**U.S.
      SECURITIES AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**




**FORM
      10-QSB**




(Mark
      One)




[X]
            QUARTERLY
                REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
                1934




For
                the quarterly period ended: September 30,
                2006




**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 000-27023**







**TECHNEST
      HOLDINGS, INC.**


(Exact
      name of registrant as specified in its charter)




**Nevada**
            **88-0357272**(*State
                or other jurisdiction of*
              *incorporation
                or organization*)
            (*IRS
                Employer*
              *Identification
                No.*)





**One
      McKinley Square, Fifth Floor, Boston, MA, 02109**


( *Address
      of principal executive offices and zip code* )




**(617)
      722-9800**


( *Registrant’s
      telephone number, including area code* )






Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to filed such reports), and (2) has been subject to such filing requirements
      for
      the past 90 days.  Yes **** X ****   No  ****




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




As
      of
      November 10, 2006, there were 16,413,441 shares of common stock, $0.001 par
      value, of the registrant issued and outstanding.




Transitional
      Small Business Disclosure Format ( *Check
      one* ):  Yes    No X ****









**TECHNEST
      HOLDINGS, INC.**




**FORM
      10-QSB**


**TABLE
      OF CONTENTS**


**SEPTEMBER
      30, 2006**




PagePART
                I.      FINANCIAL INFORMATION:Item
                1.       Financial Statements
                (Unaudited)Condensed
                Consolidated Balance Sheet at September 30, 2006
            1Condensed
                Consolidated Statements of Operations for the Three Months Ended
                September
                30, 2006 and 2005
            2Condensed
                Consolidated Statement of Stockholders’ Equity for the Three Months Ended
                September 30, 2006
            3Condensed
                Consolidated Statements of Cash Flows for the Three Months Ended
                September
                30, 2006 and 2005
            4Notes
                to Condensed Consolidated Financial Statements
            6Item
                2.       Management’s Discussion and
                Analysis or Plan of Operation
            25Item
                3.       Controls and
                Procedures
            46PART
                II.      OTHER INFORMATIONItem
                1.       Legal Proceedings
            47Item
                2.       Unregistered Sales of Equity
                Securities and Use of Proceeds
            48Item
                6.        Exhibits
            49Signatures
            50




STATEMENTS
      CONTAINED IN THIS FORM 10-QSB, WHICH ARE NOT HISTORICAL FACTS CONSTITUTE
      FORWARD-LOOKING STATEMENTS AND ARE MADE UNDER THE SAFE HARBOR PROVISIONS OF
      THE
      PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. FORWARD-LOOKING STATEMENTS
      INVOLVE SUBSTANTIAL RISKS AND UNCERTAINTIES. YOU CAN IDENTIFY THESE STATEMENTS
      BY FORWARD-LOOKING WORDS SUCH AS "MAY", "WILL", "EXPECT", "ANTICIPATE",
      "BELIEVE", "ESTIMATE", "CONTINUE", AND SIMILAR WORDS. YOU SHOULD READ STATEMENTS
      THAT CONTAIN THESE WORDS CAREFULLY. ALL FORWARD-LOOKING STATEMENTS INCLUDED
      IN
      THIS FORM 10-QSB ARE BASED ON INFORMATION AVAILABLE TO US ON THE DATE HEREOF,
      AND WE ASSUME NO OBLIGATION TO UPDATE ANY SUCH FORWARD-LOOKING STATEMENTS.
      EACH
      FORWARD-LOOKING STATEMENT SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL
      STATEMENTS AND NOTES THERETO IN PART I, ITEM 1, OF THIS QUARTERLY REPORT AND
      WITH THE INFORMATION CONTAINED IN ITEM 2 TOGETHER WITH MANAGEMENT'S DISCUSSION
      AND ANALYSIS OR PLAN OF OPERATION CONTAINED IN OUR **** ANNUAL
      REPORT ON FORM 10-KSB FOR THE YEAR ENDED JUNE 30, 2006, INCLUDING, BUT NOT
      LIMITED TO, THE SECTION THEREIN ENTITLED "RISK FACTORS."










**PART
      I. FINANCIAL INFORMATION**


**Item
      1. Financial Statements**




**TECHNEST
      HOLDINGS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED BALANCE SHEET**


**SEPTEMBER
      30, 2006**


(Unaudited)


**ASSETS****Current
                  Assets**Cash
                  and cash equivalents
              
              $
              2,243,479Accounts
                  receivable
              
              
              7,823,897Unbilled
                  receivables
              
              
              1,354,492Inventory
                  and work in process
              
              
              74,659Restricted
                  cash
              
              
              250,000Prepaid
                  expenses and other current assets
              
              
              166,307**Total
                  Current Assets**
              
              
              11,912,834**Property
                  and Equipment**-
                  Net of accumulated depreciation and amortization of $767,800
              
              
              699,822**Other
                  Assets**Deposits
              
              
              69,202Deferred
                  financing costs - Net of accumulated amortization of $63,467
              
              
              1,220,542Definite-lived
                  intangible assets - Net of accumulated amortization of $3,932,037
              
              
              11,106,017Goodwill
              
              
              14,035,55126,431,312$
              39,043,968**LIABILITIES
                  AND STOCKHOLDERS' EQUITY****Current
                  Liabilities**Accounts
                  payable
              
              $
              10,676,712Accrued
                  expenses and other current liabilities
              
              
              3,882,248Due
                  to related party
              
              
              394,412Revolving
                  line of credit
              
              
              2,645,621Current
                  portion of long-term debt
              
              
              1,761,125**Total
                  Current Liabilities**
              
              
              19,360,118**Non
                  Current Liabilities**Long-term
                  debt, less current portion and discount of $208,703
              
              
              2,602,724**Total
                  Liabilities**
              
              
              21,962,842**Commitments
                  and Contingencies****Stockholders'
                  Equity**Series
                  A Convertible Preferred Stock - $.001 par value; 150 shares authorized;
                  64.325 shares issued
                and
                  outstanding (preference in liquidation of $64,325 at September
                  30, 2006)
              
              
              --Series
                  C Convertible Preferred Stock - $.001 par value; 1,149,425 shares
                  authorized: 632,185 issued
                and
                  outstanding (preference in liquidation of $1,375,002 at September
                  30,
                  2006)
              
              
              632Common
                  stock - par value $.001 per share; 500,000,000 shares authorized;
                  16,174,031 shares issued and outstanding
              
              
              16,173Additional
                  paid-in capital
              
              
              34,174,551Accumulated
                  deficit
              
              
              (17,110,230
              )**Total
                  Stockholders' Equity**
              
              
              17,081,126**Total
                  Liabilities and Stockholders' Equity**
              
              $
              39,043,968




See
      notes
      to condensed consolidated financial statements.


1


**TECHNEST
      HOLDINGS, INC. AND SUBSIDIARIES**




**CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS**


**FOR
      THE THREE MONTHS ENDED SEPTEMBER 30, 2006 and 2005**


**** (Unaudited)




2006
            
            2005(Restated)**Revenues**
            
            $
            19,969,638
            
            $
            18,996,341**Cost
                of Revenues**
            
            
            16,209,523
            
            
            15,590,455**Gross
                Profit**
            
            
            3,760,115
            
            
            3,405,886**Operating
                Expenses:**Selling,
                general and administrative (including $250,000 to related parties
                in
              the
                three months ended September 30, 2006 and 2005,
                respectively)
            
            
            3,755,905
            
            
            3,040,732Research
                and development
            
            
            5,424
            
            
            60,745Amortization
                of intangible assets
            
            
            446,511
            
            
            440,869**Total
                Operating Expenses**
            
            
            4,207,840
            
            
            3,542,346**Operating
                Loss**
            
            
            (447,725
            )
            
            (136,460
            )**Other
                (Expenses) Income, Net**Interest
                expense
            
            
            (1,452,459
            )
            
            (669,647
            )Derivative
                income
            
            
            --
            
            
            25,046,489Other
                income, net
            
            
            27,893
            
            
            30,582**Total
                Other (Expenses) Income, Net**
            
            
            (1,424,566
            )
            
            24,407,424**Net
                ( Loss) Income**
            
            $
            (1,872,291
            )
            $
            24,270,964**Net
                Income (Loss) Per Common Share   -
                Basic**
            
            $
            (0.12
            )
            $
            1.70-**Diluted**
            
            $
            (0.12
            )
            $
            1.47**Weighted
                Average Number Of Common Shares Outstanding   -
                Basic**
            
            
            16,037,913
            
            
            14,302,721**-
                Diluted**
            
            
            16,037,913
            
            
            16,542,444




See
      notes
      to condensed consolidated financial statements.




(Reflects
      reverse stock split of 1 for 211.18 on July 19, 2005)




2




**TECHNEST
      HOLDINGS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY**


**FOR
      THE THREE MONTHS ENDED SEPTEMBER 30, 2006** (Unaudited)






COMMON
                STOCK
            
            SERIES
                A
              CONVERTIBLE
              PREFERRED
                STOCK
            
            SERIES
                C
              CONVERTIBLE
              PREFERRED
                STOCK
            
            ADDITIONAL
              PAID
                IN
              CAPITAL
            
            ACCUMU-LATED
              DEFICIT
            
            TOTAL
              STOCK-HOLDERS'
              EQUITYSHARES
            
            AMOUNT
            
            SHARES
            
            AMOUNT
            
            SHARES
            
            AMOUNT
            
            AMOUNT
            
            AMOUNT
            
            AMOUNTBalance
                - July 1, 2006
            
            
            15,867,911
            
            $
            15,867
            
            
            64
            
            $
            --
            
            
            632,185
            
            $
            632
            
            $
            32,404,174
            
            $
            (15,237,939
            )
            $
            17,182,734Stock
                issued in connection with liquidated
              damages
                associated with registration
              rights
                agreements
            
            
            206,341
            
            
            206
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            556,839
            
            
            --
            
            
            557,045Stock
                issued to note holders in connection
              with
                subordination of security interest for
              bank
                financing
            
            
            99,779
            
            
            100
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            344,138
            
            
            --
            
            
            344,238Amortization
                of stock-based compensation
              related
                to restricted stock grants
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            398,630
            
            
            --
            
            
            398,630Fair
                value of warrants issued in connection
              with
                bank financing
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            217,732
            
            
            --
            
            
            217,732Fair
                value of warrants issued to a consultant
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            253,038
            
            
            --
            
            
            253,038Net
                loss
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            --
            
            
            (1,872,291
            )
            
            (1,872,291
            )Balance
                -September
                30, 2006
            
            
            16,174,031
            
            $
            16,173
            
            
            64
            
            $
            --
            
            
            632,185
            
            $
            632
            
            $
            34,174,551
            
            $
            (17,110,230
            )
            $
            17,081,126







See
      notes
      to condensed consolidated financial statements.




3


**TECHNEST
      HOLDINGS, INC. AND SUBSIDIARIES**


**CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS**


**FOR
      THE THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005**


(Unaudited)




2006
            
            2005**Cash
                Flows From Operating Activities:**
            
            
            
            (Restated)Net
                income (loss)
            
            $
            (1,872,291
            )
            $
            24,270,964Adjustment
                to reconcile net income (loss) to net cash used in operating
                activities:Derivative
                income
            
            
            --
            
            
            (25,046,489
            )Depreciation
                and amortization of property and equipment
            
            
            104,613
            
            
            86,933Amortization
                of intangible assets
            
            
            446,511
            
            
            440,869Non-cash
                interest expense
            
            
            1,292,583
            
            
            73,399Stock-based
                compensation
            
            
            398,630
            
            
            96,339Fair
                value of warrants issued to a consultant
            
            
            253,038
            
            
            --Changes
                in operating assets and liabilities:Accounts
                receivable
            
            
            1,550,982
            
            
            (291,212
            )Unbilled
                receivables
            
            
            699,629
            
            
            --Inventory
                and work in process
            
            
            (54,424
            )
            
            120,211Deposits
                and prepaid expenses and other current assets
            
            
            (5,907
            )
            
            442,227Restricted
                cash
            
            
            --
            
            
            (251,204
            )Due
                to related parties
            
            
            (201,370
            )
            
            (1,325,590
            )Accounts
                payable
            
            
            (2,568,725
            )
            
            (1,075,084
            )Accrued
                expenses and other current liabilities
            
            
            (966,687
            )
            
            589,149**Net
                Cash Used In Operating Activities**
            
            
            (923,418
            )
            
            (1,869,488
            )**Cash
                Flows From Investing Activities:**Purchase
                of property and equipment
            
            
            (32,151
            )
            
            (55,409
            )**Net
                Cash Used In Investing Activities**
            
            
            (32,151
            )
            
            (55,409
            )**Cash
                Flows From Financing Activities:**Proceeds
                from term loan
            
            
            3,000,000
            
            
            --Proceeds
                from revolving line of credit, net
            
            
            2,645,621
            
            
            --Payment
                of debt issuance costs
            
            
            (141,667
            )
            
            --Payment
                of loan guarantee fee to Markland
            
            
            (580,372
            )
            
            --Repayment
                of term loan
            
            
            (83,333
            )
            
            --Repayment
                of notes payable
            
            
            (5,003,411
            )
            
            (610,592
            )**Net
                Cash Used in Financing Activities**
            
            
            (163,162
            )
            
            (610,592
            )





4


**TECHNEST
                HOLDINGS, INC. AND SUBSIDIARIES**
              **CONDENSED
                CONSOLIDATED STATEMENTS OF CASH FLOWS (concluded)**
              (UNAUDITED)




**For
                The Three Months Ended**
              **September
                30,**2006
            
            2005(Restated)**Net
                Decrease In Cash**
            
            
            (1,118,731
            )
            
            (2,535,489
            )**Cash
                And Cash Equivalents - Beginning Of Period**
            
            
            3,362,210
            
            
            5,862,608**Cash
                And Cash Equivalents - End Of Period**
            
            $
            2,243,479
            
            $
            3,327,119




**Supplemental
                Disclosures Of Cash Flow Information:**Cash
                paid during the periods for:Interest
            
            $
            154,876
            
            $
            66,248Taxes
            
            $
            --
            
            $
            --**Non-cash
                investing and financing activities:**Fair
                value of common stock and warrants issued as deferred financing
                costs
            
            $
            561,870
            
            $
            --






See
      notes
      to condensed consolidated financial statements.




