5,410**SUPPLEMENTAL
                  CASH FLOWS INFORMATION:**Interest
                  paid
              
              $
              846
              
              $
              93
              
              $
              362Income
                  taxes paid
              
              $
              ---
              
              $
              ---
              
              $
              ---




***Significant
      non-cash transactions are further described in Notes 7, 8, and
      11.***


***See
      Notes to the Consolidated Financial Statements.***





41


**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. The consolidated financials statements include the accounts
      of
      Nestor, Inc. and our wholly-owned subsidiary. All intercompany transactions
      and
      balances have been eliminated. Our principal office is located in Providence,
      RI.




We
      are a
      provider of innovative, automated traffic enforcement systems and services
      to
      state and local governments throughout the United States. We provide 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. Our principal product, CrossingGuard, incorporates our patented image
      processing technology into a solution that predicts and records the occurrence
      of a red light violation. Our speed enforcement product,
      Poliscanspeed, or Poliscan, utilizes technology developed by Vitronic
      GmbH. We have exclusive distribution rights to market in North America. By
      coupling CrossingGuard or Poliscan equipment with our Citation Composer citation
      preparation and processing software, we are able to provide fully integrated
      speed enforcement solutions to municipalities.





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,
      have a working capital deficit of $2,097 at December 31, 2005, and have an
      accumulated deficit of $60,988 through December 31, 2005. 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.




Although
      the Company raised $4,847, net of expenses in a private stock placement in
      January 2006, $1,250 of which was used to pay down debt. Management believes
      that given its liquidity at December 31, 2005, 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.
            *Cash
                equivalents*





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





*B.*
            *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).





42


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


C.
            *Accounts
                receivable*





Accounts
      receivable represents balances due from customers, net of $164 and $84 reserve
      for doubtful accounts at December 31, 2005 and 2004. 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.




D.
            *Unbilled
                contract revenue*





Unbilled
      contract revenue represented revenue earned by the Company in advance of being
      billable under customer contract terms. Under the terms of some current
      contracts, the Company cannot bill the municipality until the court has
      collected the citation fine. Management recorded unbilled contract revenue
      in
      these situations at a net amount, based upon a historical pattern of collections
      by the courts for the municipalities. In 2005, The Company discontinued this
      practice and records revenue when the citation has been paid.





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 December 31, 2005 and 2004 inventory balances are presented
      net of a $540 and $50, respectively, inventory reserve.





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 are an inherent cost
      of
      the Company’s business - 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. 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 under the American Institute of Certified
      Public Accountants Statement of Position 98-1.




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 sales
      arrangements exist, (b) delivery 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.




43


**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 and account
                for
                it either as a direct sale, in one instance as a sales type lease,
                as it
                met the criteria of a sales type lease in Financial Accounting Standards
                Board (FASB) Statement of Financial Accounting Standards (FAS) No.
                13 -
                Accounting for Leases, or in most other cases as an operating lease
                accounted for on a monthly basis. For each arrangement, usually upon
                delivery for the sales type lease or monthly for operating type leases,
                revenue is recognized as there exists evidence that an arrangement
                exists,
                the system is delivered, the price is fixed or determinable, and
                collectability is reasonably assured in accordance with SAB
                104;





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, or our 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, as there exists evidence that an arrangement
                exists, services have been rendered or delivered (citations and other
                services are delivered), the price is fixed or determinable, and
                collectability is reasonably assured;
                and





c)
            For
                two current customers who want to process their own citations, we
                lease
                them our detection and tracking and citation processing and back
                office
                software and provide monthly customer support on the software. For
                this
                arrangement, we recognize revenue in accordance with 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.
            *Shipping
                and handling costs*





Shipping
      and handling costs are capitalized if a material part of a leased system or
      included in engineering and operations.





K.
            *Research
                and development*





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





L.
            *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.




44


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




M.
            *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 EPS is computed giving
      effect to common stock equivalents and other dilutive securities, unless the
      computation results in anti-dilution. Diluted per share computations are not
      presented since the effect would be anti-dilutive.





N.
            *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.





O.
            *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. At times
      such
      investments may be in excess of the FDIC limit. However, 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.





Two
      customers accounted for 51% and 40% of the Company’s total revenues in fiscal
      2005 and 2004. Three customers accounted for 42% of the Company’s total revenues
      during fiscal 2003.





P.
            *Stock
                option plans*





The
      Company accounts for stock option awards granted to officers, directors and
      employees (collectively “employees”) under the recognition and measurement
      principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock
      Issued to Employees” (“APB 25”). Under APB 25, no stock-based employee
      compensation cost is reflected in net income, as all options granted to
      employees under these plans have been granted at no less than fair market value
      on the date of grant. The Company applies the disclosure only provision of
      Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for
      Stock-based Compensation” (“SFAS 123”) and SFAS No. 148, “Accounting for
      Stock-based Compensation-Transition and Disclosure (“SFAS 148”) for such
      employee stock option awards. The Company accounts for stock option awards
      granted to consultants under the fair value recognition provisions of SFAS
      123.
      Under this method, options are valued using the Black-Scholes option pricing
      model, and the calculated option value is recorded as an expense in the
      financial statements.





For
      purposes of providing pro forma disclosures for employee grants, the fair value
      for options was estimated at the date of grant using the Black-Scholes pricing
      model with the following weighted average assumptions:




2005
            
            2004
            
            2003Expected
                life (years)
            
            
            8
            
            
            8
            
            
            8Average
                risk-free interest rate
            
            
            3.2
                to 4.2
            %
            
            1.6
                to 6.8
            %
            
            1.6
                to 6.8
            %Volatility
            
            
            107.7
            %
            
            113.2
            %
            
            117.4
            %Dividend
                yield
            
            
            0
            %
            
            0
            %
            
            0
            %





The
      weighted-average fair value of options granted during 2005, 2004 and 2003 was
      $4.98, $4.17, and $2.55, respectively. The Company recognizes forfeitures as
      they occur.




45


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




Had
      the
      Company determined compensation expense for the Plan in accordance with the
      fair
      value methodology prescribed by SFAS 123, the Company’s pro forma net loss and
      loss per share would have been:





Years
                Ended December 31,2005
            
            2004
            
            2003Net
                loss - reported
            
            $
            (6,764
            )
            $
            (6,178
            )
            $
            (5,325
            )Add
                (Deduct): total stock-based compensation expense determined under
                fair-value based method for all awards,net of related tax
                effects
            
            $
            (2,754
            )
            $
            (4,913
            )
            $
            150Pro
                Forma - net loss
            
            $
            (9,518
            )
            $
            (11,091
            )
            $
            (5,175
            )Pro
                forma net loss per share -basic and diluted
            
            $
            (0.51
            )
            $
            (0.61
            )
            $
            (0.40
            )





For
      the
      purposes of this disclosure, the estimated fair value of the options is
      amortized to expense over the options’ vesting periods. The effects on pro forma
      disclosures of applying SFAS 123 may not be representative of the effects on
      pro
      forma disclosures of future years.




Q.
            *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 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
                31,2005
            
            2004Balance
                at beginning of year
            
            $
            158
            
            $
            0ARO
                incurred
            
            
            21
            
            
            158Accretion
                expense
            
            
            15
            
            
            0ARO
                settled
            
            
            ---
            
            
            ---Revisions
                to ARO estimates
            
            
            ---
            
            
            ---Balance
                at the end of year
            
            $
            194
            
            $
            158





R.
            *Deferred
                Rent*





The
      Company accounts for escalating rental payments on a straight-line basis over
      the term of the lease.





*S.*
            *Derivative
                Instruments*





In
      connection with the sale of debt or equity instruments, the Comapany 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 as 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.




46


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




The
      identification of, and accounting for, derivative instruments is complex.
      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.





T.
            *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 -**
            **RESTATEMENT
                OF CONSOLIDATED FINANCIAL
                STATEMENTS:**




The
      Company is restating its Consolidated Financial Statements for fiscal 2003
      and
      2004 as well as the first three interim periods of fiscal 2005 in order to
      bifurcate embedded derivative instruments within the Company’s debt and account
      for them separately as derivative instrument liabilities. The following provides
      a more detailed discussion of the restatement along with a comparison of the
      amounts previously reported in the Consolidated Balance Sheet for December
      31,
      2004, and Statements of Operations in the Company’s Annual Report on Form 10-K
      for fiscal 2004 and 2003.




The
      Company’s Annual Reports on Form 10-K and the Quarterly Reports on Form 10-Q for
      fiscal 2003 through the third quarter of fiscal 2005 have not been revised
      to
      reflect the Restatement, and the financial statements contained in those reports
      should not be relied upon. Instead, the financial statements for fiscal 2004
      and
      2003 included in this Annual Report on Form 10-K should be relied upon.




As
      previously reported in our Current Report on Form 8-K filed with the Securities
      and Exchange Commission on December 5, 2005, the Company has been in extensive
      discussions with the Staff of the Securities and Exchange Commission concerning
      the proper accounting treatment regarding certain of its convertible debt in
      current and previously reported financial results. However, as a result of
      these
      discussions, the Company’s 2005 quarterly and 2004 and 2003 fiscal year
      financial statements are restated to bifurcate embedded derivative instruments
      within the Company’s debt and account for them separately as derivative
      instrument liabilities.




More
      specifically, the Securities and Exchange Commission ("SEC") raised questions
      with regard to our convertible term notes suggesting that we consider EITF
      00-19
      "Accounting for Derivative Financial Instruments Indexed to, and Potentially
      Settled in, a Company's Own Stock" to evaluate whether there were any embedded
      derivative instruments and if so, whether they should be accounted for as an
      equity or liability classification.





As
      a
      result, the Company reviewed its initial accounting for its (1) First Laurus
      Convertible Note dated July 31, 2003, (2) Second Laurus Convertible Note dated
      January 14, 2004, (3) Third Laurus Convertible Note dated May 16, 2005, and
      (4)
      Senior Convertible Notes dated November 5, 2004 (See Notes 7 and 8). During
      the
      review, the Company identified that EITF 00-19 should be applied to evaluate
      whether any embedded derivative instruments qualify as equity instruments or
      as
      liabilities. As a result, certain embedded derivatives were identified that
      met
      the conditions set forth under paragraph 12 of SFAS No. 133. These embedded
      derivative instruments have been evaluated using EITF 00-19 paragraphs 12 to
      32
      and determined that these instruments would not be classified as components
      of
      stockholders equity. The instruments have been deemed liabilities, and as such,
      will be subject to SFAS 133 and should be recorded at fair value.





47


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


Features
      within the debt noted above that have been evaluated and determined to require
      such treatment include:





·
            The
                principal conversion options.





·
            The
                monthly payments conversion
                options.





·
            The
                interest rate adjustment
                provisions.





Management
      believes the scope and process of its internal review of previously reported
      financial information was sufficient to identify issues of a material nature
      that could affect our Consolidated Financial Statements and all dates and
      periods presented herein have been restated to fairly present the results of
      our
      operations.





For
      the
      quarterly impact of the restatement see Note 21.




The
      foregoing restatement adjustments did not affect the Company’s reported cash and
      cash equivalents balance during these reported periods.