5




**TECHNEST
      HOLDINGS, INC AND SUBSIDIARIES**


**NOTES
      TO CONDENSED AND CONSOLIDATED FINANCIAL STATEMENTS**


**For
      the Three Months Ended September 30, 2006 and 2005**


(Unaudited)




**1.
      NATURE OF OPERATIONS**




Business
      History




Technest
      Holdings, Inc. (“Technest” or “the Company”) had no operations between October
      10, 2003 and February 14, 2005.




On
      February 14, 2005, Technest became a majority owned subsidiary of Markland
      Technologies, Inc. (“Markland”), a homeland defense, armed services and
      intelligence contractor. Technest issued to Markland 1,954,023 shares of its
      common stock, representing at the time of the acquisition a 93% ownership
      interest in Technest’s common stock on a primary basis, in exchange for
      10,168,764 shares of Markland common stock which were used as partial
      consideration for the concurrent acquisition of Genex Technologies, Inc.
      (“Genex”) (see Note 3). The acquisition of Genex was effected pursuant to an
      Agreement and Plan of Merger dated February 14, 2005 (the "Merger Agreement"),
      by and among Markland, Technest, MTECH Acquisition, Inc. ("MTECH"), a
      wholly-owned subsidiary of Technest, Genex and Jason Geng, the sole stockholder
      of Genex.




Effective
      June 29, 2004, Markland acquired 100% of the outstanding common stock of E-OIR
      Technologies, Inc. (“EOIR”), a company incorporated under the laws of the
      Commonwealth of Virginia, in conjunction with a Stock Purchase Agreement dated
      June 29, 2004 ("the Acquisition"). Markland agreed to pay the stockholders
      of
      EOIR $19,000,000, consisting of $8,000,000 in cash and promissory notes of
      $11,000,000. Additionally, Markland issued certain members of EOIR's management
      team options to purchase approximately $4,000,000 of Markland common stock.
      As a
      result of this transaction, EOIR became a wholly-owned subsidiary of Markland
      effective June 29, 2004.





On
      August
      17, 2005, pursuant to a Stock Purchase Agreement with Markland, Technest
      purchased all of the outstanding stock of EOIR. As consideration for this
      purchase, Technest issued 12 million shares of its common stock to Markland.
      As
      a result of this transaction, EOIR became a wholly-owned subsidiary of Technest
      effective August 17, 2005. Since this was a transaction between entities under
      common control, in accordance with Statement of Financial Accounting Standards
      (“SFAS”) No. 141, “Business Combinations”, Appendix D, Technest recognized the
      net assets of EOIR at their carrying amounts in the accounts of Markland on
      the
      date Technest came into Markland’s control group, February 14, 2005 and restated
      the financial statements to include the activity of EOIR from that date forward
      (see Note 3).




In
      connection with these acquisitions, the accounts of Technest and Genex have
      been
      adjusted using the push-down basis of accounting to recognize the allocation
      of
      the consideration paid to the respective net assets acquired (see Note
      3).




Our
      business, as it exists today, consists primarily of providing advanced
      engineering and research and development services in the areas of remote sensor
      systems and technologies, intelligent surveillance, chemical and explosives
      detection, and advanced technologies research and development.




Reorganization
      and Restatement




On
      August
      17, 2005, pursuant to a Stock Purchase Agreement with Markland Technologies,
      Inc., Technest’s majority stockholder, Technest purchased all of the outstanding
      stock of E-OIR Technologies, Inc., formerly one of Markland’s wholly-owned
      subsidiaries. As consideration for the stock of EOIR, Technest issued 12 million
      shares of its common stock to Markland. Markland’s ownership of Technest
      increased, at the time of the transaction, from 85% to approximately 98% on
      a
      primary basis and from 39% to approximately 82% on a fully diluted basis
      (assuming the conversion of all convertible securities and the exercise of
      all
      warrants to purchase Technest common stock). Accordingly, this reorganization
      did not result in a change of control of EOIR and Technest did not need
      stockholder consent in order to complete this reorganization.  Since
      this is a transaction between entities under common control, in accordance
      with
      SFAS No. 141, “Business Combinations”, Appendix D, the Company recorded the net
      assets of EOIR at their carrying value on the date Technest came into Markland’s
      control group, February 14, 2005 and the Company has restated its financial
      statements to include EOIR from this date (see Note 3). Markland acquired EOIR
      on June 29, 2004.







6





Technest
      also corrected its accounting for derivative financial instruments to conform
      to
      the requirements of Statements of Financial Accounting Standards ("SFAS") No.
      133, as amended, and Emerging Issues Task Force No. ("EITF") 00-19 (See Notes
      2
      and 5). For certain warrants issued by Technest in February 2005, Technest
      could
      not conclude that the warrants were able to be settled in unregistered shares
      of
      common stock due to liquidated damage provisions in registration rights
      agreements. Therefore the warrants did not meet the requirements for
      classification as equity instruments. Instead, the warrants were recorded as
      liabilities and carried at fair value. Fair value adjustments to these
      derivative liabilities are charged (credited) to the statement of operations.





The
      impact of the restatement on the financial statements for the three months
      ended
      September 30, 2005 to correct the accounting for the warrants is as
      follows:





As
                originally
              stated
            
            Impact
                of
              restatement
            
            As
                restatedNet
                income (loss)
            
            $
            (775,525
            )
            $
            25,046,489
            
            $
            24,270,964Net
                income (loss) applicable to common stockholders
            
            $
            (775,525
            )
            $
            25,046,489
            
            $
            24,270,964Net
                income (loss) applicable to common stockholders per common share
            
            $
            (.05
            )
            $
            1.75
            
            $
            1.70





Basis
      of Presentation




The
      accompanying unaudited condensed consolidated financial statements of Technest
      have been prepared in accordance with accounting principles generally accepted
      in the United States of America for interim financial information, without
      being
      audited, pursuant to the rules and regulations of the Securities and Exchange
      Commission. Accordingly, they do not include all of the information and
      footnotes required by accounting principles generally accepted in the United
      States of America for complete financial statements. In the opinion of
      management, all adjustments (consisting of normal recurring accruals) considered
      necessary to make the financial statements not misleading have been included.
      Operating results for the three months ended September 30, 2006 are not
      necessarily indicative of the result that may be expected for the year ending
      June 30, 2007. The unaudited condensed consolidated financial statements should
      be read in conjunction with the consolidated financial statements and footnotes
      included in the Company's 10-KSB for the year ended June 30, 2006 filed with
      the
      Securities and Exchange Commission.




**2.
      SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**




Principles
      of Consolidation




The
      condensed consolidated financial statements include the accounts of Technest
      and
      its wholly-owned subsidiaries, Genex Technologies, Inc. and EOIR Technologies,
      Inc. All significant inter-company balances and transactions have been
      eliminated in consolidation.




Use
      of
      Estimates




The
      preparation of the accompanying consolidated financial statements in conformity
      with accounting principles generally accepted in the United States of America
      requires management to make certain estimates and assumptions that affect the
      reported amounts of assets and liabilities and disclosures of contingent assets
      and liabilities at the date of the financial statements and the reported amounts
      of revenue and expenses during the reporting period. Actual results could differ
      from those estimates. Significant estimates that are particularly susceptible
      to
      change are the
      revenue recognized under the percentage of completion method on firm fixed
      price
      contracts, allowance for doubtful accounts, the estimated useful lives of
      property and equipment, carrying value of goodwill, useful lives of
      definite-lived intangible assets, the realizability of deferred tax assets,
      the
      amount due to contracting government agencies as a result of their audits,
      the
      fair value allocation of consideration paid to the net assets of businesses
      acquired and the fair value of derivative liabilities and equity instruments
      issued.




7


Concentrations




A
      significant portion of revenue is generated from contracts with Federal
      government agencies, including one contract with the U.S. Army which represented
      approximately $17,430,000 of revenue for the three months ended September 30,
      2006. Consequently, a significant portion of all accounts receivable are due
      from Federal government agencies either directly or through other government
      contractors.




Cash
      and Cash Equivalents




The
      Company considers all highly liquid investments with maturities of ninety days
      or less to be cash equivalents. Cash equivalents consist of money market mutual
      funds as of September 30, 2006.  The Company has cash balances in banks in
      excess of the maximum amount insured by the FDIC as of September 30,
      2006.




Restricted
      Cash




Restricted
      cash represents a one year certificate of deposit, maturing April 2007,
      collateralizing a letter of credit in the amount of $250,000 issued in favor
      of
      a bank in conjunction with the Company’s corporate credit cards.




Accounts
      Receivable




Accounts
      receivable represent the amount invoiced for product shipped and amounts
      invoiced by the Company under contracts. An allowance for doubtful accounts
      is
      determined based on management's best estimate of probable losses inherent
      in
      the accounts receivable balance. Management assesses the allowance based on
      known trouble accounts, historical experience and other currently available
      evidence.




A
      significant portion of the Company's receivables are due from government
      contracts, either directly or as a subcontractor. The Company has not
      experienced any material losses in accounts receivable related to these
      contracts and has provided no allowance at September 30, 2006. If management
      determines amounts to be uncollectible, they will be charged to operations
      when
      that determination is made.




Inventory
      and Work in Process




Inventories
      are stated at the lower of cost or market.  Cost is determined by the
      first-in, first-out method and market represents the lower of replacement costs
      or estimated net realizable value. Work in process represents allowable costs
      incurred but not billed related to contracts.




Property
      and Equipment




Property
      and equipment are valued at cost and are being depreciated over their useful
      lives using the straight-line method for financial reporting. Routine
      maintenance and repairs are charged to expense as incurred. Expenditures which
      materially increase the value or extend useful lives are capitalized.




Property
      and equipment are depreciated using straight-line methods over the estimated
      useful lives of assets as follows:




Software
            3
                yearsComputer
                equipment
            3
                yearsFurniture
                and fixtures
            5-7
                yearsLeasehold
                improvements
            Shorter
                of useful life and lease termVehicles
            5
                years





8




Property
      and equipment consisted of the following at September 30, 2006:




Software
            
            $
            180,057Computer
                equipment
            
            
            686,282Furniture
                and fixtures
            
            
            345,275Leasehold
                improvements
            
            
            222,338Vehicles
            
            
            33,6701,467,622Less
                accumulated depreciation and amortization
            
            
            (767,800
            )$
            699,822




Depreciation
      and amortization expense for the three months ended September 30, 2006 and
      2005
      was $104,613 and $86,933, respectively.




Definite-lived
      Intangible Assets




Included
      in definite-lived intangible assets are the amounts assigned to customer
      relationships and contracts and patents acquired in connection with business
      combinations (see Note 3). Also included are certain costs of outside legal
      counsel related to obtaining new patents.




Patent
      costs are amortized over the legal life of the patents, generally fifteen years,
      starting on the patent issue date.  The costs of unsuccessful and abandoned
      patent applications are expensed when abandoned.  The cost to maintain
      existing patents are expensed as incurred.  The nature of the technology
      underlying these patents relates primarily to 3D imaging, intelligent
      surveillance and 3D facial recognition technologies.  As of September 30,
      2006, certain of these technologies have been licensed to Markland.




With
      the
      acquisition of Genex, Technest acquired commercialized technology relating
      to 3D
      facial recognition cameras and contracts and customer relationships from the
      application of 3D imaging technologies to breast cancer research for the
      National Institute of Health and disposable sensors and 3D face mapping for
      the
      U.S. Department of Defense. The amounts assigned to these definite-lived
      intangible assets were determined by management based on a number of factors
      including an independent purchase price allocation analysis. These assets are
      being amortized over their estimated useful life of five years.




Contracts
      and Customer Relationships acquired as a result of business combinations (see
      Note 3) have been valued by management considering various factors including
      independent appraisals done by valuation and financial advisory firms in
      accordance with SFAS No. 141, “Business Combinations”, SFAS No. 142, “Goodwill
      and Other Intangible Assets”, Financial Accounting Standards Board (“FASB”)
      Concepts Statement Number 7 and Emerging Issued Task Force (“EITF”) Issue No.
      02-17, “Recognition of Customer Relationship Assets Acquired in a Business
      Combination”. These assets are being amortized over the contractual terms of the
      existing contracts plus anticipated contract renewals in accordance with EITF
      Issue No. 02-17.