Net
                LossYear
                Ended December 31,2004
            
            2003As
                previously reported
            
            $
            (4,473
            )
            $
            (4,890
            )Restatement
                adjustments, net:Derivative
                instrument expense
            
            $
            (1,705
            )
            $
            (435
            )As
                restated
            
            $
            (6,178
            )
            $
            (5,325
            )





*Impact
      of the Financial Statement Adjustments on the Consolidated Statements of
      Operations*





The
      following table presents the impact of the financial statement adjustments
      on
      the Company’s previously reported consolidated statements of operations for the
      fiscal years ended December 31, 2004 and 2003:





Year
                Ended December 31,2004
            
            2004
            
            2003
            
            2003(As
                reported)
            
            (As
                restated)
            
            (As
                reported)
            
            (As
                restated)Loss
                from operations
            
            $
            (4,647
            )
            $
            (4,647
            )
            $
            (4,261
            )
            $
            (4,261
            )Gain
                on debt extinguishment, net
            
            
            508
            
            
            508
            
            
            ---
            
            
            ---(Loss)
                on debt refinancing
            
            
            ---
            
            
            ---
            
            
            ---
            
            
            ---Other
                (expense) income, net
            
            
            (334
            )
            
            (334
            )
            
            (629
            )
            
            (629
            )Derivative
                instrument expense
            
            
            ---
            
            
            (1,705
            )
            
            ---
            
            
            (435
            )Net
                Loss
            
            $
            (4,473
            )
            $
            (6,178
            )
            $
            (4,890
            )
            $
            (5,325
            )Basic
                and diluted net loss per share:
            
            $
            (0.25
            )
            $
            (0.34
            )
            $
            (0.38
            )
            $
            (0.41
            )Shares
                used in computing basic and diluted net loss per share
            
            
            18,223,609
            
            
            18,223,609
            
            
            12,964,498
            
            
            12,964,498




48


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 *In
        Thousands, Except Share And Per Share Information*




*Impact
      of the Financial Statement Adjustments on the Consolidated Balance
      Sheets*





The
      following is a summary of the impact of the adjustments on the Company’s
      previously reported consolidated balance sheet as of December 31,
      2004.





December
                31, 2004(As
                reported)
            
            (As
                restated)TOTAL
                ASSETS
            
            $
            18,847
            
            $
            18,847LIABILITIES
                AND STOCKHOLDERS’ EQUITYTotal
                current liabilities
            
            $
            1,851
            
            $
            1,851Noncurrent
                liabilities:Long
                term convertible notes payable
            
            
            6,000
            
            
            514Derivative
                financial instruments
            
            
            ---
            
            
            7,081Long
                term asset retirement obligation
            
            
            147
            
            
            147Long
                term, other
            
            
            70
            
            
            70Total
                liabilities
            
            
            8,068
            
            
            9,663Stockholders’
                EquityPreferred
                stock
            
            
            180
            
            
            180Common
                stock
            
            
            187
            
            
            187Warrants
            
            
            66
            
            
            66Additional
                paid-in capital
            
            
            62,430
            
            
            62,975Accumulated
                deficit
            
            
            (52,084
            )
            
            (54,224
            )Total
                stockholders’ equity
            
            
            10,779
            
            
            9,184TOTAL
                LIABILITIES AND STOCKHOLDERS’ EQUITY
            
            $
            18,847
            
            $
            18,847





**NOTE
              4 -**
            **CAPITALIZED
                SYSTEM COSTS:**





Equipment,
      installation, and in some cases interest costs related to operating lease
      contracts are capitalized and, after acceptance by the municipality (customer),
      are depreciated over the term of the contract, generally either three or five
      years, less an applicable residual value. There was no interest capitalized
      in
      fiscal years 2005 and 2004. Revenues realized from these agreements, 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. Many leases
      contain minimum payment requirements, which currently aggregate to $4,402 in
      2006, $3,815 in 2007, $2,469 in 2008 and $662 in 2009, and $371 in 2010.
      Management expects that these annual amounts could increase and extend to future
      years, as additional intersections are installed.





December
                31, 20042005
            
            2004Equipment
                under operating leases:Work-in-process
            
            $
            1,019
            
            $
            43Installed
                and accepted
            
            
            9,255
            
            
            6,55110,274
            
            
            6,594Less:
                Accumulated depreciation
            
            
            (4,895
            )
            
            (2,845
            )Net
                investment in leased equipment
            
            $
            5,379
            
            $
            3,749




49


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


**NOTE
              5 -**
            **PROPERTY
                AND EQUIPMENT - NET:**





December
                31, 2004Depreciable
                Life
            
            2005
            
            2004Office
                furniture and equipment
            
            
            3
                years
            
            $
            460
            
            $
            147Computer
                equipment and software
            
            
            1-5
                years
            
            
            2,157
            
            
            1,961Demonstration
                equipment
            
            
            3
                years
            
            
            81
            
            
            ---Leasehold
                improvements
            
            
            5
                years
            
            
            549
            
            
            2463,247
            
            
            2,354Less:
                Accumulated depreciation
            
            
            
            
            
            (2,322
            )
            
            (1,997
            )$
            925
            
            $
            357




Depreciation
      and amortization expense of $325 and $273 on the above assets was recorded
      for
      the years ended December 31, 2005 and 2004, respectively.





In
      2005,
      the Company disposed of no equipment. In 2004, the Company disposed of $16
      of
      computer equipment and $8 of demonstration equipment. The loss on disposal
      of
      fixed assets for 2004 is included in other expense-net.





**NOTE
              6 -**
            **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,
      2005:




Identified
                  Intangible Asset
              
              Useful
                  Life In Years
              
              Gross
                  Carrying Amount
              
              Accumulated
                  Amortization
              
              Net
                  Carrying AmountPatents
              
              
              7
              
              $
              203
              
              $
              (57
              )
              $
              146Customer
                  contracts and related customer relationships (included in Other
                  Assets)
              
              
              1-5
              
              
              1,337
              
              
              (112
              )
              
              1,225Total
              
              
              
              
              $
              1,540
              
              $
              (169
              )
              $
              1,371





For
      fiscal 2005, amortization expense related to identified intangible assets was
      $135, of which $112 was included cost of sales and $23 was included in operating
      expenses.





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





Fiscal
                Year
            
            Estimated
                Amortization Expense2006
            
            $
            3452007
            
            
            3192008
            
            
            3172009
            
            
            2932010
            
            
            52Thereafter
            
            
            45Total
            
            $
            1,371




50


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


**NOTE
              7 -**
            **NOTES
                PAYABLE:**





The
      Company considers its long term convertible notes payable, long term notes
      payable, and derivative financial instruments, which are described in Footnotes
      7 and 8, to be its long-term financial obligations.




Long-term
      financial obligations consisted of the following as of December 31.





2005
            
            2004RestatedSenior
                Convertible Notes
            
            
            5,200
            
            
            6,000Discount
            
            
            (3,550
            )
            
            (5,486
            )FMV
                of embedded derivatives
            
            
            1,419
            
            
            7,081Foundation
                Partners Secured Promissory Note
            
            
            1,250
            
            
            ---Heil
                Secured Promissory Note
            
            
            1,250
            
            
            ---Fourth
                Laurus Note
            
            
            6,000
            
            
            ---Discount
            
            
            (1,078
            )
            
            ---10,491
            
            
            7,595Less
                current portion
            
            
            4,136
            
            
            ---Total
            
            
            6,355
            
            
            7,595





Aggregate
      maturities of long-term obligations for the years following December 31, 2005
      are as follows:





2006
            
            2007
            
            2008
            
            TotalFourth
                Laurus Note
            
            
            1,636
            
            
            2,182
            
            
            2,182
            
            
            6,000Senior
                Convertible Notes
            
            
            ---
            
            
            5,200
            
            
            ---
            
            
            5,200Foundation
                Partners Secured Promissory Note
            
            
            1,250
            
            
            ---
            
            
            ---
            
            
            1,250Heil
                Secured Promissory Note
            
            
            1,250
            
            
            ---
            
            
            ---
            
            
            1,250Total:
            
            
            4,136
            
            
            7,382
            
            
            2,182
            
            
            13,700




*First
      Laurus Convertible Note:*





On
      July
      31, 2003, the Company entered into a Securities Purchase Agreement ("the
      Agreement") with Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement,
      the Company issued to Laurus a Secured Convertible Note ("Note") in the
      principal amount of $2,000 that bore interest at the prime rate plus 1.25%
      (subject to a floor of 5.25%) and maturing on July 31, 2005. The principal
      amount of the Note was repayable at rates commencing in December 2003 of $20
      per
      month and gradually increasing to $140 per month in April 2005 through the
      end
      of the Note. Such amounts may be paid (at the company’s option) (i) in cash with
      a 3% premium on principal paid plus unpaid interest, or (ii) in shares of common
      stock, assuming the shares are registered under the Securities Act of 1933
      and
      no default under the Note exists, or (iii) in a combination of the above. If
      paid in common stock, the number of shares issued shall equal the total amount
      due, divided by $1.55. If the average closing price of the common stock for
      the
      ten consecutive days prior to a repayment date is equal to or greater than
      $1.86, we may require the holder to convert into common stock an amount of
      principal, accrued interest and fees due under the Note equal to a maximum
      of
      25% of the aggregate dollar trading volume of the common stock for the 20
      consecutive trading days prior to a notice of conversion. The Note restricts
      our
      ability to make repayment in our common stock at the fixed conversion price,
      if
      the then current market price is below 120% of the fixed conversion price (or
      $1.86). The Note may be redeemed at any time by us in cash by paying the holder
      115% of the principal amount, plus accrued interest. The holder of the Note
      may
      require us to convert all or a portion of the Note, together with interest
      and
      fees thereon, at any time. The number of shares to be issued shall equal the
      total amount to be converted, divided by $1.55. The conversion price of the
      secured convertible notes may be adjusted if we pay a stock dividend, or
      subdivide or combine outstanding shares of common stock into a greater or lesser
      number of shares.




51


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




The
      note
      was collateralized by a first lien on all available CrossingGuard, Inc. assets.
      Laurus had a general security interest in four customer contracts assigned
      by
      NTS to CrossingGuard, Inc. and NTS had pledged the common stock of
      CrossingGuard, Inc. In connection with financing, Laurus was paid a fee of
      $80,
      had certain of its expenses reimbursed and received a warrant to purchase
      140,000 shares of the Company's common stock. The warrant exercise price was
      as
      follows: $1.78 per share for the purchase of up to 83,000 shares; $1.94 per
      share for the purchase of an additional 33,000 shares; and $2.25 per share
      for
      the purchase of an additional 24,000 shares. These warrants were exercised
      on a
      cashless basis during the quarter-ended September 30, 2004, resulting in the
      Company issuing 76,466 shares of its common stock at a conversion price of
      $4.18
      per share.





Also
      in
      connection with financing, Management Services Group/Sage Investments, Inc.
      (“Sage”) was paid a fee of $80 and received $4 per month for nine months for
      continuing consultation. Sage received warrants to purchase 14,000 shares of
      Company stock as follows: $1.78 per share for the purchase of up to 8,300
      shares; $1.94 per share for the purchase of an additional 3,300 shares; and
      $2.25 per share for the purchase of an additional 2,400 shares. During the
      period June through August 2004, Sage exercised 11,720 of these warrants on
      a
      cashless basis, resulting in the Company issuing 5,953 shares of stock at
      conversion prices of $3.54 to $4.46 per share. The warrant expiration date
      is
      July 31, 2008.





The
      Black-Scholes values of the warrants issued in connection with this financing
      totaled $144 (Laurus) and $14 (Sage) and were recorded as additional paid-in
      capital. The Laurus warrant value was recorded as a discount on the note
      payable. During the quarter ended September 30, 2003, the Company amortized
      $12
      of the discount as interest expense. As the Note was satisfied on January 14,
      2004, the remaining unamortized discount of $114, deferred interest of $55
      and
      deferred financing fees of $131 had negligible continuing value and were
      consequently written off to interest expense (discount and deferred interest)
      and financing fees, respectively, at December 31, 2003.





During
      November and December 2003, Laurus converted $85 of the Note into 55,000 shares
      of Nestor common stock at $1.55 per share. On January 14, 2004, the Company
      satisfied its remaining payment obligations on the Note by issuing 492,904
      shares of its common stock to Laurus at the fixed conversion price of $1.55
      per
      share and redeeming the remaining $1,151 note balance by a “payment” of $1,341,
      which included accrued interest and a $173 prepayment penalty. This “payment”
was netted against the proceeds from the Second Laurus Convertible Note (see
      below), resulting in $98 net cash proceeds to the Company.





*Second
      Laurus Convertible Note:*





On
      January 14, 2004, the Company entered into a second securities purchase
      agreement with Laurus. Pursuant to that agreement, the Company issued to Laurus
      a new secured convertible note in the principal amount of $1,500 that bore
      interest at the prime rate plus 1.25% (subject to a floor of 5.25% per year)
      and
      matured on January 14, 2006. The principal amount of the Note was repayable
      at
      rates commencing in May 2004 of $15 per month and gradually increasing to $105
      per month in September 2006 through the end of the Note term. Such amounts
      may
      be paid (at the company’s option) (i) in cash with a 3% premium on principal
      paid plus unpaid interest, or (ii) in shares of common stock, assuming the
      shares are registered under the Securities Act of 1933 and no default under
      the
      Note exists, or (iii) in a combination of the above. If paid in common stock,
      the number of shares issued shall equal the total amount due, divided by $3.50.
      If the average closing price of the common stock for the ten consecutive days
      prior to a repayment date is equal to or greater than $4.20, we may require
      the
      holder to convert into common stock an amount of principal, accrued interest
      and
      fees due under the Note equal to a maximum of 25% of the aggregate dollar
      trading volume of the common stock for the 20 consecutive trading days prior
      to
      a notice of conversion. The Note restricts our ability to make repayment in
      our
      common stock at the fixed conversion price, if the then current market price
      is
      below 120% of the fixed conversion price (or $4.20). The Note may be redeemed
      at
      any time by us in cash by paying the holder 115% of the principal amount, plus
      accrued interest. The holder of the Note may require us to convert all or a
      portion of the Note, together with interest and fees thereon, at any time.
      The
      number of shares to be issued shall equal the total amount to be converted,
      divided by $3.50. The conversion price of the secured convertible notes may
      be
      adjusted if we pay a stock dividend, or subdivide or combine outstanding shares
      of common stock into a greater or lesser number of shares. In conjunction with
      this transaction, Sage received a fee of $60 and an affiliate of Laurus received
      a management fee of $45 and reimbursement of certain expenses. The first lien,
      security interest and pledge of CrossingGuard, Inc. stock from the first Laurus
      Note continued to this second note.




52


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




During
      September 2004, Laurus converted $60 due on this note into 17,143 shares of
      Nestor common stock at $3.50 per share. Laurus subsequently converted their
      remaining $1,245 note balance into 355,714 shares of Nestor common stock during
      the period October to November 3, 2004.





*Third
      Laurus Convertible Note:*





On
      May
      16, 2005, we entered into a Securities Purchase Agreement ("the Agreement")
      with
      Laurus Master Fund, Ltd. ("Laurus"). Pursuant to the Agreement, we issued to
      Laurus a convertible Note ("the Note") in the principal amount of $6,000 (which
      was fully paid on December 28, 2005). The Note was convertible into our common
      stock at the option of Laurus at a fixed conversion price of $5.82 per share.
      The Note beared interest at the coupon rate of the prime rate plus 4.00% and
      was
      subject to a floor interest rate of 6.00%. The Agreement provided for a
      reduction in the interest rate to the prime rate plus 2.00% in months during
      which the price of our common stock exceeded the fixed conversion price of
      $5.82
      for five consecutive trading days, and additional reductions of 2.00% for every
      25% increase in the price of our common stock above the fixed conversion price
      of $5.82 (an increase of $1.46), subject to a minimum coupon rate of 0.00%.
      The
      Note originally matured on May 16, 2008. The principal amount of the Note was
      repayable at rates commencing in September 2005 of $181 per month through the
      end of the Note term in December 2006. Such amounts could have been paid (at
      the
      company’s option) (i) in cash with a 3% premium on principal paid plus unpaid
      interest, or (ii) in shares of common stock, assuming the shares were registered
      under the Securities Act of 1933 and no default under the Note existed, or
      (iii)
      in a combination of the above. If paid in common stock, the number of shares
      issued should have equalled the total amount due, divided by $5.82. If the
      average closing price of the common stock for the ten consecutive days prior
      to
      a repayment date was equal to or greater than $5.82, we could have required
      the
      holder to convert into common stock an amount of principal, accrued interest
      and
      fees due under the Note equal to a maximum of 25% of the aggregate dollar
      trading volume of the common stock for the 20 consecutive trading days prior
      to
      a notice of conversion. The Note restricted our ability to make repayment in
      our
      common stock at the fixed conversion price, if the then current market price
      was
      below 120% of the fixed conversion price (or $6.98). The Note could have been
      redeemed at any time by us in cash by paying the holder 115% of the principal
      amount, plus accrued interest. The holder of the Note could have required us
      to
      convert all or a portion of the Note, together with interest and fees thereon,
      at any time. The number of shares to be issued should have equalled the total
      amount to be converted, divided by $5.82. The conversion price of the secured
      convertible notes could have been adjusted if we payed a stock dividend, or
      subdivided, or combined outstanding shares of common stock into a greater or
      lesser number of shares.





The
      net
      proceeds from the Note could only be used for the design, engineering,
      construction, installation and maintenance of certain of our traffic enforcement
      systems.





We
      filed
      a registration statement for the shares of common stock into which the Note
      may
      be converted and for the shares underlying the warrant issued as part of the
      Agreement (see below). The Agreement requires that the registration statement
      be
      declared effective by September 16, 2005. We were obligated to pay Laurus
      damages because the registration statement was not declared effective by its
      due
      date. Under the Agreement, Laurus was entitled to liquidated damages in an
      amount equal to 1% of the outstanding principal amount for each 30 consecutive
      days after September 16, 2005 during which the Registration Statement is
      not effective, prorated daily.  The Agreement and related registration
      rights obligation was satisfied on December 28, 2005 as described below and
      any
      registration rights liquidated damages were waived.




53


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




The
      Note
      was collateralized by a security interest in the proceeds of our existing
      CrossingGuard contracts except for our Delaware contract.





In
      connection with the financing, Laurus was paid a fee of $234 and had
      approximately $47 of its expenses reimbursed. Laurus received five year warrants
      to purchase 100,000 shares of our common stock. The exercise prices of the
      warrants are as follows: $6.69 per share for the purchase of up to 60,000
      shares; $7.28 per share for the purchase of an additional 23,000 shares; and
      $8.43 per share for the purchase of an additional 17,000 shares. The warrants
      expire on May 16, 2010.





The
      Black-Scholes value of the warrants issued in connection with this financing
      totaled approximately $419 and is recorded as additional paid-in capital and
      a
      corresponding discount (reduction) to the note payable. The warrant’s entire
      discount was written off to interest expense in 2005 due to the underlying
      note
      being refinanced on December 28, 2005.





After
      taking into consideration the value of the warrants, we ascribed $38 as a
      beneficial conversion value and recorded the amount as additional paid-in
      capital and a corresponding discount to the note payable. This beneficial
      conversion feature was written off to interest expense in 2005 due to the
      underlying note being refinanced on December 28, 2005.





*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 discussed above (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 is repayable at rates commencing
      in
      April 2006 of $181 per month through the end of the Note term in December 2008.
      The Note bears interest at the coupon rate of the prime rate plus 2.00% and
      is
      subject to a floor interest rate of 7.00%. The Note contains 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 requires 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.




*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
      bears interest at the rate of one percent (1.00%) per month until the note
      is
      paid in full. The due date of the principal and all accrued interest can be
      accelerated if we default on the note. The note can be prepaid in full or in
      part on the last calendar day of any month during the term. The note is secured
      by ten mobile speed enforcement units including all associated speed detection
      systems and all rights to operate said systems. If Mr. Heil forecloses on the
      units, we will provide citation processing services for Mr. Heil with respect
      to
      violation data generated by the units at commercially reasonable prices and
      Mr.
      Heil will have all rights and licenses necessary to so operate the units for
      their intended uses. If we are 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 will amortize the origination
      fee and any legal fees over the 12 month note term.




54


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


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.





*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
      bears interest at the rate of 10% per year. Interest is payable monthly and
      the
      principal is payable in full on the maturity date. The due date of the principal
      and all accrued interest can be accelerated if we default on the note. The
      note
      can be prepaid in full or in part on the last calendar day of any month during
      the term. The note is secured by ten mobile speed enforcement units including
      all associated speed detection systems and all rights to operate said systems.
      If Foundation Partners forecloses on the units, we will provide citation
      processing services for Foundation Partners with respect to violation data
      generated by the units at commercially reasonable prices and Foundation Partners
      will have all rights and licenses necessary to so operate the units for their
      intended uses. If we are 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 will 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 Chief Executive Officer, President,
      and a 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 are amortizing the origination fee over the 12 month term of the
      note.





*Silver
      Star Convertible Note:*





On
      October 15, 2003, the Company sold a $2,000 convertible note (“Silver Star
      Note") to Silver Star Partners I, LLC ("Silver Star"). The Silver Star Note
      was
      due on January 15, 2004 and bore interest at the rate of 7% per year. On
      December 31, 2003, the Company exercised its option to satisfy the Silver Star
      note and accrued interest by issuing 676,384 shares of Nestor common stock
      at
      $3.00 per share. See Common and Preferred Stock footnote also.





Silver
      Star had the right to require the Company to register with the SEC Silver Star's
      resale of all shares of common stock that it owned as soon as practicable after
      Silver Star requested that registration. The Company was obligated to pay all
      expenses associated with that registration. The Company had other obligations
      in
      connection with that registration, including causing the registration statement
      filed to remain continuously effective until the distribution of shares covered
      by the registration statement was complete and indemnifying Silver Star from
      liabilities it might have incurred resulting from any untrue statement or
      omission of a material fact in the registration statement and related documents
      and from other liabilities related to the registration. Danzell Investment
      Management, Ltd. received a 3% finders fee from the Company in connection with
      the Silver Star Note.