Fair
      Value of Financial Instruments




The
      financial statements include various estimated fair value information at
      September 30, 2006, as required by SFAS No. 107, "Disclosures about Fair Value
      of Financial Instruments." Financial instruments are initially recorded at
      historical cost. If subsequent circumstances indicate that a decline in the
      fair
      value of a financial asset is other than temporary, the financial asset is
      written down to its fair value.




Unless
      otherwise indicated, the fair values of financial instruments approximate their
      carrying amounts. By their nature, all financial instruments involve risk,
      including credit risk for non-performance by counterparties. The maximum
      potential loss may exceed any amounts recognized in the consolidated balance
      sheets.




The
      fair
      value of cash, accounts receivable and long-term debt approximate their recorded
      amounts because of their relative market and settlement terms. The fair value
      of
      the notes payable issued to the former owners of EOIR (see Note 3) have been
      recorded at their fair value. Management was primarily responsible for
      determining this fair value and in making its determination, management
      considered a number of factors, including an independent valuation.




9


Operating
      Segments




The
      Company operates in two Operating Segments as defined in paragraph 10 of SFAS
      No. 131, “Disclosures about Segments of an Enterprise and Related Information”.
      These are (1) the business of EOIR which primarily consists of products and
      services in remote sensing technology and (2) the business of Genex which
      primarily consists of research and development, design and fabrication of 3D
      imaging and of intelligent surveillance products. Further, since both these
      operating segments have similar economic characteristics, as well as similar
      products and services, production processes, customers, distribution methods
      and
      regulatory environment, the Company concluded that they meet the aggregation
      criteria outlined in paragraph 17 of SFAS No. 131. Therefore, the Company
      aggregates the two operating segments into a single reportable segment in
      accordance with paragraph 16 of SFAS No. 131.




Revenue
      Recognition





Revenues
      from products are recognized when the following criteria are met: (1) there
      is
      persuasive evidence of an arrangement, such as contracts, purchase orders or
      written requests; (2) delivery has been completed and no significant obligations
      remain; (3) price to the customer is fixed or determinable; and (4) collection
      is probable. Revenues from services related to border security logistic support
      are recognized at the time these services are performed.




Revenues
      from time and materials contracts are recognized as costs are incurred and
      billed. Allowable costs incurred but not billed as of a period end are recorded
      as work in process.




Revenues
      from firm fixed price contracts are recognized on the percentage-of-completion
      method, either measured based on the proportion of costs recorded to date on
      the
      contract to total estimated contract costs or measured based on the proportion
      of labor hours expended to date on the contract to total estimated contract
      labor hours, as specified in the contract.




Provisions
      for estimated losses on all contracts are made in the period in which such
      losses become known. Changes in job performance, job conditions, and estimated
      profitability, including those arising from contract penalty provisions, and
      final contract settlements may result in revision to cost and income and are
      recognized in the period in which the revisions are determined.





EOIR
      participates in teaming agreements where they are the primary contractor and
      they participate with other organizations to provide complex integrated remote
      sensor product and technology development services to the Federal government.
      EOIR has managerial and oversight responsibility for all team members as well
      as
      the responsibility for the ultimate acceptability of all integrated technical
      performance criteria under the contracts for deliverable services and products.
      EOIR, as the prime contractor who accepts risks for these customer funded tasks,
      includes as revenues the amounts that they bill under these teaming arrangements
      and include as direct costs amounts that are reimbursable or paid to team
      members because these teaming arrangements meet the criteria for gross revenue
      reporting as discussed in EITF Issue No. 99-19, “Reporting Revenue Gross as a
      Principal versus Net as an Agent”. This policy on revenue recognition is also
      supported by paragraph 60 of the AICPA’s Statement of Position No. 81-1
“Accounting for Performance of Construction-Type and Certain Production-Type
      Contracts”.   Revenues under teaming arrangements amounted to approximately
      $707,000 for the three months ended September 30, 2006.




Shipping
      Costs




Delivery
      and shipping costs are included in cost of revenue in the accompanying
      consolidated statements of operations.




Research
      and Development





The
      Company charges unfunded research and development costs to expense as incurred.
      Funded research and development is part of the Company's revenue base and the
      associated costs are included in cost of revenues. The Company capitalizes
      costs
      related to acquired technologies that have achieved technological feasibility
      and have alternative uses. The Company expenses as research and development
      costs the technologies we acquire if they are in process at the date of
      acquisition or have no alternative uses.





10


Income
      Taxes





In
      accordance with SFAS No. 109, “Accounting for Income Taxes,” the Company
      allocates current and deferred taxes as if it were a separate tax payer.





Since
      its
      acquisition by Markland, the Company files consolidated income tax returns
      with
      Markland and, for financial statement purposes, computes its provision or
      benefit for income taxes based on the income and expenses reported in the
      Company’s statements of operations. The allocation is not subject to a tax
      sharing arrangement with Markland and it is based on the tax effect of the
      Company’s operations as if it had not been included in a consolidated return,
      based on the preacquisition book and tax basis of the Company’s assets and
      liabilities. Therefore, the impact of applying push down accounting (see Note
      3)
      to the Company is not considered in determining the Company’s provision for
      income taxes. Amounts included in the Company’s statement of operations related
      to the impact of push down accounting, including the amortization of
      definite-lived intangible assets and stock-based compensation, have been
      considered permanent differences for purposes of the intercompany tax
      allocation.




Deferred
      tax assets and liabilities are recognized for the future tax consequences
      attributable to differences between the financial statement carrying amounts
      of
      existing assets and liabilities and their respective tax bases, and operating
      loss and tax credit carry forwards. Deferred tax assets and liabilities are
      measured using enacted tax rates expected to apply to taxable income in the
      years in which these temporary differences are expected to be recovered or
      settled. A deferred tax asset is recorded for net operating loss and tax credit
      carry forwards to the extent that their realization is more likely than not.
      The
      deferred tax benefit or expense for the period represents the change in the
      deferred tax asset or liability from the beginning to the end of the
      period.





Income
      (Loss) Per Share





Basic
      and
      diluted net income (loss) per common share has been computed based on the
      weighted average number of shares of common stock outstanding during the periods
      presented. Basic net income (loss) per share is computed by dividing net income
      (loss) by weighted-average common shares outstanding during the year. Diluted
      net income(loss) per share is computed by dividing net income (loss) by the
      weighted-average number of common and dilutive option and warrant shares
      outstanding based on the average market price of Technest’s common stock (under
      the treasury stock method).





Common
      stock equivalents, consisting of Series A and C Convertible Preferred Stock
      and
      warrants were not included in the calculation of the diluted loss per share
      in
      the three months ended September 30, 2006 because their inclusion would have
      had
      the effect of decreasing the loss per share otherwise computed.





The
      following table sets forth the computation of the weighted-average number of
      shares used in calculating basic and diluted net income per share in the three
      months ended September 30, 2005:





Weighted-average
                shares outstanding for basic net income per share
            
            
            14,302,721Series
                A Convertible Preferred Stock
            
            
            588,716Series
                C Convertible Preferred Stock
            
            
            1,149,425Warrants
                to purchase common stock
            
            
            501,582Total
                shares for diluted net income per share
            
            
            16,542,444




For
      purposes of computing the weighted average number of common shares outstanding,
      the Company assumed that the 12,000,000 shares of common stock issued to
      Markland in conjunction with the acquisition of EOIR (see Note 3) were issued
      on
      February 14, 2005.





Net
      income (loss) per share for all prior periods have been retroactively restated
      to reflect a 1 for 211.18 reverse stock split effective at the close of business
      on July 19, 2005.




Impairment
      of Intangible Assets




The
      Company records as goodwill the excess of the purchase price over the fair
      value
      of the identifiable net assets acquired. Goodwill is identified and recorded
      at
      the reporting unit level as required by paragraphs 30-31 of SFAS No. 142,
      "Goodwill and Other Intangible Assets". SFAS No. 142 prescribes a two-step
      process for impairment testing, at the reporting unit level, of goodwill
      annually as well as when an event triggering impairment may have occurred.
      The
      first step tests for impairment, while the second step, if necessary, measures
      the impairment. The Company has determined that its reporting units are its
      operating segments since this is the lowest level at which discrete financial
      information is available and regularly reviewed by management. The Company
      has
      elected to perform its annual analysis during the fourth quarter of each fiscal
      year. No indicators of impairment were identified in the three months ended
      September 30, 2006.




11


Impairment
      of Long-Lived Assets




Pursuant
      to SFAS No. 144, "Accounting for the Impairment or Disposal of Long-lived
      Assets", Technest continually monitors events and changes in circumstances
      that
      could indicate carrying amounts of long-lived assets may not be recoverable.
      An
      impairment loss is recognized when expected cash flows are less than the asset's
      carrying value. Accordingly, when indicators of impairment are present, Technest
      evaluates the carrying value of such assets in relation to the operating
      performance and future undiscounted cash flows of the underlying assets.
      Technest’s policy is to record an impairment loss when it is determined that the
      carrying amount of the asset may not be recoverable. No impairment charges
      were
      recorded in the three months ended September 30, 2006.




Derivative
      Instruments





Technest
      generally does not use derivative instruments to hedge exposures to cash-flow
      or
      market risks. However, certain warrants to purchase common stock that are
      indexed to the Company's common stock were classified as liabilities when the
      Company was not permitted to settle the instruments in unregistered shares.
      In
      such instances, net-cash settlement is assumed for financial reporting purposes,
      even when the terms of the underlying contracts do not provide for net-cash
      settlement. Such financial instruments were initially recorded at relative
      fair
      value with subsequent changes in fair value charged (credited) to operations
      in
      each reporting period. If the Company subsequently achieves the ability to
      settle the instruments in unregistered shares, the instruments are reclassified
      to equity at their fair value.




Stock-Based
      Compensation




On
      July 1, 2006, the Company adopted the provisions of SFAS No. 123(R),
“Share-Based Payment”, which is a revision of SFAS No. 123, “Accounting for
      Stock Based Compensation”. There was no cumulative effect to the Company as a
      result of adopting this new accounting principle. Under SFAS No. 123(R),
      the Company now recognizes compensation costs resulting from the issuance of
      stock-based awards to employees and directors as an expense in the statement
      of
      operations over the service period based on a measurement of fair value for
      each
      stock award. As permitted under SFAS No. 123, prior to July 1, 2006, the
      Company accounted for its stock-based employee and director awards under the
      recognition and measurement principles of Accounting Principles Board (“APB”)
      Opinion No. 25, “Accounting for Stock Issued to Employees”, and related
      interpretation including Financial Accounting Standards Board ("FASB")
      Interpretation No. 44, "Accounting for Certain Transactions Involving Stock
      Compensation", an interpretation of APB No. 25. Under this intrinsic value
      method, compensation expense represented the excess, if any, of the quoted
      market price of the Company’s common stock at the grant date over the exercise
      price.




Had
      the
      Company followed the fair value method in accounting for its stock-based
      employee compensation it would have had the following effect on the net income
      for the three m onths
      ended September 30, 2005.




Three
                months ended
              September
                30,  2005Net
                income as reported (restated)
            
            $
            24,270,964Add:
                stock-based employee compensation under intrinsic value method included
                in
                net income
            
            
            96,339Deduct:
                stock-based employee compensation under fair value method
            
            
            (196,958
            )Pro
                forma net income applicable to common stockholders
            
            $
            24,170,345Basic
                net income per share - as reported (restated)
            
            $
            1.70Diluted
                net income per share - as reported (restated)
            
            $
            1.47Basic
                net income per share - pro forma
            
            $
            1.69Diluted
                net income per share - pro forma
            
            $
            1.46







12


Recent
      Accounting Pronouncements




In
      September 2006, the FASB issued SFAS No. 157, “Fair Value
      Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework
      for measuring fair value in generally accepted accounting principles, and
      expands disclosures about fair value measurements. This statement is effective
      for financial statements issued for fiscal years beginning after Nov. 15, 2007.
      The Company is currently evaluating the impact of SFAS 157 on the consolidated
      financial statements.




In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB
      108”). SAB 108 considers the effects of prior year misstatements when
      quantifying misstatements in current year financial statements. It is effective
      for fiscal years ending after Nov. 15, 2006. The Company does not believe the
      adoption of SAB 108 will have a material impact on the consolidated financial
      statements.




In
      June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in
      Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”),
      which clarifies the accounting for uncertainty in tax positions. FIN 48 requires
      financial statement recognition of the impact of a tax position, if that
      position is more likely than not to be sustained on examination, based on the
      technical merits of the position. The provisions of FIN 48 will be effective
      for
      financial statements issued for fiscal years beginning after Dec. 15, 2006,
      with
      the cumulative effect of the change in accounting principle recorded as an
      adjustment to opening retained earnings. The Company does not expect the
      adoption of FIN 48 to have a material effect on the consolidated financial
      statements.