William
      B. Danzell is the Chief Executive Officer of Nestor, Inc., the President of
      Danzell Investment Management, Ltd. and the Managing Director of Silver Star
      Partners I, LLC. David N. Jordan and George L. Ball, directors of Nestor, are
      each also affiliates of Silver Star Partners I, LLC. Robert M. Krasne and
      Stephen H. Marbut, former directors of Nestor, are also affiliates of Silver
      Star Partners I, LLC. The sale of the note by Nestor to Silver Star Partners
      I,
      LLC and the satisfaction of our obligations under it by issuing common stock
      were approved by the directors of Nestor not affiliated with Silver Star
      Partners I, LLC.




**NOTE
                8 -**
            **PRIVATE
                PLACEMENT OF SENIOR CONVERTIBLE
                NOTES:**





In
      November 2004, the Company completed the sale of $6,000 aggregate principal
      amount of its 5% 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.




55


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


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 to $4.20 on
      the
      date of the January transaction.





The
      senior convertible notes and the convertible notes payable in Note 7 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.





Over
      the
      life of the senior convertible notes and the convertible notes payable, the
      Company recorded the following type of embedded derivative financial
      instruments:





·
            Principal’s
                Conversion Options





·
            Monthly
                Payment Conversion Options





·
            Interest
                Rate Adjustment provisions





As
      of
      December 31, 2005 and 2004, respectively, these derivatives were valued at
      $1,419 and $7,081. The only embedded derivative remaining at December 31, 2005
      relates to the senior convertible notes. 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
      56%
      to 211%; and risk free interest rate of 3.04% to 4.82%.





As
      of
      December 31, 2005 and 2004, the derivative as well as warrants were recorded
      as
      discounts to the Notes and are being amortized over the expected term of the
      debt. At December 31, 2005, the unamortized discount on the Notes was $4,628
      and
      $5,486 for 2005 and 2004, respectively.




56


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


**NOTE
              9 -**
            **TRANSOL
                ASSET PURCHASE:**





On
      August
      31, 2005, we entered into a purchase and sale agreement with Transol Holdings
      Pty Limited, Transol PTY Limited, Transol Corporation Limited and Alleasing
      Finance Australia Limited pursuant to which we purchased certain assets of
      Transol and its Australian and US subsidiaries related to Transol’s red light
      enforcement business, including assets leased by Transol USA Inc., Transol
      Holding’s indirect U.S. subsidiary, from Alleasing. Alleasing held a security
      interest in all of the assets of Transol USA and sold us the acquired assets
      in
      a foreclosure sale. Transol was one of our competitors in the automated traffic
      enforcement business. The transaction was closed from escrow with final
      adjustments on January 16, 2006.





The
      assets purchased, as adjusted, include:





·
            Contracts
                to provide automated red light enforcement services in six US cities
                at an
                aggregate of 39 approaches, of which 35 are fully installed and
                operating.





·
            Equipment
                located at the contracted approaches used for providing automated
                red
                light enforcement services.





·
            Transol’s
                intellectual property, including one U.S., one Australian and one
                international patent application (each related to the technology
                underlying their red light enforcement services, the Transol website,
                computer source code for Transol’s products and services and all other
                “technical know how,” except that relating to Transol’s automated driver’s
                licensing testing business).





·
            Inventory,
                work in process, accounts receivable and unbilled contract revenue
                related
                to Transol’s red light enforcement
                services.





·
            The
                goodwill of the Transol business, except that relating to the automated
                driver’s licensing testing
                business.





Under
      the
      agreement, the sellers were obligated to terminate the “Transol Group” trade
      name registration.





The
      purchase price we paid into escrow for the acquired assets is $2,000, subject
      to
      reduction for any liens on the assets we acquired and subject to reduction
      if
      any of the assigned contracts that are terminated before January 16, 2006 by
      the
      cities because of their assignment to us or that are terminated by January
      16,
      2006 pursuant to termination for convenience rights that cities may have under
      the contracts. The price reduction for any contracts so terminated will be
      $50
      per installed approach and up to $20 per uninstalled approach. In addition,
      we
      would receive a price reduction of up to $20 for each unapproved approach for
      which we do not receive municipal authorization by January 15, 2006 to go
      forward and for which we did not receive a price reduction because of a contract
      termination. The final payment from escrow was $1,760.





We
      also
      entered into a Transition Services Agreement with Transol USA pursuant to which
      we were able to use their Tempe, AZ warehouse until October 31, 2005 and their
      Phoenix, AZ office until December 31, 2005, as well as the services of some
      of
      their employees and consultants until December 31, 2005. We paid Transol USA’s
      direct costs for the services that we receive under the Transition Services
      Agreement. As of December 31, 2005, we had converted all but one of the existing
      installations to our back office processing environment. We do not intend to
      use
      the Transol name following the transition period.





57


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information


The
      combined purchase price of the acquisition was allocated on a fair value basis
      as follows:








Gross
                purchase price:
            
            $
            2,000Adjustment
                for contracts not expected to be assigned:Uninstalled
                approaches
            
            
            12Price
                adjustment per approach
            
            
            (20
            )Total
                purchase price adjustment
            
            
            (240
            )Adjusted
                purchase price
            
            $
            1,760Purchase
                price allociation:Accounts
                receivable
            
            $
            7Inventory
            
            
            204Capitalized
                system costs1
            
            
            118Property
                and equipment1
            
            
            94Contracts
                (intangible other assets)1
              Weighted-average
                amortization period of 52 months
            
            
            1,337$
            1,760




1
              These
                  assets received a fair value allocation reduction totaling $95,
                  due to
                  fair value in excess of the $1,760 adjusted purchase
                  price.




The
      value
      of contracts, net of amortization, at December 31, 2005 was $1,225 and was
      recorded in other assets.








**NOTE
              10 -**
            **LEASES
                PAYABLE:**





On
      June
      28, 2001, NTS executed a Master Lease Purchase Agreement with Electronic Data
      Systems Corporation (“EDS”), later amended on January 10, 2003, whereby EDS
      provided lease financing to support installation of the NTS CrossingGuard
      product to municipalities under leasing terms. NTS received $3,183 in advances,
      which were collateralized by equipment delivered under leased CrossingGuard
      systems. During 2003, the Company recorded $164 of EDS interest expense.





On
      January 26, 2004, the Company satisfied its remaining obligations to EDS by
      making a payment of $2,179. This transaction resulted in the Company recording
      a
      gain on early extinguishment of debt of $681 in January 2004.




58


**NESTOR,
        INC.**
 **NOTES
        TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
        Thousands, Except Share And Per Share Information




**NOTE
                  11 -**
              **COMMON
                  AND PREFERRED STOCK:**
 
 *Private
        Placement and Silver Star Note Conversion:*
 
 The
        Company sold 2,843,000 shares of its common stock to accredited investors
        in
        private placements conducted during December 2003 (1,596,560 shares), and
        January 2004 (1,246,440 shares). The shares were sold at $3.00 per share,
        with
        net proceeds to Nestor (after $682 of expenses of the offering) of $2.76
        per
        share totaling $7,847 ($3,440 in January 2004). The Securities and Exchange
        Commission declared the Registration Statement on Form S-2 (SEC File No.
        333-112359) for the resale of these shares effective on April 23, 2004. The
        Company has continuing obligations in connection with the registration of
        the
        resale of the shares offered, including causing the registration statement
        filed
        to remain continuously effective for two years or, if earlier, until the
        sale of
        shares covered by the registration statement is complete and indemnifying
        the
        holders from liabilities it may incur resulting from any untrue statement
        or
        omission of a material fact in the registration statement and related documents
        and from other liabilities related to the registration.
 
 On
        December 31, 2003, after the initial closing of the private placement above,
        the
        Company exercised its right to convert the Silver Star Note and accrued interest
        (see Note 7 ) by issuing 676,384 shares of Nestor common stock at $3.00 per
        share.
 
 Although
        the proceeds from the initial closing above were received in December 2003
        and
        the Silver Star note conversion was effective December 31, 2003, the associated
        stock certificates were not issued until January 2004. As such, these 2,272,944
        shares are classified as “Stock Pending Issuance” on the balance sheet at
        December 31, 2003.
 
 *Laurus
        Note Conversions:*
 
 As
        more
        fully described in Note 7, Laurus elected to convert $85 of their first note
        into 55,000 shares of Nestor common stock in 2003. In January 2004, Laurus
        further converted $764 of the note into 492,904 shares of Nestor common stock.
        Both conversions were priced at $1.55 per share. During the period September
        through November 3, 2004, Laurus converted $1,305 due on its second note
        into
        372,857 shares of Nestor common stock at $3.50 per share.
 
 As
        more
        fully described in Note 7, the Company issued 203,774 shares of common stock
        to
        Laurus on December 28, 2005 in exchange for Laurus agreeing to retire the
        unpaid
        portion of the May 2005 convertible debt and interest amounting to $5,320
        in
        exchange for a non-convertible three year Note for $6,000 and cash of $680.
        The
        market value of the common shares issued to Laurus on December 28, 2005 were
        $1,080 and will be recorded as a discount to the new note, and amortized
        over
        the three year life of the Note, unless paid earlier.
 
 *One-for-Ten
        Reverse Stock Split:*
 
 The
        Company filed a certificate of amendment to its certificate of incorporation
        on
        April 11, 2003, causing a one-for-ten reverse stock split of the outstanding
        shares of the Company common stock effective on that date. The Company’s common
        stock began trading on a post reverse split basis on April 21, 2003 under
        the
        new trading symbol “NESO” (previously “NEST”). These financials reflect common
        stock and loss per share on a post-split basis.
 
 *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,
        2005
        and 2004.
  59
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **NOTE
                  12 -**
              **OPTIONS
                  AND WARRANTS:**
 
 On
        April
        1, 1984, the Company adopted an Incentive Stock Option Plan, which authorized
        the grant of options for up to 245,000 shares (post-reverse split) of the
        Company’s common stock. This plan terminated April 1, 2004.
 
 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.
 
 The
        following table presents the activity of the Company’s Stock Option Plans for
        the years ended December 31, 2005, 2004 and 2003 on post-reverse split basis.
        In
        2003, options granted were to directors of the Company; many of which were
        canceled later in 2003 due to changes in the Board.
 
 The
        number of options granted and outstanding in 2005 and 2004 rose significantly
        due to grants made pursuant to employment agreements as well as grants made
        to
        each employee and director during the year.
 
 Years
                  Ended December 31,2005
              
              2004
              
              2003Shares
              
              Weighted
                  Av. Ex. Price
              
              Shares
              
              Weighted
                  Av. Ex. Price
              
              Shares
              
              Weighted
                  Av. Ex. PriceOutstanding
                  beginning of year
              
              
              2,887,655
              
              $
              4.71
              
              
              312,397
              
              $
              5.75
              
              
              324,199
              
              $
              6.50Granted
              
              
              474,665
              
              
              5.63
              
              
              2,777,650
              
              
              4.66
              
              
              176,250
              
              
              3.34Exercised
              
              
              100,844
              
              
              3.99
              
              
              28,000
              
              
              1.34
              
              
              ---
              
              
              ---Canceled
              
              
              395,449
              
              
              4.81
              
              
              174,392
              
              
              6.28
              
              
              188,052
              
              
              4.85Outstanding
                  end of year
              
              
              2,866,027
              
              
              4.87
              
              
              2,887,655
              
              
              4.71
              
              
              312,397
              
              
              5.75Options
                  exercisable at year end
              
              
              1,413,243
              
              $
              4.79
              
              
              1,010,236
              
              $
              4.87
              
              
              233,970
              
              $
              6.80
  The
        following table presents weighted average price and life information about
        significant option groups outstanding at December 31, 2005:
 
 Options
                  Outstanding
              
              Options
                  ExercisableRange
                  of Ex. Price
              
              Number
                  of
                Outstanding
                  at
                12-31-05
              
              Weighted
                  Average Remaining Contractural Life (Years)
              
              Weighted
                  Average Exercise Price
              
              Number
                  Exercisable at 12-31-05
              
              Weighted
                  Averaged Exercisable Price$
              1.00
              -
              1.90
              
              23,050
              
              $
              4.38
              
              $
              1.76
              
              17,790
              
              $
              1.753.55
              -
              3.85
              
              163,400
              
              
              5.83
              
              
              3.69
              
              115,800
              
              
              3.754.50
              -
              5.95
              
              2,627,312
              
              
              7.44
              
              
              4.94
              
              1,285,388
              
              
              4.916.04
              -
              7.23
              
              52,265
              
              $
              7.75
              
              
              6.47
              
              12,265
              
              
              6.852,866,027
              
              $
              7.33
              
              $
              4.87
              
              1,431,243
              
              $
              4.79
  60
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
  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 154,000 warrants in connection with the first Laurus note financing
        in
        July 2003, 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.
 
 The
        following table presents warrants outstanding after adjusting to a post-reverse
        split basis:
 
 Years
                  Ended December 31,2005
              
              2004
              
              2003Eligible,
                  end of year for exercise, currently
              
              
              178,331
              
              
              80,611
              
              
              660,936Warrants
                  issued
              
              
              100,000
              
              
              60,000
              
              
              154,000Low
                  exercise price
              
              $
              4.80
              
              $
              0.49
              
              $
              1.78High
                  exercise price
              
              $
              8.43
              
              $
              2.72
              
              $
              2.25
  The
        warrants outstanding as of December 31, 2005 are currently exercisable and
        expire at various dates through May, 2010. The outstanding warrants entitle
        the
        owner to purchase one share of common stock for each warrant, at prices ranging
        from $4.80 to $8.43 per share.
 
 During
        the year ended June 30, 1996, the exercise price of 100,000 warrants issued
        in
        the prior year was reduced from $15.00 to $6.50 (post-reverse split). The
        Company recorded, on a prorated basis, the $850 cumulative expense over the
        life
        of the warrants through August 1, 2004. Accordingly, the Company recognized
        expenses totaling $62, $106 and $106 in 2004, 2003 and 2002. During the quarter
        ended September 30, 2004, all warrants with an expiration date of August
        1, 2004
        were exercised on a cashless basis. This resulted in Company issuing 136,292
        shares of its common stock at conversion prices from $3.98 to $4.28 per share
        in
        exchange for 269,856 warrants with exercise prices from $.49 to $2.65 per
        share.
        The Company also reclassified $850 related to these warrants and $375 related
        to
        other expired warrants from warrants to additional paid-in capital on the
        balance sheet.
 
 In
        2004,
        Laurus Master Fund, Ltd. exercised their 140,000 warrants with exercise prices
        from $1.78 to $2.25 per share on a cashless basis, resulting in the Company
        issuing 76,466 shares of its common stock at a conversion price of $4.18
        per
        share. Sage also exercised 11,720 warrants on a cashless basis, resulting
        in the
        issuance of 5,953 shares of Nestor stock at conversion prices of $3.54 to
        $4.46
        per share.
 
 In
        addition, 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 100,0000 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. Such remaining warrants are treated as variable
        and, accordingly, are revalued quarterly with offsetting adjustments to
        additional paid-in capital.
 
 **NOTE
                  13 -**
              **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.
  61
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **NOTE
                  14**-
              **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
                  15 -**
              **OTHER
                  EXPENSE - NET:**
 
 Other
        expense as reflected in the consolidated statements of operations consists
        of
        the following:
 
 Years
                  Ended December 31,2005
              
              2004
              
              2003Interest
                  and dividend income
              
              $
              113
              
              $
              79
              
              $
              13Interest
                  expense
              
              
              (847
              )
              
              (239
              )
              
              (470
              )Expense
                  relating to financing operations
              
              
              ---
              
              
              (63
              )
              
              (106
              )Unrealized
                  loss
              
              
              (3
              )
              
              (10
              )
              
              ---Realized
                  loss
              
              
              ---
              
              
              (96
              )
              
              ---Other
                  income
              
              
              33
              
              
              ---
              
              
              64Contract
                  termination charge
              
              
              ---
              
              
              ---
              
              
              (125
              )Gain
                  (Loss) on disposal of fixed assets
              
              
              ---
              
              
              (5
              )
              
              (5
              )Other
                  expense - net
              
              $
              (704
              )
              $
              (334
              )
              $
              (629
              )
 
 **NOTE
                  16 -**
              **INCOME
                  TAXES:**
 
 During
        2005 and 2004, the Company recorded deferred tax assets primarily for the
        benefit of net operating losses in the amount of $4,054 and $2,697 respectively.
        The cumulative amount of these assets, which is $21,523 and $17,469 at December
        31, 2005 and 2004, 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 available at December 31, 2005, $54,007 and $34,180 of net operating
        loss carryforwards for federal and state purposes, respectively. Approximately
        $13,318 and $4,062 of these federal and state net operating loss carryforwards
        were acquired as part of the merger with NTS. These loss carryforwards may
        be
        applied against future taxable income and began to expire in 2005.
 
 The
        Company’s effective income tax rate differs from the statutory federal income
        tax rate for the years ended December 31, 2005, 2004, and 2003 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.
  62
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **NOTE
                  17 -**
              **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
        7, 8, 11, and 20 for transactions with Silver Star and Foundation Partners
        I,
        LLC.
 
 **NOTE
                  18 -**
              **COMMITMENTS
                  AND CONTINGENCIES:**
 
 Minimum
        rental commitments of non-cancelable operating leases are approximately as
        follows:
 
 Year
                  ending December 31,2006
              
              $
              2052007
              
              
              1662008
              
              
              1352009
              
              
              1352010
              
              
              90$
              731
 
 Rental
        expense was approximately $394, $224, and $149 during 2005, 2004, and 2003,
        respectively.
 
 NTS
        entered into an operating lease dated June 21, 2000 for office and warehouse
        facilities in East Providence, Rhode Island. This lease provides for monthly
        rentals of $10 through July 2003 and then increased to $10 monthly through
        July
        2005. Rent payments for this lease was $127 in 2003, $139 in 2004, and $120
        for
        2005. Space was leased adjacent to this facility in July 2004, for additional
        office and warehouse facilities. This lease provides for monthly rentals
        of $5
        through May 2005 then increases two hundred dollars monthly in each of the
        two
        following years. Rent expense for this lease was $40 in 2004 and $50 for
        2005.
        The Company relocated to new office and warehouse space in September 2005,
        and
        has recorded a reserve for lease termination costs related to the July 2004
        adjacent space in the amount of $145 as of December 31, 2005.
 
 In
        September 2005, the company entered into a new office lease in Providence,
        RI,
        which calls for monthly lease payments ranging from $8 to $11 through September
        2010.
 
 NTS
        also
        leases office space in San Diego, California. The July 2004 operating lease
        calls for monthly rent of $3 through the lease term expiration of June 2006.
        Rent expense was $15 in 2004 and $32 for 2005. The Company also leases warehouse
        space in Placentia, California. The February 2004 operating lease calls for
        monthly rent of $1 through the lease term expiration of January 2006. Rent
        expense was $15 in 2004 and $17 in 2005. The Company expects to relocate
        these
        California offices into one facility in Los Angeles to support the processing
        and support requirements of the CrossingGuard agreement with the City of
        Los
        Angeles and other California customers in the Los Angeles area.
 
 On
        October 13, 2004, the Board of Directors approved employment agreements for
        the
        Company’s Chief Executive Officer and Chief Operating Officer (now the CFO
        effective January 2006) through December 31, 2007. The agreements automatically
        renew for a two-year period unless the Company elects not to renew. The
        agreements provide for a base salary of not less than $250 (CEO)/$200 (COO)
        and
        annual performance-based bonuses to be determined by the Company’s Compensation
        Committee. The Company also granted 1,000,000 stock options to the CEO and
        600,000 stock options to the COO pursuant to the employment agreements. See
        Form
        8-K dated October 13, 2004 for further information. On March 25, 2005, the
        COO’s
        position changed to Executive Vice President of Nestor, Inc., and on January
        05,
        2006 his position was expanded to include the CFO responsibilities, and his
        compensation remains unchanged.
  63
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 Further,
        in March 2005 the Board of Directors approved employment agreements for a
        new
        Chief Operating Officer and a Vice President and General Counsel of Nestor,
        Inc.
        through December 31, 2008. The agreements automatically renew for one year
        unless the Company elects not to renew. The agreements provide for a base
        salary
        of not less than $175 (COO)/$165 (Counsel) and the COO is entitled to receive
        performance-based cash and option bonuses, as defined. The Company also granted
        30,000 stock options to the COO and 135,000 stock options to Counsel pursuant
        to
        the employment agreements.
 
 In
        November 2005, the Company signed a purchase agreement with one of its vendors.
        This agreement commits the Company to purchase a minimum of $750 over eighteen
        months expiring in May 2007.
  **NOTE
                19 -**
              **LITIGATION:**
 
 Two
        suits
        have been filed against The Company 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. No decision has been made by
        the
        judge on that motion. The judge stayed all discovery pending the outcome
        of that
        motion.
  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, nusiance, 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. No decision has been made by the judge on that
        motion.
        The judge stayed all discovery pending the outcome of that motion.
  Sherrod
        Vans of Jacksonville, Inc., a former vendor that provided van customization
        services to us, has filed suit against us in the Circuit Court (Duval County,
        Florida), alleging that we failed to pay for some of the services that they
        provided. Sherrod is seeking payment from us of $114. Among the items for
        which
        they are seeking payment are items that have not been delivered to us. If
        Sherrod delivers those items, the amount in dispute is less than $20.
  In
        addition, from time to time, we are involved in legal proceedings arising
        in the
        ordinary course of business. We do not currently have any pending litigation
        other than that described above.
 
 **NOTE
                  20 -**
              **SUBSEQUENT
                  EVENTS:**
 
 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.
 