**3.
      ACQUISITIONS**




Purchase
      by Markland Technologies, Inc.




On
      February 14, 2005, in conjunction with a Securities Purchase Agreement between
      Technest and Markland, Technest issued 1,954,023 shares of common stock to
      Markland Technologies, Inc. in exchange for 10,168,764 shares of Markland’s
      common stock (“the Markland Investment”). The common stock issued to Markland
      represents a 93% interest in Technest’s common stock. Consequently, Technest
      became a majority owned subsidiary of Markland on that date. The Securities
      Purchase Agreement contains provisions for Markland to deliver additional shares
      of its common stock to Technest in conjunction with the acquisition of Genex
      Technologies, Inc. (see below) and conversion of the Series B Convertible
      Preferred Stock (see Note 7).




Purchase
      of Genex Technologies, Inc.




The
      acquisition of Genex was effected pursuant to an Agreement and Plan of Merger
      dated February 14, 2005 (the "Merger Agreement"), by and among Markland,
      Technest, MTECH Acquisition, Inc. ("MTECH"), a wholly-owned subsidiary of
      Technest, Genex and Jason Geng, the sole stockholder of Genex.




In
      accordance with the terms of the Merger Agreement, on February 14, 2005, MTECH,
      a wholly-owned subsidiary of Technest, merged with and into Genex, with Genex
      surviving the merger as a wholly-owned subsidiary of Technest. As a result
      of
      the merger, all of the outstanding shares of the capital stock of Genex were
      automatically converted into the right to receive in the aggregate (i) $3
      million in cash; (ii) 10,168,764 shares of Markland's common stock (the shares
      of Markland common stock issued to Technest in the Markland Investment); and
      (iii) if earned, contingent payments in the form of additional shares of
      Technest common stock. A brokerage fee in connection with this acquisition
      of
      $300,000 was also paid. In addition, Mr. Geng was to receive a twelve month
      unsecured promissory note in the principal amount of $550,000 that paid interest
      at the rate of 6% per annum. Mr. Geng's share consideration was to be adjusted
      to reflect changes in the closing bid price of Markland common stock in the
      10
      trading days following February 14, 2005, subject to limitations set forth
      in
      the Merger Agreement. Following the acquisition, the Company discovered what
      it
      believes were material misrepresentations made by Mr. Geng in the Merger
      Agreement. As a result of damages arising in connection with these breaches,
      the
      Company has refused to issue the promissory note, the additional Markland share
      consideration or the contingent payments of Technest common stock.




13




A
      summary
      of the initial allocation of the purchase price to the estimated fair value
      of
      the assets acquired and liabilities assumed is as follows:




Cash
            
            $
            3,300,000Shares
                of Markland Technologies, Inc. common stock
            
            
            6,101,258Total
                Purchase Price
            
            $
            9,401,258Fair
                value allocation to net assets acquired:Fair
                value of assets acquired -Current
                assets, including cash of $784,484
            
            $
            1,199,402Property
                and equipment
            
            
            44,000Fair
                value of liabilities assumed -Accounts
                payable & accrued expenses
            
            
            (544,292
            )Fair
                value of identifiable net tangible assets acquired
            
            
            699,110Intangible
                assets - intellectual property
            
            
            161,110In-process
                research and development
            
            
            2,095,000Commercialized
                patents
            
            
            440,000Contracts
                and customer relationships
            
            
            1,130,000Goodwill
            
            
            4,876,038Total
            
            $
            9,401,258




As
      a
      result of the transaction being structured as a stock acquisition, Technest
      does
      not expect any goodwill resulting from the transaction to be deductible for
      tax
      purposes. Consequently, no deferred tax assets were recorded in connection
      with
      the merger.




In
      connection with the Genex acquisition, Technest also raised gross proceeds
      of
      $5,000,000 through a private placement of units consisting of 1,149,425 shares
      of Series B Convertible Preferred Stock, 1,149,425 shares of Series C
      Convertible Preferred Stock and warrants to purchase 1,149,425 shares of
      Technest’s common stock (see Note 7).




Push
      Down Accounting




Based
      on
      the substantial change in ownership and control of Technest, as well as the
      fact
      that the investors in the Technest financing (see Note 7) represented a
      collaborative group brought together to accomplish the acquisition of Genex,
      the
      push down basis of accounting has been applied to the acquisition of Technest
      by
      Markland and the acquisition of Genex by Technest. In accordance with the push
      down basis of accounting, Technest’s and Genex’s net assets were adjusted to
      their estimated fair values as of the date of acquisition which resulted in
      the
      basis of the net assets acquired being adjusted as disclosed above and
      accumulated deficit was reset to zero as of the acquisition date.




Acquisition
      of EOIR and Restatement




On
      August
      17, 2005, pursuant to a Stock Purchase Agreement with Markland Technologies,
      Inc., our majority stockholder, we purchased all of the outstanding stock of
      E-OIR Technologies, Inc., (“EOIR”), formerly one of Markland’s wholly-owned
      subsidiaries. As consideration for the stock of EOIR, we issued 12 million
      shares of our common stock to Markland. Markland’s ownership of Technest
      increased, at the time of the transaction, from 85% to approximately 98% on
      a
      primary basis and from 39% to approximately 82% on a fully diluted basis
      (assuming the conversion of all of our convertible securities and the exercise
      of all warrants to purchase Technest common stock). Accordingly, this
      reorganization did not result in a change of control of EOIR and Technest did
      not need stockholder consent in order to complete this
      reorganization.  Since this is a transaction between entities under
      common control, in accordance with Statement of Financial Accounting Standards
      (SFAS) No. 141, “Business Combinations”, Appendix D, the Company recorded the
      net assets of EOIR at their carrying value on the date Technest
      came into Markland’s control group, February 14, 2005 and the Company has
      restated its financial statements to include EOIR from this date (see Note
      1) .
      Additionally, the Company has reported the results of operations and cash flows
      as though the transfer of EOIR occurred at the beginning of the periods
      presented. Financial statements and financial information for prior periods
      has
      been restated to include the results of EOIR in order to provide comparative
      information. Markland acquired EOIR on June 29, 2004.  EOIR generated
      approximately 97% of Markland’s revenue for its latest fiscal year ended June
      30, 2005.




14




**4.
      DEFINITE-LIVED INTANGIBLE ASSETS**




Definite-lived
      intangible assets consist of the following at September 30, 2006:




Patents
            
            $
            601,110Customer
                relationships and contracts
            
            
            14,436,944Accumulated
                amortization
            
            
            (3,932,037
            )Net
                definite-lived intangible asset
            
            $
            11,106,017




Amortization
      expense was $446,511 and $440,869 for the three months ended September 30,
      2006
      and 2005, respectively.




**5.
      DERIVATIVE LIABILITY**




On
      February 14, 2005, in conjunction with the issuance of Technest’s Series B and C
      Convertible Preferred Stock, the Company issued warrants to purchase 1,149,425
      shares of common stock at $6.50 per share. The shares issuable upon exercise
      of
      these warrants are covered by a Registration Rights Agreement which requires
      the
      Company to pay certain liquidated damages in the event that the Company does
      not
      have an effective registration statement. Due to the significance of the
      liquidated damages potentially due under the Registration Rights Agreement,
      the
      Company must conclude that settling the warrants in unregistered shares was
      “uneconomic”. Since it is not within the Company’s control to settle the
      warrants in registered shares, the Company is required to assume that the
      warrants will be net-cash settled. As a result, under EITF 00-19, the warrants
      did not meet the definition of equity instruments.




On
      September 30, 2005, the Company amended the terms of the Registration Rights
      Agreement such that any liquidated damages would only be payable in common
      stock. As a result of this amendment, the Company was able to conclude that
      the
      settlement of the warrants in unregistered shares was no longer uneconomic.
      Therefore, on September 30, 2005, the then fair value of the warrants,
      $1,917,127, was reclassified from derivative liabilities to additional paid-in
      capital.




In
      the
      three months ended September 30, 2005 changes in the fair value of the warrants
      recorded as derivative income in the statements of operations was
      $25,046,489.




**6.
      LONG-TERM DEBT AND REVOLVING LINE OF CREDIT**




Bank
      loan





On
      August
      10, 2006, Technest, EOIR and Genex, closed on a financing (the “Financing”)
      under two Loan and Security Agreements with Silicon Valley Bank (the “Bank”).
      One Credit Agreement provides for a term loan facility under which the Company
      may borrow term loans with an initial minimum loan of $3,000,000 (the “Term
      Loan”). Subject to the Bank’s receipt of additional documentation for the period
      through the month ending December 31, 2006 and if no event of default under
      the
      Credit Agreement has occurred or is continuing, the Company may borrow up to
      an
      additional $1,000,000 under the Term Loan facility on or before February 15,
      2007. The other Credit Agreement provides for a one year revolving line of
      credit for up to $8,750,000 (the “Revolver”), provided that the Company’s
      borrowing under the Revolver is limited to 80% of Eligible Accounts Receivable,
      as defined. In addition, the maximum amount outstanding under both Credit
      Agreements at any time may not exceed $10,000,000. Both the Term Loan facility
      and the Revolver are secured by all of the Company’s assets and the assets of
      its subsidiaries, including all intellectual property.





15


Upon
      the
      date of closing under the Credit Agreements, the Company borrowed the entire
      $3,000,000 available under the Term Loan facility and borrowed approximately
      $4,445,000 under the Revolver. At September 30, 2006, the outstanding balance
      was $2,916,667 on the Term Loan and $2,645,621 on the Revolver.




Interest
      on all outstanding amounts under the Term Loan is payable monthly at a rate
      equal to the Bank’s prime rate plus 2.75%. Each loan under the Term Loan is
      repayable in 36 equal monthly principal installments (currently $83,333) plus
      accrued interest.





The
      Revolver will bear interest at a rate equal to the Bank’s prime rate plus 0.50%
      per annum, but the Company must pay a minimum quarterly amount equal to the
      interest on an outstanding balance of $1,400,000. In addition, the Company
      will
      pay a monthly collateral handling fee of 0.10% per month on financed
      receivables. Interest and handling fees are paid as invoices are
      collected.





The
      Bank’s prime rate as of September 30, 2006 is 8.25%.




The
      financial covenants under the Term Loan require that the Company maintain,
      on a
      monthly basis tested as of the last day of each month, a minimum quick ratio
      (representing the ratio of quick assets (or cash and accounts receivable) plus
      total marketable securities to current liabilities, plus all short-term
      indebtedness to the Bank but excluding subordinated debt and debt from
      affiliates) of 0.70 to 1.0 through November 30, 2006, 0.85 to 1.0 from December
      31, 2006 through May 31, 2007, 1.0 to 1.0 from June 30, 2007 through August
      31,
      2007 and 1.20 to 1.0 from September 30, 2007 and all monthly reporting periods
      thereafter. If the Company does not maintain these ratios, then the sum of
      the
      Company’s cash plus 80% of eligible accounts receivable minus borrowings under
      the Revolver must exceed $2,000,000. The Company must maintain a Fixed Charge
      Coverage Ratio, as defined, measured on the last day of every month for the
      three month period ending on the last day of such month, of at least 1:0 to
      1:0
      through periods ending November 30, 2006; at least 1.25:1.0 for periods ending
      on December 31, 2006 through May 31, 2007; and at least 1.50:1.0 for all periods
      thereafter. In addition, the Credit Agreements contain affirmative and negative
      covenants concerning the Company operations including restrictions on our
      ability to dispose of our assets, change our business, ownership or management,
      incur other indebtedness, create or permit liens on the Company’s property, make
      investments, pay dividends, redeem stock or engage in transactions with
      affiliates.





In
      the
      event of prepayment, the Company will pay to the Bank a Prepayment Fee equal
      to:
      (i) three percent (3.0%) of the amount of any Term Advance prepaid during the
      first year of the Term Loan and (ii) two percent (2.0%) of the amount of any
      Term Advance prepaid for each year thereafter, prior to the Commitment
      Termination Date (as defined in the Credit Agreement).





Markland
      has entered into an Unconditional Guaranty pursuant to which Markland agreed
      to
      guaranty up to $6,000,000 of the principal obligations plus interest thereon
      and
      related expenses under the Credit Agreements and a Stock Pledge Agreement
      pursuant to which Markland pledged to the Bank 1,739,130 shares of Technest
      common stock currently owned by Markland, which had a market value of $6,000,000
      as of August 4, 2006. The Guaranty and the Stock Pledge Agreement terminate
      August 3, 2008 if no event of default has occurred. In consideration for this
      guarantee and stock pledge, Technest paid Markland $580,372.
      This amount has been recorded as a debt issuance cost and will be amortized
      over
      the life of the Term Loan of 36 months. The Company incurred additional debt
      issuance costs of approximately $141,667.