 On
        March
        6, 2006, the Company initiated steps to reduce costs including the reduction
        in
        salaries to most employees of 10% including management under employment
        contracts, and terminated nine employees. The severance cost is estimated
        to be
        $102.
  64
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **NOTE
                    21-**
                  **QUARTERLY
                      FINANCIAL INFORMATION
                      (UNAUDITED):**
 
 As
        described in Note 3 “Restatement of Consolidated Financial Statements” the
        quarterly information for the first three quarters for the fiscal year ended
        December 31, 2005 and the four quarters for the fiscal year ended December
        31,
        2004 have been restated. The effects of this restatement are reflected
        below.
 
 **Year
                  Ended December 31, 2005****First
                  Quarter**
              
              **Second
                  Quarter**(As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)Revenues
              
              $
              1,852
              
              $
              1,852
              
              $
              2,414
              
              $
              2,414Gross
                  Profit
              
              $
              660
              
              $
              660
              
              $
              678
              
              $
              678Net
                  income (loss)
              
              $
              (1,910
              )
              $
              166
              
              $
              (2,325
              )
              $
              (3,444
              )Basic
                  and diluted income (loss) per share
              
              $
              (0.10
              )
              $
              0.01
              
              $
              (0.12
              )
              $
              (0.18
              )Shares
                  used in computing basic and diluted net income (loss) per
                  share
              
              
              18,751,942
              
              
              18,751,942
              
              
              18,815,049
              
              
              18,815,049
 Third
                  Quarter
              
              Fourth
                  Quarter
              
              Total(As
                  reported)
              
              (As
                  restated)Revenues
              
              $
              1,914
              
              $
              1,914
              
              $
              1,589
              
              $
              7,769Gross
                  Profit
              
              $
              624
              
              $
              624
              
              $
              75
              
              $
              2,037Net
                  (loss)
              
              $
              (2,792
              )
              $
              (2,217
              )
              $
              (1,269
              )
              $
              (6,764
              )Basic
                  and diluted (loss) per share
              
              $
              (0.15
              )
              $
              (0.12
              )
              $
              (0.07
              )
              $
              (0.36
              )Shares
                  used in computing basic and diluted net (loss) per share
              
              
              18,879,464
              
              
              18,879,464
              
              
              18,838,148
              
              
              18,826,966
  65
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **Year
                  Ended December 31, 2004**First
                  Quarter
              
              Second
                  Quarter(As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)Revenues
              
              $
              1,099
              
              $
              1,099
              
              $
              1,552
              
              $
              1,552Gross
                  Profit
              
              $
              464
              
              $
              464
              
              $
              600
              
              $
              600Net
                  (Loss)
              
              $
              (525
              )
              $
              (490
              )
              $
              (1,120
              )
              $
              (1,385
              )Basic
                  and diluted (loss)Per share
              
              $
              (0.03
              )
              $
              (0.03
              )
              $
              (0.06
              )
              $
              (0.08
              )Shares
                  used in computing basic and diluted net(loss) per share
              
              
              18,030,526
              
              
              18,030,526
              
              
              18,035,899
              
              
              18,035,899
 
 
 
 Third
                  Quarter
              
              Fourth
                  Quarter
              
              Total
              
              Total(As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)Revenues
              
              $
              1,833
              
              $
              1,833
              
              $
              1,551
              
              $
              1,551
              
              $
              6,035
              
              $
              6,035Gross
                  Profit
              
              $
              796
              
              $
              796
              
              $
              243
              
              $
              243
              
              $
              2,103
              
              $
              2,103Net
                  (loss)
              
              $
              (869
              )
              $
              (748
              )
              $
              (1,959
              )
              $
              (3,555
              )
              $
              (4,473
              )
              $
              (6,178
              )Basic
                  and diluted (loss)Per share
              
              $
              (0.05
              )
              $
              (0.04
              )
              $
              (0.11
              )
              $
              (0.19
              )
              $
              (0.25
              )
              $
              (0.34
              )Shares
                  used in computing basic and diluted net(loss) per share
              
              
              18,208,242
              
              
              18,208,242
              
              
              18,557,669
              
              
              18,557,669
              
              
              18,223,609
              
              
              18,223,609
  66
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
  **Years
                  Ended December 31, 2005****First
                  Quarter**
              
              **Second
                  Quarter**
              
              **Third
                  Quarter**(As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)**Balance
                  Sheet**TOTAL
                  ASSETS
              
              
              17,089
              
              
              17,089
              
              
              21,113
              
              
              21,113
              
              
              21,086
              
              
              21,086LIABILITIES
                  AND STOCKHOLERS’ EQUITYTotal
                  current liabilities
              
              
              2,009
              
              
              2,009
              
              
              4,236
              
              
              4,236
              
              
              6,904
              
              
              6,904Noncurrent
                  liabilities:Long
                  term convertible notes payable
              
              
              5,400
              
              
              398
              
              
              5,200
              
              
              682
              
              
              8,436
              
              
              4,402Long
                  term notes payable
              
              
              ---
              
              
              ---
              
              
              3,780
              
              
              1,750
              
              
              ---
              
              
              (1,853
              )Long
                  term asset retirement obligation
              
              
              162
              
              
              162
              
              
              95
              
              
              95
              
              
              104
              
              
              104Long
                  term, other
              
              
              44
              
              
              44
              
              
              33
              
              
              33
              
              
              22
              
              
              22Derivative
                  financial instruments
              
              
              ---
              
              
              4,520
              
              
              ---
              
              
              7,185
              
              
              ---
              
              
              5,949Total
                  liabilities
              
              
              7,615
              
              
              7,133
              
              
              13,344
              
              
              13,981
              
              
              15,466
              
              
              15,528Stockholders’
                  Equity:Preferred
                  stock
              
              
              180
              
              
              180
              
              
              180
              
              
              180
              
              
              180
              
              
              180Common
                  stock
              
              
              188
              
              
              188
              
              
              188
              
              
              188
              
              
              189
              
              
              189Warrants
              
              
              36
              
              
              36
              
              
              29
              
              
              29
              
              
              21
              
              
              21Additional
                  paid-in capital
              
              
              63,065
              
              
              63,610
              
              
              63,691
              
              
              64,235
              
              
              64,341
              
              
              64,885Accumulated
                  deficit
              
              
              (53,995
              )
              
              (54,058
              )
              
              (56,319
              )
              
              (57,500
              )
              
              (59,111
              )
              
              (59,717
              )Total
                  Stockholders’ Equity
              
              
              9,474
              
              
              9,956
              
              
              7,769
              
              
              7,132
              
              
              5,620
              
              
              5,558TOTAL
                  LIABILITIES AND STOCKHOLDERS’ EQUITY
              
              
              17,089
              
              
              17,089
              
              
              21,113
              
              
              21,113
              
              
              21,086
              
              
              21,086
  67
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **Years
                  Ended December 31, 2004****First
                  Quarter**
              
              **Second
                  Quarter**
              
              **Third
                  Quarter**(As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)
              
              (As
                  reported)
              
              (As
                  restated)**Balance
                  Sheet**TOTAL
                  ASSETS
              
              
              16,192
              
              
              16,192
              
              
              15,697
              
              
              15,697
              
              
              14,924
              
              
              14,924LIABILITIES
                  AND STOCKHOLERS’ EQUITYTotal
                  current liabilities
              
              
              1,901
              
              
              1,901
              
              
              2,644
              
              
              2,644
              
              
              2,933
              
              
              2,933Noncurrent
                  liabilities:Long
                  term convertible notes payable
              
              
              ---
              
              
              ---
              
              
              ---
              
              
              ---
              
              
              ---
              
              
              ---Long
                  term notes payable
              
              
              923
              
              
              810
              
              
              698
              
              
              600
              
              
              428
              
              
              345Long
                  term asset retirement obligation
              
              
              ---
              
              
              ---
              
              
              ---
              
              
              ---
              
              
              ---
              
              
              ---Long
                  term, other
              
              
              20
              
              
              20
              
              
              100
              
              
              100
              
              
              81
              
              
              81Derivative
                  financial instruments
              
              
              ---
              
              
              355
              
              
              ---
              
              
              604
              
              
              ---
              
              
              469Total
                  liabilities
              
              
              2,844
              
              
              3,086
              
              
              3,442
              
              
              3,948
              
              
              3,442
              
              
              3,828Stockholders’
                  Equity:Preferred
                  stock
              
              
              180
              
              
              180
              
              
              180
              
              
              180
              
              
              180
              
              
              180Common
                  stock
              
              
              180
              
              
              180
              
              
              180
              
              
              180
              
              
              183
              
              
              183Warrants
              
              
              1,351
              
              
              1,351
              
              
              1,381
              
              
              1,381
              
              
              160
              
              
              160Additional
                  paid-in capital
              
              
              59,774
              
              
              59,933
              
              
              59,770
              
              
              59,929
              
              
              61,085
              
              
              61,243Accumulated
                  deficit
              
              
              (48,137
              )
              
              (48,538
              )
              
              (49,256
              )
              
              (49,921
              )
              
              (50,126
              )
              
              (50,670
              )Total
                  Stockholders’ Equity
              
              
              13,348
              
              
              13,106
              
              
              12,255
              
              
              11,749
              
              
              11,482
              
              
              11,096TOTAL
                  LIABILITIES AND STOCKHOLDERS’ EQUITY
              
              
              16,192
              
              
              16,192
              
              
              15,697
              
              
              15,697
              
              
              14,924
              
              
              14,924
  68
 **NESTOR,
          INC.**
 **NOTES
          TO THE CONSOLIDATED FINANCIAL STATEMENTS**
 In
          Thousands, Except Share And Per Share Information
 **NOTE
                  22-**
              **RECENT
                  ACCOUNTING PRONOUNCEMENTS:**
  On
        December 16, 2004, the FASB issued SFAS 123 (revised 2004),
        Share-Based Payment (“SFAS 123(R)”), which is a revision of
        SFAS No. 123. SFAS 123(R) supersedes APB Opinion No. 25,
        Accounting for Stock Issued to Employees (“APB 25”) and amends
        SFAS No. 95, Statement of Cash Flows. Generally, the approach in
        SFAS 123(R) is similar to the approach described in SFAS 123. However,
        SFAS 123(R) requires all share-based payments to employees, including
        grants of employee stock options, to be recognized in the income statement
        based
        on their fair values at the date of grant. Pro forma disclosure is no longer
        an
        alternative. SFAS 123(R) must be adopted in fiscal years beginning after
        June 15, 2005. The Company adopted SFAS 123(R) on January 1, 2006, the
        commencement of its first quarter of fiscal 2006. The Company believes the
        effect will be comparable to the pro forma effect as shown in Note 2P - Stock
        Option Plans.
  The
        Company adopted the “modified prospective” transition method in which awards
        that are granted, modified, or settled after the date of adoption should
        be
        measured and accounted for in accordance with SFAS 123(R). Unvested
        equity-classified awards that were granted prior to the effective date should
        continue to be accounted for in accordance with SFAS 123, except that
        amounts must be recognized in the income statement.
  As
        permitted by SFAS 123, the Company currently accounts for share-based
        payments to employees using the intrinsic value method in accordance with
        APB 25 and, as such, generally recognizes no compensation cost for employee
        stock options. Accordingly, the adoption of SFAS 123(R)’s fair value method
        will have a significant impact on the Company’s results of operations, although
        it will have no impact on the Company’s overall cash flows.
  In
        March
        2005, the SEC issued Staff Accounting Bulletin 107 (SAB 107) to assist
        preparers by simplifying some of the implementation challenges of
        SFAS 123(R). In particular, SAB 107 provides supplemental
        implementation guidance on SFAS 123(R), including guidance on valuation
        methods, classification of compensation expense, inventory capitalization
        of
        share-based compensation cost, income tax effects, disclosures in Management’s
        Discussion of an Analysis and several other issues. The Company will apply
        the
        principles of SAB 107 in conjunction with its adoption of
        SFAS 123(R).
  In
        May
        2005, the FASB issued SFAS No. 154, “ *Accounting
        Changes and Error Corrections,* ”
which
        replaces APB Opinion No. 20, “ *Accounting
        Changes* ”
and
        SFAS No. 3, “ *Reporting
        Accounting Changes in Interim Financial Statements,* ”
and
        requires the retrospective application to prior periods financial statements
        for
        changes in accounting principles, unless it is impracticable to determine
        either
        the period-specific effects or the cumulative effect of the change. The
        retrospective application of the change would be limited to the direct effects
        of the change, and indirect effects would be recognized in the period of
        the
        accounting change. The Company adopted this standard on January 1, 2006,
        and
        does not believe that it will have a material impact on the consolidated
        financial statements.
  69
 
 ITEM
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
 
 None.
 
 ITEM
                  9A.
              Controls
                  and Procedures
 
 Disclosure
        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.
        Any
        system of controls can provide only reasonable, and not absolute, assurance
        that
        the objectives of the control system are met. In addition, the design of
        any
        control system is based in part on certain assumptions about the likelihood
        of
        future events. Because of these and other inherent limitations of control
        systems, there can be no assurance that any design will succeed in achieving
        its
        stated goal under all potential future conditions.
 
 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,
        2005.
 
 Based
        upon that evaluation and as a result of comments received in November 2005
        from
        the Staff of the SEC pertaining to our Registration Statement on Form S-2,
        File
        No. 333-126047 as discussed in our Currrent Report on Form 8-K filed on December
        5, 2005, our Chief Executive Officer and Chief Financial Officer concluded
        that
        as of December 31, 2005, our disclosure controls and procedures were ineffective
        with respect to the accounting and reporting of complex financial transactions
        involving the sale by us of non-conventional convertible debt instruments
        to
        Laurus Master Fund, Ltd. in July 2003, January 2004 and May 2005, and to
        accredited investors in November 2004. Specifically, we did not account for
        embedded derivatives in those debt instruments in accordance with Statement
        of
        Financial Accounting Standards No. 133, “Accounting for Derivative Instruments
        and Hedging Activities” and EITF 00-19, “Accounting for Derivative Financial
        Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.” That
        failure to so account for those embedded derivatives constitutes a material
        weakness in our internal control over financial reporting as set forth in
        the
        Guidance in Auditing Standards No. 2 of the Public Company Accounting Oversight
        Board regarding previously issued financial statements. This material weakness
        was also noted by our independent auditors in a letter to the Audit Committee
        of
        the Company’s Board of Directors dated April 12, 2006. As a result of that
        material weakness, in April 2006, we restated our financial statements for
        years
        ended December 31, 2003 and 2004, as well as for the quarters ended March
        31,
        June 30 and September 30, 2004 and 2005. See Note 3 to the financial statements
        included in this Report. To address this ineffectiveness of our disclosure
        controls and procedures and material weakness in our internal control over
        financial reporting, we have identified and retained outside consultants
        with
        experience and expertise in the identification, classification and accounting
        treatment of embedded derivatives and implemented internal procedures whereby
        we
        will use those consultants to advise us on identifying, classifying and
        accounting for future transactions which could involve embedded derivatives.
        We
        believe that this change will remediate the ineffectiveness of our disclosure
        controls and procedures and material weakness in our internal control over
        financial reporting relating to the accounting for complex financial
        instruments; however, given the nature and continuing evolvement of the
        accounting rules governing these financial transactions there is no assurance
        that the guidance provided to us by consultants on these transactions will
        be
        correctly interpreted.
 
 Based
        upon the evaluation of the effectiveness of the design and operation of our
        disclosure controls and procedures, our Chief Executive Officer and Chief
        Financial Officer concluded that as of December 31, 2005, except as discussed
        in
        the previous paragraph, our disclosure controls and procedures were effective,
        in that they (i) provide reasonable assurance 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) ensure 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.
  70
 
 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 year ended December
        31, 2005 that has materially affected, or is reasonably likely to materially
        affect, the Company’s internal control over financial reporting. To remediate
        the ineffectiveness of our disclosure controls and procedures and material
        weakness in our internal control over financial reporting relating to the
        accounting for complex financial instruments discussed above, during the
        quarter
        ended March 31, 2006, we identified and retained outside consultants with
        experience and expertise in the identification, classification and accounting
        treatment of embedded derivatives and implemented internal procedures whereby
        we
        will use those consultants to advise us on identifying, classifying and
        accounting for future transactions which could involve embedded
        derivatives.
 
 Management’s
        Report on Internal Control Over Financial Reporting
 
 We
        will
        be required by the Sarbanes-Oxley Act to include an assessment of our internal
        control over financial reporting and attestation from an independent registered
        public accounting firm in our Annual Report on Form 10-K beginning with our
        filing for our fiscal year ending December 31, 2007. Pending revisions to
        the
        scope of the Sarbanes-Oxley Act may change our compliance requirements and
        timing based on our market capitalization and revenue levels.
 
 ITEM
                  9B.
              Other
                  Information
 
 None.
 
 ITEM
                  10.
              Directors
                  and Executive Officers of the Registrant.
  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.
  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: Nigel P.
        Hebborn.
 
 ITEM
                  11.
              Executive
                  Compensation.
 
 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.
 
 ITEM
                  12.
              Security
                  Ownership of Certain Beneficial Owners and Management.
 
 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.
 
 ITEM
                13.
              Certain
                  Relationships and Related Transactions.
 
 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.
 
 ITEM
                  14.
              Principal
                  Accounting Fees and Services.
 
 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.
  71
 
 **PART
        IV**
 
 ITEM15.
              Exhibits,
                  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 the contents to the financial statements annexed hereto,
                  are
                  included in Part II, Item 8.
  (2)
              Consolidated
                  Financial Statement Schedule: Valuation and Qualifying Accounts
                  and
                  Reserves. All other schedules are omitted because such information
                  is not
                  applicable.
  (3)
              Exhibits
                  numbered in accordance with Item 601 of Regulation S-K and filed
                  herewith.
 
 See
        Exhibit Index.
 
 (b)
              See
                  Exhibit Index.
  72
  **PART
        IV**
 
 ITEM 15(a)(2)
 
 NESTOR,
        Inc.
 Consolidated
        Financial Statement Schedule
 Valuation
        and Qualifying Accounts and Reserves
 (In
        Thousands)
 
 For
        Years
        ended December 31, 2005, 2004, 2003
  Accounts
        receivable allowance for doubtful accounts:
  2005
              
              2004
              
              2003Balance
                  at beginning of year
              
              $
              84
              
              $
              84
              
              $
              ---Provision
                  charged to expense
              
              
              80
              
              
              34
              
              
              84Write-offs
                  and recoveries
              
              
              ---
              
              
              (34
              )
              
              ---Balance
                  at end of year
              
              $
              164
              
              $
              84
              
              $
              84
   Inventory
        allowance for obsolescence:
  2005
              
              2004
              
              2003Balance
                  at beginning of year
              
              $
              50
              
              $
              ---
              
              $
              ---Provision
                  charged to expense
              
              
              330
              
              
              50
              
              
              ---Provision
                  in other accounts
              
              
              173
              
              
              ---
              
              
              ---Write-offs
                  and recoveries
              
              
              (13
              )
              
              ---
              
              
              ---Balance
                  at end of year
              
              $
              (540
              )
              $
              (50
              )
              $
              (0
              )
  73
  **SIGNATURE**
 
 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)/s/
                  William B. DanzellWilliam
                  B. Danzell, Chief Executive Officer/s/
                  Nigel P. HebbornNigel
                  P. Hebborn, Chief Financial Officer
 
 Date:
        April 14, 2006
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, this report has
        been
        signed below by the following persons on behalf of the registrant and in
        the
        capacities and on the dates indicated.
 
 **Signatures**
              
              **Title**
              
              **Date**/s/
                  George L. BallGeorge
                  L. Ball
              
              Chairman
                  of the Board of Directors
              
              April
                  14, 2006/s/
                  William B. DanzellWilliam
                  B. Danzell
              
              Director,
                  President, and Chief Executive Officer
              
              April
                  14, 2006/s/
                  Albert H. CoxAlbert
                  H. Cox
              
              Director
              
              April
                  14, 2006/s/
                  Terry E. FieldsTerry
                  E. Fields
              
              Director
              
              April
                  14, 2006/s/
                  David N. JordanDavid
                  N. Jordan
              