A
      summary
      of the deferred financing costs as of September 30, 2006 is as
      follows:





Payment
                to Markland for guaranty
            
            $
            580,372Fair
                value of warrants granted to Silicon Valley Bank (see Note
                8)
            
            
            217,732Fair
                value of common stock issued to EOIR note holders in connection with
                subordination (see Note 7)
            
            
            344,238Other
                deferred financing costs paid
            
            
            141,667Gross
                deferred financing costs
            
            
            1,284,009Accumulated
                amortization
            
            
            (63,467
            )Net
                deferred financing costs
            
            $
            1,220,542





16


Pre-Payment
      of Promissory Notes





On
      June
      29, 2004, EOIR issued notes guaranteed by Markland in the face amount of
      $11,000,000 in connection with Markland’s acquisition of EOIR’s common stock.
      These notes accrue interest at 6% compounded monthly and are payable in
      quarterly installments over 60 months. The fair market value of these notes
      was
      $9,532,044 as determined by management based on a number of factors including
      an
      independent valuation. The discount of $1,467,956 is amortized to interest
      expense over the life of the note.





The
      Company used a portion of the proceeds of the Financing to pre-pay the
      outstanding principal of $4,952,526 of certain EOIR promissory notes issued
      in
      June 2004. After these payments, there remain outstanding, notes having a total
      principal balance of $1,655,885. The security interest securing these remaining
      notes was subordinated to the Bank’s first priority security interest.





At
      September 30, 2006, the face value of the notes and unamortized discount was
      $1,655,885 and $208,703, respectively. During the three month ended September
      30, 2006, the Company amortized $672,070 to non-cash interest
      expense.





During
      the three months ended September 30, 2006, the Company also prepaid in total
      $50,885 of debt due to First Market Bank. There is no outstanding balance on
      these loans at September 30, 2006.




**7.
      STOCKHOLDERS' EQUITY**




Series
      A Convertible Preferred Stock




On
      February 8, 2005, the Company's board of directors designated 150 shares of
      preferred stock as Series A Convertible Preferred Stock (“Series A Preferred
      Stock”). The Series A Preferred Stock is non-interest bearing, is not entitled
      to receive dividends and is not redeemable. The Series A Preferred Stock has
      a
      liquidation preference of $1,000 per share. The holders of Series A Preferred
      Stock have no voting rights except that they will be entitled to vote as a
      separate class on any amendment to the terms or authorized number of shares
      of
      Series A Preferred Stock, the issuance of any equity security ranking senior
      to
      the Series A Preferred Stock and the redemption of or the payment of a dividend
      in respect of any junior security. At any time, holders of Series A Preferred
      Stock may elect to convert their Series A Preferred Stock into common stock.
      Each share of Series A Preferred Stock is currently convertible into 4,735
      shares of common stock provided that, following such conversion, the total
      number of shares of common stock then beneficially owned by such holder and
      its
      affiliates and any other persons whose beneficial ownership of common stock
      would be aggregated with the holder's for purposes of Section 13(d) of the
      Exchange Act, does not exceed 4.999% of the total number of issued and
      outstanding shares of common stock. The Series A Preferred Stock ranks pari
      passu with the Company's Series B and C Preferred Stock.




At
      September 30, 2006, there were 64.325 shares of Series A Preferred Stock issued
      and outstanding.




Series
      B and C Convertible Preferred Stock




On
      February 14, 2005, immediately after the acquisition by Markland of a
      controlling interest in Technest (see Note 3), Southridge Partners LP,
      Southshore Capital Fund Limited, Verdi Consulting, Inc., ipPartners, Inc.,
      DKR
      Soundshore Oasis Holding Fund, Ltd., DKR Soundshore Strategic Holding Fund,
      Ltd.
      and Deer Creek Fund, LP (collectively, the "Investors") paid $5,000,000 in
      cash
      to Technest for 1,149,425 shares of Series B Convertible Preferred Stock
      (“Series B Preferred Stock”), 1,149,425 shares of Series C Convertible Preferred
      Stock (“Series C Preferred Stock), and five-year warrants to purchase up to
      1,149,425 shares of Technest’s common stock at an exercise price of $6.50 per
      share (“the Investor Financing”) after adjusting for a 211.18 for one reverse
      stock split on July 19, 2005.




These
      securities were sold in units for a price of $4.35 per unit. Each unit consists
      of one share of Series B Preferred Stock; one share of Series C Preferred Stock
      and a warrant to purchase up to one share of Technest's common stock. Gross
      proceeds received from the sale of the units was $5,000,000. From these
      proceeds, the Company paid a finder’s fee of $1,200,000 and legal fees related
      to the financing of $287,578.




The
      Series B Preferred Stock was convertible into Markland common stock upon the
      earlier to occur of February 14, 2006 or the trading day immediately following
      the first period of five trading days during which Markland common stock has
      a
      closing bid price of $2.50 or higher on each day, if any. The number of shares
      issuable upon conversion of each share of Series B preferred stock was equal
      to
      approximately 4.35 divided by the lower of $0.60 and the average closing bid
      price for the 20 trading days preceding such conversion. Shares of the Series
      B
      Preferred Stock had a liquidation preference of $2.175 per share, could only
      vote on changes to the rights, privileges and priority of the Series B Preferred
      Stock, did not accrue dividends and were not redeemable. Upon conversion, the
      Series B Preferred Stock would be cancelled and not reissuable. The
      Series B Preferred Stock ranked pari passu with the Company's Series A and
      C
      Preferred Stock. At September 30, 2006, all Series B Preferred stock was
      converted and cancelled.




17




The
      Series C Preferred Stock is convertible into Technest common stock at any time
      at the option of the stockholder. The number of shares of Technest common stock
      into which each share of Series C Preferred Stock is convertible is determined
      by dividing $2.175 by the Series C Conversion Price. The Series C Conversion
      Price is $2.175. Shares of the Series C Preferred Stock have a liquidation
      preference of approximately $2.175 per share, may only vote on changes to the
      rights, privileges and priority of the Series C Preferred Stock, receive
      dividends on an as converted basis whenever dividends are made to the Technest
      common stock holders, and are not redeemable. The Series C Preferred Stock
      ranks
      pari passu with the Company's Series A and B Preferred Stock.




Technest
      and the Investors entered into a Registration Rights Agreement dated February
      14, 2005. Pursuant to this agreement, Technest agreed to file a registration
      statement covering the resale of (a) all of the common stock issuable upon
      conversion of the Series C preferred stock, (b) all of the common stock issuable
      upon exercise of the common stock purchase warrants, and (c) common stock which
      may become issuable to selling stockholders as liquidated damages for breach
      of
      covenants contained in or as a result of adjustments contemplated by the
      securities purchase agreement related to the Investor Financing and the
      Registration Rights Agreement. Technest agreed to use its best efforts to cause
      the registration statement to be declared effective as promptly as possible
      thereafter. On September 30, 2005, the Company amended the terms of this
      Registration Rights Agreement so that liquidated damages could only be paid
      for
      in the Company’s common stock at a rate of 4% of the initial subscription amount
      for any month.




Technest
      agreed to issue additional shares of its common stock to the Investors if the
      combined market prices of Markland and Technest’s common stock do not equal or
      exceed $6.525 at the end of one year from the purchase date and assuming such
      Investors are still holding all the securities comprising the units. Effective
      October 25, 2005, there are no longer any units outstanding and the Company
      was
      not obligated to issue any additional common stock.




On
      August
      19, 2005, Markland entered into a definitive exchange agreement with the Deer
      Creek Fund LLC, pursuant to which Markland exchanged 500 shares of Markland
      Series D Preferred Stock for 114,942 shares of Technest Series B Convertible
      Preferred Stock. Subsequently, the Technest Series B Convertible Preferred
      shares held by Markland were cancelled. The Company recorded this as a
      contribution of capital from Markland with no net impact on equity.




On
      September 30, 2006, the Company had 632,185 shares of Series C Preferred Stock
      issued and outstanding.




In
      the
      three months ended September 30, 2006, the Company incurred liquidated damages
      of $562,045 which was charged to non-cash interest expense related to the
      Company's failure to file a registration statement and settled by the issuance
      of 206,341 shares of Technest common stock.




Common
      Stock Issuances




On
      August
      17, 2005, pursuant to a Stock Purchase Agreement with Markland Technologies,
      Inc., our majority stockholder, we purchased all of the outstanding stock of
      EOIR, formerly one of Markland’s wholly-owned subsidiaries. As consideration for
      the stock of EOIR, we issued 12 million shares of our common stock to Markland.
      Since this was a transaction between entities under common control, the
      Company has reported this stock issuance as though the transfer of EOIR occurred
      at the date Technest became part of Markland’s control group,




During
      the three months ended September 30, 2006, the Company issued the following
      amounts of common stock.




·
            206,341
                shares of Technest common stock with a fair value of $557,045 in
                settlement of liquidated damages for failure to have an effective
                registration statement which has been recorded as non-cash interest
                expense.




·
            99,779
                shares of Technest common stock with a fair value of $344,238 to
                certain
                employees of EOIR that hold remaining outstanding sellers notes in
                consideration for subordination of their security interest in the
                assets
                of the Company to Silicon Valley Bank in connection with the bank
                financing.This
                amount has been recorded as deferred financing costs (see Note 6)
                and will
                be amortized over the life of the Term Loan of 36 months.This
                issuance includes 23,913 shares of common stock issued to the Company’s
                Chairman and Chief Executive Officer, Dr. Joseph
                Mackin.




18




**8.
      OPTIONS AND WARRANTS**




In
      June
      2001, the Company established the 2001 Stock Option Plan (the "Plan") which
      provides for the granting of options which are intended to qualify either as
      incentive stock options ("Incentive Stock Options") within the meaning of
      Section 422 of the Internal Revenue Code of 1986, as amended, or as options
      which are not intended to meet the requirements of such section ("Non-Statutory
      Stock Options"). The total number of shares of common stock for issuance under
      the Plan shall not exceed 10,000,000. Options to purchase shares may be
      granted under the Plan to persons who, in the case of Incentive Stock Options,
      are key employees (including officers) of the Company or, in the case of
      Non-Statutory Stock Options, are key employees (including officers) or
      nonemployee directors of, or nonemployee consultants to, the Company.




The
      exercise price of all Incentive Stock Options granted under the Plan must be
      at
      least equal to the fair market value of such shares on the date of the grant
      or,
      in the case of Incentive Stock Options granted to the holder of more than 10%
      of
      the Company's common stock, at least 110% of the fair market value of such
      shares on the date of the grant. The maximum exercise period for which Incentive
      Stock Options may be granted is ten years from the date of grant (five years
      in
      the case of an individual owning more than 10% of the Company's common stock).
      The aggregate fair market value (determined at the date of the option grant)
      of
      shares with respect to which Incentive Stock Options are exercisable for the
      first time by the holder of the option during any calendar year shall not exceed
      $100,000.




The
      exercise price of all Non-Statutory Stock Options granted under the Plan must
      be
      at least equal to 80% of the fair market value of such shares on the date of
      the
      grant.




No
      options were granted pursuant to the Plan during the periods ended September
      30,
      2006 and 2005.




Summary
      information with respect to warrants is as follows:




Number
                of
              Shares
            
            Weighted
                average
              Exercise
                PriceBalance,
                June 30, 2006
            
            
            374,286
            
            $
            6.50Issued
            
            
            275,000
            
            
            2.97Expired
            
            
            -
            
            
            -Balance,
                September 30, 2006
            
            
            649,286
            
            $
            5.00




The
      weighted average fair value per share of the warrants issued in the three months
      ended September 30, 2006 is $1.83.




The
      following table summarizes the Company's warrants outstanding at September
      30,
      2006:




Warrants
      outstanding and exercisable




Exercise
                price
            
            Number
            
            Expiration
                Date$6.50
            
            374,286
            
            02/14/2010$5.85
            
            75,000
            
            08/13/2013$1.89
            
            200,000
            
            07/17/2011649,286Weighted
                average remaining life
            4.2
                years




As
      of
      September 30, 2006, all warrants are exercisable.




In
      connection with the acquisition of Genex (see Note 3), Markland agreed to
      replace options to purchase 312,000 shares of Genex common stock with fully
      vested options for the purchase of the same number of shares of Markland common
      stock with an exercise price equal to the fair value of Markland’s common stock
      on the grant date. The fair value of these options was considered to be
      immaterial for purposes of determining the total consideration paid for
      Genex.




19




Certain
      employees of EOIR were granted options for the purchase of Markland common
      stock
      on the original acquisition of EOIR on June 30, 2004, by Markland Technologies,
      Technest’s parent company. The amortization of stock-based compensation under
      these options exercisable for Markland common stock was $96,339 for the three
      months ended September 30, 2005, and is included in selling, general and
      administrative expense and as a contribution of capital.




As
      consideration for the Credit Agreements and in connection with the closing
      of
      the Financing (see Note 6), the Company issued Silicon Valley Bank a warrant
      to
      purchase 75,000 shares of Technest common stock at an exercise price of $5.85
      per share with a term of 7 years. The warrant expires August 3, 2013. The
      Company also entered into a Registration Rights Agreement with the Bank pursuant
      to which we granted “piggy-back” and S-3 registration rights for the shares of
      Technest common stock underlying the warrant. The Registration Rights Agreement
      does not include any liquidated damage provisions. The fair value of this
      warrant was $217,732 and is recorded as deferred financing costs (see Note
      6)
      and amortized to interest expense over the term of the Term Loan.