              Director
              
              April
                  14, 2006
  74
  **Exhibit
                        No.**
                    **Description
                        of Exhibits**3.1
                    Restated
                        Certificate of Incorporation.4.1
                    Specimen
                        Certificate for shares of Common Stock, $.01 par value, of
                        the Registrant
                        filed as Exhibit 4.1 to the Company’s Registration Statement on Form S-2
                        (File No. 333-108432), filed September 2, 2003, is hereby
                        incorporated
                        herein by reference.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.10.3
                    License
                        Agreement dated as of March 28, 1997, between Nestor, Inc.
                        and Total
                        System Services, Inc. filed as an Exhibit to the Company's
                        Current report
                        on Form 8-K dated April 8, 1997, 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, 1999.10.6
                    Secured
                        Note Agreement by and among Nestor, Inc., Nestor Traffic
                        Systems, Inc. and
                        NTS Investors LLC dated January 9, 2001 and filed as an Exhibit
                        to the
                        Company's Current Report on Form 8-K on 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 on
                        February 9, 2001 is hereby incorporated by reference.10.8
                    License
                        Agreement dated May 18, 2001 between the Company and Retail
                        Decisions,
                        Inc. filed as an exhibit to the Company's current report
                        on Form 8K dated
                        May 18, 2001, which is hereby incorporated by reference.10.9
                    Security
                        Purchase Agreement dated July 31, 2003 between Nestor, Inc.
                        and Laurus
                        Master Fund, Ltd. filed as an exhibit to the Company's current
                        report on
                        Form 8-K dated July 31, 2003, which is hereby incorporated
                        by
                        reference.10.10
                    Convertible
                        Note dated July 31, 2003 made by Nestor, Inc. to Laurus Master
                        Fund, Ltd.
                        filed as an exhibit to the Company's current report on Form
                        8-K dated July
                        31, 2003 which is hereby incorporated by reference.10.11
                    Registration
                        Rights Agreement dated July 31, 2003 between Nestor, Inc.
                        and Laurus
                        Master Fund, Ltd. filed as an exhibit to the Company's current
                        report on
                        Form 8-K dated July 31, 2003, which is hereby incorporated
                        by
                        reference.10.12
                    Common
                        Stock Purchase Warrant dated July 31, 2003 issued by Nestor,
                        Inc. to
                        Laurus Master Fund, Ltd. filed as an exhibit to the Company's
                        current
                        report on Form 8-K dated July 31, 2003 which is hereby incorporated
                        by
                        reference.10.13
                    Stock
                        Pledge Agreement dated July 31, 2003 between Nestor Traffic
                        Systems, Inc.
                        and Laurus Master Fund, Ltd. filed as an exhibit to the Company's
                        current
                        report on Form 8-K dated July 31, 2003, which is hereby incorporated
                        by
                        reference.
  75
  **Exhibit
                    No.**
                **Description
                    of Exhibits**10.14
                Pledge
                    and Security Agreement dated July 31, 2003 between CrossingGuard,
                    Inc. and
                    Laurus Master Fund, Ltd. filed as an exhibit to the Company's
                    current
                    report on Form 8-K dated July 31, 2003 which is hereby incorporated
                    by
                    reference.10.15
                Guaranty
                    dated July 31, 2003 by CrossingGuard, Inc. to Laurus Master Fund,
                    Ltd.
                    filed as an exhibit to the Company's current report on Form 8-K
                    dated July
                    31, 2003, which is hereby incorporated by reference.10.16
                Nestor,
                    Inc. Incentive Stock Option Plan, as amended, filed as an Exhibit
                    to the
                    Company’s Registration Statement on Form S-8, filed May 5, 1987, is hereby
                    incorporated herein by reference10.17
                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.10.18
                Nestor
                    Traffic Systems, Inc., Form of Subscription Agreement dated March
                    25,
                    1999, to sell a 37.5% equity position in its common stock and
                    issue a
                    warrant for an additional 17.5% common stock interest filed as
                    an Exhibit
                    to Nestor's Current Report on Form 8-K dated April 23, 1999 is
                    hereby
                    incorporated by reference.10.19
                Security
                    Purchase Agreement dated January 14, 2004 between Nestor, Inc.
                    and Laurus
                    Master Fund, Ltd. filed as an Exhibit to Nestor's Current Report
                    on Form
                    8-K dated December 31, 2003 is hereby incorporated by
                    reference.10.20
                Convertible
                    Note dated January 14, 2004 made by Nestor, Inc. to Laurus Master
                    Fund,
                    Ltd. filed as an Exhibit to Nestor's Current Report on Form 8-K
                    dated
                    December 31, 2003 is hereby incorporated by reference.10.21
                Registration
                    Rights Agreement dated January 14, 2004 between Nestor, Inc.
                    and Laurus
                    Master Fund, Ltd. filed as an Exhibit to Nestor's Current Report
                    on Form
                    8-K dated December 31, 2003 is hereby incorporated by
                    reference.10.22
                Redemption
                    and Conversion Agreement dated January 14, 2004 between Nestor,
                    Inc. and
                    Laurus Master Fund, Ltd. 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.10.23
                Placement
                    Agent Agreement dated December 24, 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.10.24
                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 Nestor'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.10.26
                Employment
                    Agreement dated October 13, 2004 between Nestor, Inc. and William
                    B.
                    Danzell, filed as an Exhibit to Nestor's Current Report on Form
                    8-K dated
                    October 13, 2004, 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 Nestor'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 Nestor'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 Nestor's Current
                    Report
                    on Form 8-K dated November 5, 2004, is hereby incorporated by
                    reference.
  76
  **Exhibit
                    No.**
                **Description
                    of Exhibits**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 Nestor's
                    Current
                    Report on Form 8-K dated November 5, 2004, is hereby incorporated
                    by
                    reference.10.31
                Distributorship
                    Agreement by and between Nestor, Inc. and Vitronics Machine Vision,
                    Ltd.
                    dated August 17, 2004 filed as an Exhibit to Nestor's Quarterly
                    Report on
                    Form 10-Q for the quarter ended September 30, 2004, is hereby
                    incorporated
                    by reference.10.32
                Incentive
                    Stock Option Agreement by and between Nestor, Inc. and William
                    B. Danzell
                    dated October 13, 2004 filed as an Exhibit to Nestor's Quarterly
                    Report on
                    Form 10-Q for the quarter ended September 30, 2004, is hereby
                    incorporated
                    by reference.10.33
                Incentive
                    Stock Option Agreement by and between Nestor, Inc. and William
                    B. Danzell
                    dated October 13, 2004 filed as an Exhibit to Nestor's Quarterly
                    Report on
                    Form 10-Q for the quarter ended September 30, 2004, is hereby
                    incorporated
                    by reference.10.34
                Incentive
                    Stock Option Agreement by and between Nestor, Inc. and Nigel
                    P. Hebborn
                    dated October 13, 2004 filed as an Exhibit to Nestor'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 Nestor'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 Nestor's Annual Report on Form 10-K for
                    the year
                    ended December 31, 2004, is hereby incorporated by
                    reference.10.37
                Employment
                    Agreement dated March 29, 2005 between Nestor, Inc. and Benjamin
                    M.
                    Alexander filed as an Exhibit to Nestor'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 Nestor's Annual Report
                    on Form
                    10-K for the year ended December 31, 2004, is hereby incorporated
                    by
                    reference.10.39
                Incentive
                    Stock Option Agreement by and between Nestor, Inc. and Benjamin
                    M.
                    Alexander dated March 29, 2005 filed as an Exhibit to Nestor's
                    Annual
                    Report on Form 10-K for the year ended December 31, 2004, is
                    hereby
                    incorporated by reference.10.40
                Bonus
                    Targets Letter to William B. Danzell dated March 29, 2005 filed
                    as an
                    Exhibit to Nestor'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 Nestor'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 Nestor's Current Report
                    on Form
                    8-K dated May 27, 2005, is hereby incorporated by
                    reference.10.43
                Subsidiary
                    Guaranty dated May 16, 2005 by Nestor, Inc. to Laurus Master
                    Fund, Ltd.
                    filed as an Exhibit to Nestor's Registration Statement on Form
                    S-2 (File
                    No. 333-126047), is hereby incorporated by reference.10.44
                Security
                    Agreement by Nestor, Inc. and Nestor Traffic Systems, Inc. to
                    Laurus
                    Master Fund, Ltd. filed as an Exhibit to Nestor's Registration
                    Statement
                    on Form S-2 (File No. 333-126047), is hereby incorporated by
                    reference.10.45
                NTSI
                    Pledge and Security Agreement dated May 16, 2005, between Laurus
                    Master
                    Fund, Ltd and Nestor Traffic Systems, Inc. filed as an Exhibit
                    to Nestor's
                    Registration Statement on Form S-2 (File No. 333-126047), is
                    hereby
                    incorporated by reference.
  77
 
 **Exhibit
                    No.**
                **Description
                    of Exhibits**10.46
                Common
                    Stock Purchase Warrant dated May 16, 2005 by Nestor, Inc. to
                    Laurus Master
                    Fund, Ltd. filed as an Exhibit to Nestor's Registration Statement
                    on Form
                    S-2 (File No. 333-126047), is hereby incorporated by
                    reference.10.47
                Settlement
                    Agreement and Mutual Release by and between Transol Corporation
                    Ltd.,
                    Transol USA, Inc. and Nestor, Inc. dated June 28, 2005 filed
                    as an Exhibit
                    to Nestor's Quarterly Report on Form 10-Q for the quarter ended
                    June 30,
                    2005, is hereby incorporated by reference.10.48
                Secured
                    Promissory Note by Nestor, Inc. to Foundation Partners I, LLC.
                    dated
                    August 30, 2005 filed as an Exhibit to Nestor's Current Report
                    on Form 8-K
                    dated August 30, 2005, is hereby incorporated by
                    reference.10.49
                Purchase
                    and Sale Agreement dated August 31, 2005 by and among Transol
                    Holdings Pty
                    Limited (ACN 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 Nestor's
                    Quarterly
                    Report on Form 10-Q for the quarter ended September 30, 2005,
                    is hereby
                    incorporated by reference.10.50
                Securities
                    Purchase Agreement by and between Nestor, Inc. and Laurus Master
                    Fund,
                    Ltd. dated December 28, 2005 filed as an Exhibit to Nestor's
                    Current
                    Report on Form 8-K dated December 28, 2005, is hereby incorporated
                    by
                    reference.10.51
                Secured
                    Term Note made by Nestor, Inc. to Laurus Master Fund, Ltd. dated
                    December
                    28, 2005 filed as an Exhibit to Nestor's Current Report on Form
                    8-K dated
                    December 28, 2005, is hereby incorporated by reference.10.52
                Registration
                    Rights Agreement by and between Nestor, Inc. and Laurus Master
                    Fund, Ltd.
                    dated December 28, 2005 filed as an Exhibit to Nestor's Current
                    Report on
                    Form 8-K dated December 28, 2005, is hereby incorporated by
                    reference.10.53
                Reaffirmation
                    and Ratification Agreement and Amendment by and among Nestor,
                    Inc., Nestor
                    Traffic Systems, Inc. and Laurus Master Fund, Ltd. dated December
                    28, 2005
                    filed as an Exhibit to Nestor's Current Report on Form 8-K dated
                    December
                    28, 2005, is hereby incorporated by reference.10.54
                Letter
                    agreement from William B. Danzell to Nestor, Inc. dated March
                    6, 2006
                    filed as an Exhibit to Nestor's Current Report on Form 8-K dated
                    March 6,
                    2006, is hereby incorporated by reference.10.55
                Letter
                    agreement from Nigel P. Hebborn to Nestor, Inc. dated March 6,
                    2006 dated
                    March 6, 2006 filed as an Exhibit to Nestor'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 dated
                    March 6, 2006 filed as an Exhibit to Nestor's Current Report
                    on Form 8-K
                    dated March 6, 2006, is hereby incorporated by
                    reference.10.57
                Letter
                    agreement from Benjamin M. Alexander to Nestor, Inc. dated March
                    6, 2006
                    dated March 6, 2006 filed as an Exhibit to Nestor's Current Report
                    on Form
                    8-K dated March 6, 2006, is hereby incorporated by
                    reference.10.58
                Memorandum
                    of Agreement dated November 10, 2005 by and between Vitronic
                    Machine
                    Vision Ltd., a Georgia limited partnership and Nestor Traffic
                    Systems,
                    Inc.10.59
                Securities
                    Purchase Agreement dated January 31, 2006 by and among Nestor,
                    Inc. and
                    the investors named therein.10.60
                Form
                    of Common Stock Warrant dated January 31, 2006.23.01
                Consent
                    of Carlin, Charron & Rosen LLP dated April 12, 200631.1
                Certification
                    of principal executive officer pursuant to Rule 13a-14(a)/15d-14(a)
                    of the
                    Securities Exchange Act of 1934, as
                    amended
  78
 
 **Exhibit
                    No.**
                **Description
                    of Exhibits**31.2
                Certification
                    of principal financial officer pursuant to Rule 13a-14(a)/15d-14(a)
                    of the
                    Securities Exchange Act of 1934, as amended32
                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.






79