On
      July
      17, 2006, the Company entered into an agreement with Crystal Research Associates
      to have an Executive Informational Overview independently written about the
      company. As part of the consideration, the Company issued Crystal Research
      a
      fully vested warrant to purchase 200,000 shares of Technest common stock at
      an
      exercise price of 110% of the closing price of the Company’s stock on July 17,
      2006 or $1.89 with a term of 5 years. The fair value of this warrant was
      $253,038 and was included in selling, general and administrative expense in
      the
      three months ended September 30, 2006.





The fair
      value of these warrants was estimated using the Black-Scholes model and the
      following assumptions:




Exercise
                price
            $
                1.89 - $5.85Expected
                dividend yield
            0%Expected
                lives of warrants (in years)
            5.0-
                7.0Volatility
            110%Risk-free
                interest rate
            4.78%





Stock
      Award Plan





On
      March
      13, 2006, Technest adopted the Technest Holdings, Inc. 2006 Stock Award Plan,
      pursuant to which Technest may award up to 1,000,000 shares of its common stock
      to employees, officers, directors, consultants and advisors to Technest and
      its
      subsidiaries. The purpose of this plan is to secure for Technest and its
      shareholders the benefits arising from capital stock ownership by employees,
      officers and directors of, and consultants or advisors to, Technest and its
      subsidiaries who are expected to contribute to the Company’s future growth and
      success.





Technest
      has broad discretion in making grants under the Plan and may make grants subject
      to such terms and conditions as determined by the board of directors or the
      committee appointed by the board of directors to administer the Plan. Stock
      awards under the Plan will be subject to the terms and conditions, including
      any
      applicable purchase price and any provisions pursuant to which the stock may
      be
      forfeited, set forth in the document making the award. Pursuant to the
      Stockholder Agreement with Markland, (i) awards relating to no more than 500,000
      shares may be granted in calendar year 2006 (the “2006 Awards”), (ii) the 2006
      Awards shall vest no earlier than twelve (12) months following the date of
      grant
      of such awards, and (iii) awards granted on or after January 1, 2007 shall
      vest
      no more frequently than in four equal quarterly installments.





In
      the
      three months ended September 30, 2006, stock-based compensation related to
      previously granted restricted stock awards was $398,630.




**9.
      NET LOSS PER SHARE**




Securities
      that could potentially dilute basic net loss per share in the future, and that
      were not included in the computation of diluted net loss per share for the
      three
      months ended September 30, 2006 because to do so would have been anti-dilutive
      consists of the following:




20


Shares
                PotentiallyIssuableSeries
                A Convertible Preferred Stock
            
            
            306,028Series
                C Convertible Preferred Stock
            
            
            632,185Warrants
            
            
            649,286Total
                as of September 30, 2006
            
            
            1,587,499




**10.
      COMMITMENTS AND CONTINGENCIES**




Facility
      Rental




Technest
      has a three-year lease for executive offices of approximately 2,000 square
      feet
      in Boston, Massachusetts, which expires December 31, 2009. The monthly rental
      amount for this facility is approximately $4,500.




Genex
      Technologies, Inc., a wholly-owned subsidiary of Technest, currently leases
      offices with approximately 6,848 square feet in Bethesda, Maryland, pursuant
      to
      a five-year lease which expires March 31, 2011. Monthly lease amounts for this
      facility total approximately $14,263, increasing annually by 3%. Genex moved
      into this space on April 1, 2006. Genex had leased offices with approximately
      6,831 square feet in Kensington, Maryland, pursuant to a five-year lease which
      expired on January 31, 2006, which we had been extending on a monthly basis.
      Monthly lease amounts for this facility totaled approximately $10,100.





EOIR
      holds a three-year lease for its executive and administrative offices of
      approximately 5,420 square feet in Woodbridge, Virginia. The lease expires
      on
      September 30, 2008. EOIR leases approximately 10,000 square feet in
      Spotsylvania, Virginia, where it houses its software development unit. The
      lease
      expires on October 31, 2009. EOIR also holds a five-year lease for 6,951 square
      feet in Spotsylvania, Virginia. The lease expires on October 15, 2010. EOIR
      also
      has several offices located in Fredericksburg, Virginia - one office with 1,200
      square feet, with a two-year lease that expires on October 31, 2006, and one
      with 4,200 square feet, with a three-year lease that expires on June 30, 2007.
      Monthly lease amounts for these facilities total approximately
      $36,600.




Rent
      expense for the three months ended September 30, 2006 and 2005, was $175,422
      and
      $126,717 respectively.




Government
      Contracts - Genex




The
      Company's billings and revenue on time and material contracts are based on
      provisional fringe, general & administrative and overhead rates which are
      subject to audit by the contracting government agency.  During an audit
      conducted in November 2004 covering the fiscal year 2002, the Defense Contract
      Audit Agency (“DCAA”) discovered significant deficiencies in Genex’s accounting
      system that resulted in misclassified and unallowable costs. Their
      examination disclosed eight significant deficiencies in Genex’s accounting
      system that resulted in misclassified costs. They were:




1.
            Contractor
                does not follow policies and procedures concerning accounting for
                unallowable costs.


2.
            Contractor
                does not follow policies and procedures concerning accounting for
                material
                costs.


3.
            Contractor
                lacks adequate written policies and procedures concerning capitalization
                of assets.


4.
            Contractor
                does not have adequate policies and procedures to ensure proper
                segregation of duties in handling its labor
                costs.


5.
            Contractor’s
                procedure for calculating the proposed hourly labor rate of its employees
                results in overstated labor costs.


6.
            Contractor
                fails to maintain policies and procedures for classifying the labor
                categories of its employees.


7.
            Employees
                fail to follow the contractor’s policies and procedures in regards to
                maintaining timesheets on a current
                basis.


8.
            Contractor’s
                policy of billing labor costs results in billing the Government for
                employees that are not employees of Genex.




21


Since
      the
      acquisition of Genex, the management of Technest has terminated the Genex
      employees responsible for this function and rapidly installed appropriate
      internal controls and oversight over Genex’s accounting system to ensure that
      they comply with applicable laws and regulations and are adequate and operating
      effectively. The DCAA has since re-audited the Genex financial systems and
      has
      communicated to Genex that the revised procedures are satisfactory. Genex will
      be allowed to complete certain previous contacts awarded by the Department
      of
      Defense but may be required to refund amounts overbilled to its
      customers.




The
      Company has accrued $68,017 for overpayments for 2002 and has extended the
      analysis of misclassified and unallowed costs to June 30, 2005. T he
      Company has determined that $102,228 is the total amount repayable to the
      government (inclusive of $68,017 accrued for 2002 overpayments). This amount
      is
      included in accrued expenses at September 30, 2006.




The
      Company's billings related to certain U.S. Government contracts are based on
      provisional general & administrative and overhead rates which are subject to
      audit by the contracting government agency.





Lien
      on Assets





Silicon
      Valley Bank (see Note 6) has a primary lien on all the assets of Technest and
      its subsidiaries. The balance outstanding to Silicon Valley Bank as of September
      30, 2006 was $5,562,288.




Letter
      of Credit





EOIR
      has
      a letter of credit in the amount of $250,000 issued in favor of a bank in
      conjunction with corporate credit cards.




Employment
      Agreements




The
      Company is obligated under employment agreements with certain members of senior
      management.




**11.
      INCOME TAXES**




There
      was
      no provision for federal or state income taxes for the three months ended
      September 30, 2006 and 2005, due to the Company's operating losses and a full
      valuation reserve. Since its acquisition by Markland, the Company files a
      consolidated tax return with Markland.




The
      Company's deferred tax assets consist primarily of the net operating loss carry
      forwards. The use of the federal net operating loss carry forwards may be
      limited in future years as a result of ownership changes in the Company's common
      stock, as defined by section 382 of the Internal Revenue Code. The Company
      has
      not completed an analysis of these changes.




The
      Company has provided a full valuation reserve against the deferred tax asset
      because of the Company's loss history and significant uncertainty surrounding
      the Company's ability to utilize its net operating loss and tax credit
      carryforward.




**12.
      RELATED PARTY TRANSACTIONS**




With
      the
      exception of Deer Creek Fund LP, ipPartners, Inc., and Southshore Capital Fund
      Limited, all of the Investors in the Investor Financing on February
      14,  2005
      are
      either shareholders, officers and/or directors of Markland. ipPartners, Inc.
      is
      a corporation majority owned and controlled by Mr. Tarini, Markland's Chief
      Executive Officer and Chairman. The Investor Financing was negotiated on behalf
      of Markland by senior management of Markland, including Mr. Tarini. The Markland
      Investment was approved by a unanimous vote of the Board of Directors of
      Markland including, Mr. Mackin and Mr. Ducey, neither of whom has an interest
      in
      the transaction.




During
      the three months ended September 30, 2006, Markland invoiced EOIR $250,000
      for
      administrative support services, engineering services and services rendered
      by
      Markland. During the three months ended September 30, 2006, EOIR paid Markland
      $451,370 in conjunction with the intercompany transactions described
      above.





At
      June
      30, 2006, the Company had amounts due Markland in the amount of
      $394,412.





22


As
      consideration for the subordination of the security interest to the Bank and
      in
      connection with the closing of the Financing on August 10, 2006, the Company
      issued to the seven remaining EOIR subordinated note holders a total of 99,779
      shares of the Company’s common stock having a fair value of $344,238, of which
      our current Chief Executive Officer and one of the Company’s directors, Joseph
      P. Mackin, received 23,913 shares. These were recorded as deferred financing
      costs (see Note 6).




Markland
      has entered into an Unconditional Guaranty pursuant to which Markland agreed
      to
      guaranty up to $6,000,000 of the principal obligations plus interest thereon
      and
      related expenses under the Credit Agreements and a Stock Pledge Agreement
      pursuant to which Markland pledged to the Bank 1,739,130 shares of Technest
      common stock currently owned by Markland, which had a market value of $6,000,000
      as of August 4, 2006. The Guaranty and the Stock Pledge Agreement terminate
      August 3, 2008 if no event of default has occurred. In consideration for this
      guarantee and stock pledge, Technest paid Markland $580,372. This was
      recorded as a deferred financing cost (see Note 6).




**13.
      EMPLOYEE BENEFIT PLANS**




Genex
      maintains a Simplified Employee Pension (the SEP Plan) for all employees who
      have attained the age of 21 and have completed three years of service.
      Participants may make voluntary contributions up to the maximum amount allowed
      by law, but not to exceed 15% of each participant’s eligible compensation. The
      combined totals of participant and Genex contributions may not exceed $30,000
      by
      law. Genex contributions vest immediately to the participants.




Genex
      also maintains a defined contribution 401(k) profit sharing plan (the 401(k)
      Plan) for all employees except those who are non-resident aliens or are covered
      by a collective bargaining agreement.  Participants may make voluntary
      contributions up to the maximum amount allowable by law but not to exceed 20%
      of
      the participant's eligible compensation.  Genex contributions to the 401(k)
      Plan are at the discretion of management and vest to the participants ratably
      over a five-year period, beginning with the second year of
      participation.




EOIR
      has
      adopted a 401(k) plan for the benefit of certain employees. Essentially all
      EOIR
      employees are eligible to participate. The Company also contributes to the
      plan
      under a safe harbor plan requiring a 3% contribution for all eligible
      participants. In addition, the Company may contribute a 3% elective match.
      The
      Company contributed 6%, excluding bonuses on an annual basis, to those who
      have
      been employed by EOIR for more than one year and remain employed on the last
      day
      of the fiscal year.




Contributions
      and other costs of these plans in the three months ended September 30, 2006
      and
      2005 were $213,946 and $193,617, respectively.




**14.
      LITIGATION**




H&H
      Acquisition Corp.




On
      July
      23, 1998, H & H Acquisition Corp., individually and purportedly on behalf of
      Technest, commenced an action in federal court in the Southern District of
      New
      York against Technest, the founder and certain officers, among others. The
      complaint is an action to recover shares of common stock of the Company and
      unspecified damages. Management believes that the claims against the Company
      and
      certain officers are without merit and is vigorously defending the action.
      The
      Company cannot make any assurances about the litigation's outcome. However,
      the
      Company could be adversely affected if the plaintiff prevails.




In
      September 2002 the Company was served with a Summary Judgment Motion regarding
      H
& H Acquisition Corp. and the Company answered the motion in November 2002.
      On January 3, 2005, the court denied the motion for summary judgment.


As
      of
      November 7, 2006, Technest has not been notified of a trial date for this
      matter.




Deer
      Creek




On
      or
      about May 30, 2006, Deer Creek Fund LLC filed a claim for Interference with
      Contract and Breach of the Implied Covenant of Good Faith and Fair Dealing
      against Technest, seeking unspecified monetary damages.  Deer Creek alleges
      misconduct on the part of Technest related to a proposed sale by Deer Creek
      of
      157,163 shares of Technest common stock at $7.00 per share and the applicability
      of certain selling restrictions under a registration rights agreement entered
      into between the parties. Technest believes that the allegations in this
      lawsuit are entirely without merit. Technest has been aggressively defending
      this action, and has filed an answer denying Deer Creek’s allegations and
      vigorously opposes all relief sought.





23




Joseph
      R. Moulton




On
      or
      about September 16, 2004, Joseph R. Moulton, Sr. initiated a lawsuit in the
      Circuit Court of Spotsylvania County, Virginia, against Markland, EOIR, and
      our
      former Chief Executive Officer and former Director, Robert Tarini, in his
      capacity as Markland’s Chief Executive Officer. Mr. Moulton was the largest
      single shareholder of EOIR prior to its acquisition by Markland, owning
      approximately 67% of the EOIR capital stock. Mr. Moulton received approximately
      $5,863,000 in cash and a promissory note of EOIR in the approximate principal
      amount of $6,967,000 for his shares of EOIR at the closing of the acquisition
      of
      EOIR by Markland.




In
      his
      complaint Mr. Moulton asserts, among other things, that Markland and EOIR
      breached their obligations under the Stock Purchase Agreement, dated June 30,
      2004, pursuant to which Markland acquired EOIR, by terminating Mr. Moulton's
      employment with EOIR and removing him from the EOIR board of
      directors.




On
      August
      3, 2006, Mr. Moulton, Technest, Markland, EOIR and Robert Tarini reached a
      settlement agreement pursuant to which upon payment of $120,000 and the
      pre-payment of certain EOIR outstanding promissory notes, the parties each
      dismissed their claims against one another.




Greg
      & Mary Williams




Markland
      and EOIR were notified on July 11, 2005 by counsel for Greg and Mary Williams,
      former shareholders and employees of EOIR and, in the case of Mr. Williams,
      a
      former director of Markland, that the Williamses filed a lawsuit in the
      Commonwealth of Virginia, naming EOIR and Markland as defendants, regarding
      a
      number of contractual disputes involving the registration of shares of Markland
      common stock underlying certain options issued to the Williamses in connection
      with the acquisition of EOIR by Markland and severance payments called for
      pursuant to severance agreements by and among the Willliamses, EOIR and
      Markland.




On
      May 4,
      2006, the court granted the Williams’ motion for summary judgment with regard to
      liability on Count I of the Williams’ claim regarding severance payment and
      Count III of their claim regarding Markland’s failure to register shares of
      Markland’s common stock underlying their options. We have, and continue to
      assert that Count III of the Williams’ complaint does not allege wrongdoing by
      EOIR and thus, we believe that we have no liability on that claim. Count II
      of
      the claim, which seeks a declaration that the promissory notes issued to Mr.
      and
      Mrs. Williams in connection with the acquisition of EOIR by Markland on June
      29,
      2004 are in default and an acceleration of the payments due under those notes,
      was not addressed by the court’s order.





On
      July
      27, 2006, we entered into an agreement with the Williams pursuant to which
      we
      paid them $246,525 in satisfaction of their claims for severance under Count
      I
      and agreed to pay the outstanding balance of their promissory notes, along
      with
      all accrued but unpaid interest, in satisfaction of Count II which was paid
      on
      August 10, 2006. The Williams continue to assert claims against us for
      attorney’s fees and costs on all three counts of their complaint. Count III was
      not addressed by this agreement.





On
      September 1, 2006, we entered into an agreement with Markland pursuant to which
      we agreed to indemnify Markland against any judgment for damages or attorney’s
      fees ordered by the Court pursuant to Counts I or II and Markland agreed to
      indemnify us against any judgment for damages or attorney’s fees ordered by the
      Court pursuant to Count III.





On
      October 24, 2006 the trial of this case was continued to March 21, 2007, at
      which time the damages, if any, for Count III will be determined as well as
      costs and attorney’s fees, if applicable, for Counts I, II and III.





In
      the
      event that Mr. and Mrs. Williams prevail in any of their claims against
      Markland, Technest shares owned by Markland would be among the assets available
      to satisfy a resulting judgment.




**15.
       SUBSEQUENT EVENTS**




***Common
      Stock Issuances***





Subsequent
      to September 30, 2006, the Company has issued 179,410 shares of common stock
      in
      satisfaction of liquidated damages under our Registration Rights Agreement
      dated
      February 14, 2005, as amended on October 3, 2005 and February 27, 2006.





24




On
      October 20, 2006, we issued 20,000 shares of our common stock to each of Darlene
      Deptula-Hicks, Robert Doto and David Gust, or non-employee directors, as
      compensation for their election and service on the Company’s board of directors
      beginning in March 2006. These shares are subject to forfeiture in the event
      that the grantee is not providing services to Technest as a director on April
      1,
      2007.




**Item
      2.**  **Management’s
      Discussion and Analysis or Plan of Operation**




*The
      following discussion and analysis of our financial condition and results of
      operations for our financial quarter ending September 30, 2006 should be
      read together with our financial statements and related notes included elsewhere
      in this report.*




**FORWARD
      LOOKING STATEMENTS**




The
      information in this discussion contains forward-looking statements. These
      forward-looking statements involve risks and uncertainties, including but not
      limited, to statements regarding Technest Holdings, Inc.’s capital needs,
      business strategy and expectations. Any statements contained herein that are
      not
      statements of historical facts may be deemed to be forward-looking statements.
      In some cases, you can identify forward-looking statements by terminology such
      as “may”, “should”, “expect”, “plan”, “intend”, “anticipate”, “believe”,
“estimate”, “predict”, “potential” or “continue”, the negative of such terms or
      other comparable terminology. Actual events or results may differ materially.
      In
      evaluating these statements, you should consider various factors, including
      the
      risks outlined in the Risk Factors section below, and, from time to time, in
      other reports we file with the Securities and Exchange Commission (the “SEC”).
      These factors may cause our actual results to differ materially from any
      forward-looking statement. Readers are cautioned not to place undue reliance
      on
      any forward looking statements contained in this report. We will not update
      these forward looking statements unless the securities laws and regulations
      require us to do so.




**OVERVIEW**




**General**




On
      February 14, 2005, Technest became a majority owned subsidiary of Markland
      Technologies, Inc., a homeland defense, armed services and intelligence
      contractor. Markland is a public company with a class of equity securities
      registered pursuant to Section 12(g) of the Exchange Act. Technest issued to
      Markland 1,954,023 shares of its common stock in exchange for 10,168,764 shares
      of Markland common stock which were used as partial consideration for the
      concurrent acquisition of Genex Technologies, Inc. (“Genex”).




Prior
      to
      our acquisition of Genex, we were a public “shell” company with no operations,
      nominal assets, accrued liabilities totaling $184,468 and 139,620 (post-split)
      shares of common stock issued and outstanding. From May 2002 through our
      acquisition of Genex, we had no operations.




On
      August
      17, 2005, pursuant to a Stock Purchase Agreement with Markland Technologies,
      Inc., our majority stockholder, we purchased all of the outstanding stock of
      E-OIR Technologies, Inc., (“EOIR”), formerly one of Markland’s wholly-owned
      subsidiaries. As consideration for the stock of EOIR, we issued 12 million
      shares of our common stock to Markland.




**Technest
      Business**




We
      operate in five principal technical areas: Advanced Sensor Systems, Imaging
      and
      Intelligence Solutions, Operational Management, Intelligent Surveillance, and
      Chemical and Explosive Detection.





**Advanced
      Sensor Systems**





Advanced
      Sensor Systems is engaged in design, research and development, systems
      integration, sustainment, support, and upgrade of advanced sensor systems for
      the U.S. military; this includes high performance targeting and surveillance
      sensors, driving enhancements, rifle sights, fusion and automatic target
      recognition, mine and minefield detection, mine neutralization, minefield
      breaching, sensor system performance modeling and analysis, virtual prototyping,
      simulation-based analyses, high-performance multi-color Focal Plane Array (FPA),
      multi-function lasers, distributed sensor networks, Long Wavelength Infrared
      (LWIR) and Short Wavelength Infrared (SWIR) arrays, unattended ground sensors,
      and rapid prototyping.





25


The
      majority of the work performed by Advanced Sensor Systems is carried out through
      an Omnibus Contract with the United States Army Night Vision and Electronic
      Sensors Directorate. We retain non exclusive rights to sell the technologies
      that we develop under this contract. Our main products, developed or nearing
      development, include Interchangeable Wide Area Search Surveillance System
      (IWAS 3 ),
      Safety
      Evaluation Range Training System (SERTS TM ),
      Universal Sensor Remoting Device (USRD), Pelco Camera Translators,
      WinProc TM ,
      IProc TM ,
      GPS
      GroundTruther, TTAASP TM ,
      and
      EOIRTA TM .





**Imaging
      and Intelligence Solutions**





Imaging
      and Intelligence Solutions is engaged in the design, research and development,
      integration, analysis, modeling, and training of classified solutions in support
      of the United States’ intelligence community and homeland security.





We
      provide support to the National Geospatial-Intelligence Agency (NGA) College,
      including program management support, curriculum development and instruction
      in
      Geospatial and Imaging Analysis, Advanced Geospatial Intelligence, and
      Measurements and Signal Intelligence. We develop core curriculum: platform,
      web-
      and computer-based training; and maintain the Soft Copy Keys Program. We develop
      specialized tools and algorithms for atmospheric computation and full-spectrum
      signal processing, promote imaging standards, evaluate new technology, assist
      users with Advanced Geospatial Intelligence technologies, and maintain spectral
      libraries used throughout the Intelligence Community. For the National Ground
      Intelligence Center, we provide systems modeling, intelligence analysis for
      military operations and disaster relief, and we develop and integrate remote
      triggering devices and monitoring stations used in field testing and air-and
      ground-based sensor analysis. We support maritime advanced geospatial imagery
      exploitation and counter drug operations, as well as all-source analysis for
      Army operational forces.





The
      Advanced Technologies Research and Development group of Genex is focused on
      developing our imaging technology portfolio via advanced research in 3D facial
      recognition, intelligent surveillance 3D imaging, and medical imaging. By
      integrating our marketing pursuits with our R&D efforts, we expect to bring
      to market technological advances that have enhanced customer value. Some of
      our
      targeted research areas include: (i) fully integrated SurematchTM suite of 3D
      facial recognition software application programs; (ii) intelligent surveillance
      using two- and three-dimensional image processing to support homeland
      security, military, and commercial applications; (iii) detection of concealment
      of intent using thermal and 3D imaging to support anti-terrorist efforts; (iv)
      early detection of cancer using non-invasive and non-radiological diffuse
      optical tomography; and (v) more effective and less risky radiation treatment
      for cancer by use of 3D imaging for patient positioning.





**Operational
      Management**





Operational
      Management is engaged in the program management, integration, training,
      logistics, analysis, and field support of numerous projects for the U.S.
      military.





We
      provide program management support for the Marine Corps Systems Command (MCSC),
      which includes providing logistical support of current projects and integration
      with legacy systems. We also are assisting in the development of the
      Electro-Optical Test Facility (EOTF) for the Program Manager Optics and
      Non-Lethal Systems (PM ONLS). This encompasses the full life-cycle of the test
      facility; as we will design the facility, oversee the procurement of equipment,
      develop standard operating procedures, and manage the thermal testing portion
      of
      the lab. We provide systems integration, board design, training, and field
      support for products, such as DoubleShot, which is currently actively deployed
      in Operation Iraqi Freedom (OIF) in support of the Marine Corps Warfighting
      Lab
      (MCWL). In addition, we represent the Marine Corps in the joint development
      of
      Joint Chemical Agent Detector (JCAD), Joint Service Light Standoff Chemical
      Agent Detector (JSLSCAD), Joint Service Light Nuclear, Biological, Chemical,
      Reconnaissance System (JSLNBCRS), as well as other engineering technology in
      support of the MCSC Chemical, Biological, Radiological, Nuclear Defense (CBRND)
      team. This support consists of testing emerging technology, providing logistical
      support and management of legacy systems. We also provide systems integration
      support for the Directed Energy Technology Office (DETO) at Naval Surface
      Warface Center Dahlgren Division (NSWCDD) integrating various sensors, such
      as
      Driver Viewer Enhancer and Blue Force Tracker, into a prototype directed energy
      system in support of OIF.





26


**Intelligent
      Surveillance**





Intelligent
      Surveillance is engaged in the design, research and development, integration,
      analysis, modeling, system networking, and support of advanced surveillance
      and
      three-dimensional imaging devices and systems.





We
      provide full life-cycle support, technology, and very specialized expertise
      in
      the areas of real-time embedded image processing, software and systems
      engineering, as well as three-dimensional facial recognition. We also develop
      re-configurable, multi-sensor systems with unique, nonstandard architectures.
      In
      addition, we develop sensors for detection of concealment of intent using
      thermal and three-dimensional imaging, devices for early detection of cancer
      using non-invasive and non-radiological diffuse optical tomography, and more
      effective and less risky radiation treatments for cancer by using
      three-dimensional imaging for patient re-positioning. Our major products,
      developed or nearing development, include our OmniEyeTM Wellcam, OmniEyeTM
Cerberus, Smart Optical Sensor (SOS), Smart SuiteTM, Omnivision, Small Tactical
      Ubiquitous Detection System (STUDS), and 3D SketchArtist.





**Chemical
      and Explosive Detection**





Chemical
      and Explosive Detection is engaged in the design, research and development,
      software and hardware engineering, integration, training, and networking of
      advanced Chemical/Biological and Improvised Explosive Devices detection
      sensors.





We
      provide technologies that reliably detect the presence of chemical, biological,
      and explosive devices or components from stand-off distances utilizing
      multi-spectral electro-optical sensing methods. We also provide
      Chemical/Biological and Improvised Explosive Devices simulators and real-time
      training devices with product specific specifications. Our major
      products,developed or nearing development, include our Shipboard Automatic
      Chemical Agent Detection and Alarm (ACADA), Automated, Adaptive Chemical
      Examination System (AACES), and M22 Simulator.




**RESULTS
      OF OPERATIONS**




For
      the
      three months ended September 30, 2005, Technest corrected its accounting for
      derivative financial instruments to conform to the requirements of Statements
      of
      Financial Accounting Standards ("SFAS") No. 133, as amended, and Emerging Issues
      Task Force No. ("EITF") No. 00-19. For certain warrants issued by Technest
      in
      February 2005, Technest could not conclude that the warrants were able to be
      settled in unregistered shares of common stock due to liquidated damage
      provisions in registration rights agreements. Therefore the warrants did not
      meet the requirements for classification as equity instruments. Instead, the
      warrants were recorded as liabilities and carried at fair value. Fair value
      adjustments to these derivative liabilities are charged (credited) to the
      statement of operations.




Three
      months ended September 30, 2006 compared with the three months ended September
      30, 2005




**Revenue**




Technest
      had $19,969,638 in revenue during the three months ended September 30, 2006
      compared with $18,996,341 for the same period in 2005.




Revenues
      from EOIR’s omnibus contract were $17,429,682 for the three months ended
      September 30, 2006 compared to $16,318,285 for the three months ended September
      30, 2005.  In August 2006, the Government granted EOIR an additional “award
      term” for one year from July 2006 to July 2007. The performance periods for
      these contracts extend for 12 months beyond the end of the contract award period
      expiring in July 2008.




**Gross
      profit**




The
      gross
      profit for the three months ended September 30, 2006 was $3,760,115 compared
      with $3,405,886 for the same period in 2005. The gross profit margin for the
      three months ended September 30, 2006 was 19% compared with 18% for the same
      period in 2005.




27


**Selling,
      general and administrative expenses**




Selling,
      general and administrative expenses for the three months ended September 30,
      2006 was $3,755,905 and consisted primarily of payroll. Selling, general and
      administrative expenses for the three months ended September 30, 2005 was
      $3,040,732. The increase in selling, general and administrative expenses is
      due
      higher stock compensation expense and the fair value of a warrant issued to
      a
      consultant in the quarter. Included in selling, general and administrative
      expenses, amortization of compensatory element of stock issuances for the three
      months ended September 30, 2006 were $398,630. This represents the amortization
      of stock-based compensation related to restricted stock grants to certain
      officers, directors and senior employees. Amortization of compensatory element
      of stock issuances for the three months ended September 30, 2005 were $96,339
      and related to options for the purchase of Markland common stock granted to
      EOIR
      employees by Markland in conjunction with the original acquisition of EOIR
      in
      June 2004. Selling, general and administrative expenses for the three months
      ended September 30, 2006 included a charge of $253,038 for the fair value of
      a
      warrant granted to a consultant in the quarter. Also included in selling general
      and administrative expenses are management fees paid to Markland. These amounted
      to $250,000 for the three months ended September 30, 2006 and 2005, respectively
      and are expected to terminate in March 2007.




**Research
      and development**




Research
      and development expenses for the three months ended September 30, 2006 and
      2005
      were $5,424 and $60,745, respectively. These expenditures consisted primarily
      of
      unfunded research for new product development. Funded research and development
      is part of the Company’s revenue base and the associated costs are included in
      cost of revenues.




**Amortization
      of intangible assets**




Amortization
      of intangible assets for the three months ended September 30, 2006 and 2005
      were
      $446,511 and $440,869 respectively.




**Operating
      loss**




The
      operating loss for the three months ended September 30, 2006 was $447,725
      compared with a loss of $136,460 for the period ended September 30,
      2005.




**Interest
      expense and other income**




In
      connection with the acquisition of EOIR by Markland, EOIR issued $11,000,000
      in
      original principal amount of notes due to the former stockholders of EOIR.
      The
      fair market value of these notes was $9,532,044 as determined by Markland’s
      management based on a number of factors including an independent valuation.
      The
      discount of $1,467,956 is being amortized to interest expense over the life
      of
      the note. These notes bear interest at the rate of six percent (6%) per annum
      and must be repaid within the next three years. In the three months ended
      September 30, 2006, Technest pre-paid outstanding principal of $4,952,526 of
      certain of the EOIR promissory notes. After these payments, there remain
      outstanding EOIR notes having a total principal balance of
      $1,655,893.




Interest
      expense for the three months ended September 30, 2006 and 2005 were $1,452,459
      and $669,647, respectively. This included non-cash interest expense of $562,045
      (primarily paid in common stock) related to liquidated damages incurred for
      failure to have an effective registration statement, $63,467 related to
      amortization of deferred financing costs and $672,070 related to the
      accelerated accretion of the note discount resulting from the prepayment of
      the
      EOIR note. The Company also incurred and paid interest of $95,132 and $59,651
      on
      the Silicon Valley Bank debt and remaining EOIR notes,
      respectively.





Derivative
      income represents the change in the fair value of certain warrants issued by
      Technest on February 14, 2005. These warrants did not meet the requirements
      for
      classification as equity instruments since the Company could not conclude that
      the warrants were settleable in unregistered shares of its common stock. As
      a
      result, the Company was required to reflect these warrants as derivative
      liabilities on the balance sheet. Each period, the change in the fair value
      of
      the warrants was charged (credited) to the statement of operations. In the
      three
      months ended September 30, 2005, the change in the fair value of the warrants
      recorded as derivative income in the statements of operations was $25,046,489.
      Derivative income had no impact of the Company’s cash flows and none of the
      warrants have been settled in cash. The Company determined the fair value of
      the
      warrants using the Black-Scholes option pricing model. Excluding derivative
      income would have resulted in pro forma net loss applicable to common
      shareholders of ($775,525) for the three months ended September 30, 2005. Pro
      forma basic and diluted loss per common share would have been ($0.05) for the
      same period.





28


On
      September 30, 2005, the Company amended the terms of its Registration Rights
      Agreement such that any liquidated damages would only be payable in common
      stock. As a result of this amendment, the Company was able to conclude that
      the
      warrants could be settled in unregistered shares. Therefore, the warrants were
      no longer required to be recorded as derivative liabilities and there have
      been
      no additional derivative income (loss) recorded related to these warrants since
      that date.





Other
      income for the three months ended September 30, 2006 and 2005 was $27,893 and
      $30,582, respectively, and was primarily related to interest income on cash
      balances.




**Net
      income (loss) applicable to common shareholders**





The
      net
      loss applicable to common stockholders for the three months ended September
      30,
      2006 was ($1,872,291).





The
      net
      income applicable to common stockholders for the three months ended September
      30, 2005 was $24,270,964. As previously described, the net income was entirely
      due to derivative income of $25,046,489.




**LIQUIDITY
      AND CAPITAL RESOURCES**




**Cash
      and Working Capital**




On
      September 30, 2006, Technest had a negative working capital balance of
      $7,447,284. This represents an increase in the negative working capital balance
      of $3,922,042 compared with June 30, 2006. This is the result of an increase
      in
      the current portion of long-term debt by $1,710,240 and $2,645,621 related
      to
      the revolving line of credit as a result of the bank financing. This was
      partially offset by a reduction in long term debt of $3,124,914 compared with
      the previous quarter. Technest’s current liabilities include $394,412 due
      to Markland, Technest’s parent company. Net cash used in operating activities
      was $923,418 for the three months ended September 30, 2006. Non-cash expenses
      included in the net loss totaled $2,495,373 while changes in the components
      of
      working capital used cash of $1,546,502. Most of this change in working capital
      was related to reductions in accounts payables and accrued expenses and other
      current liabilities of $3,535,412.




**Cash
      Used in Investing Activities**




Technest
      used cash of $32,151 for the acquisition of equipment.




**Cash
      Used in Financing Activities**




In
      the
      three months ended September 30, 2006, $5,086,744 was used for loan repayments
      and $4,923,582 was raised from bank financing, net of expenses.




**Sources
      of Liquidity**




During
      the three months ended September 30, 2006, we satisfied our cash requirements
      primarily through operating cash flows, our cash reserves and a bank loan.
      On
      September 30, 2006, the Company had cash and cash equivalents of $2,243,479
      and
      a funded contract backlog from the Government of $41.2 million. In addition,
      the
      Company obtained a revolving line of credit and a term loan with a commercial
      bank in the maximum amount of $10 million. At September 30, 2006, under certain
      conditions, an additional $4.4 million is available under the revolving line
      of
      credit to fund the Company’s working capital needs. As a result of the forgoing,
      management believes that Technest has sufficient sources of liquidity to satisfy
      its obligations for at least the next 12 months.




**Off
      Balance Sheet Arrangements**




We
      have a
      letter of credit in the amount of $250,000 issued in favor of a bank in
      conjunction with our corporate credit cards. Other than this letter of credit,
      we have no other off-balance sheet arrangements that have or are reasonably
      likely to have a current or future effect on our financial condition, changes
      in
      financial condition, revenues or expenses, results of operations, liquidity,
      capital expenditures or capital resources that is material to stockholders.
      As
      of September 30, 2006, Technest had warrants outstanding for the purchase of
      649,286 shares of common stock. However, due to the net share settlement
      provisions of the majority of these warrants, Technest does not expect any
      material cash proceeds upon exercise.




29


**Effect
      of inflation and changes in prices**




Management
      does not believe that inflation and changes in price will have a material effect
      on operations.




**CRITICAL
      ACCOUNTING POLICIES**





The
      preparation of Technest's financial statements and related disclosures 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 the disclosure of contingent
      assets and liabilities as of the date of the financial statements and the
      amounts of revenues and expenses recorded during the reporting periods. We
      base
      our estimates on historical experience, where applicable, and other assumptions
      that we believe are reasonable under the circumstances. Actual results may
      differ from our estimates under different assumptions or
      conditions.




The
      sections below present information about the nature of and rationale for our
      critical accounting policies.





**PRINCIPLES
      OF CONSOLIDATION**




Our
      consolidated financial statements as of September 30, 2006 include the accounts
      of Technest, and our wholly-owned subsidiaries- Genex and EOIR. We have
      eliminated all significant inter-company balances and transactions.




**CONCENTRATIONS**




Statement
      of Financial Accounting Standards ("SFAS") No. 105, "Disclosure of Information
      about Financial Instruments with Off-Balance-Sheet Risk and Financial
      Instruments with Concentrations of Credit Risk," requires that we disclose
      any
      significant off-balance-sheet and credit risk concentrations. We are subject
      to
      concentrations of credit risk because the majority of our revenues and accounts
      receivable are derived from the U.S. government, including the Department of
      Defense, who is not required to provide collateral for amounts owed to us.
      We do
      not believe that we are subject to any unusual credit risks, other than the
      normal level of risk attendant to operating our business.




As
      of
      September 30, 2006, we had cash balances in banks in excess of the maximum
      amount insured by the FDIC. In addition, we derive substantially all of our
      contract revenue from contracts with Federal government agencies. Consequently,
      substantially all of our accounts receivable are due from Federal government
      agencies either directly or through other government contractors.




**RESEARCH
      AND DEVELOPMENT**




We
      charge
      research and development costs to expense as incurred. Funded research and
      development is part of our revenue base and the associated costs are included
      in
      cost of revenues. We capitalize costs related to acquired technologies that
      have
      achieved technological feasibility and have alternative uses. We expense as
      research and development costs the technologies we acquire if they are in
      process at the date of acquisition or have no alternative uses.





No
      new
      technologies were acquired during the three months ended September 30, 2006
      and
      as such there are no capitalized or expensed in-process research and development
      costs during this period relating thereto.




**IMPAIRMENT
      OF GOODWILL AND AMORTIZABLE INTANGIBLES**




In
      accordance with SFAS No. 142, "Goodwill and Other Intangible Assets," we review
      goodwill and amortizable intangibles for impairment annually, or more frequently
      if an event occurs or circumstances change that would more likely than not
      reduce the fair value of our business enterprise below its carrying value.
      The
      impairment test requires us to estimate the fair value of our overall business
      enterprise down to the reporting unit level. We identify and record our
      intangible assets at the reporting unit level and also conduct our impairment
      tests at the reporting unit level as required by paragraphs 30-31 of SFAS No.
      142, “Goodwill and Other Intangible Assets”.





30


We
      estimate fair value using either a discounted cash flows model, or an approach
      using market comparables, to determine fair value. Under the discounted cash
      flows method, we utilize estimated long-term revenue and cash flows forecasts
      developed as part of our planning process, together with an applicable discount
      rate, to determine fair value. Under the market approach, fair value is
      determined by comparing us to similar businesses (or guideline companies).
      Selection of guideline companies and market ratios require management's
      judgment. The use of different assumptions within our discounted cash flows
      model or within our market approach model when determining fair value could
      result in different valuations for goodwill.





**ESTIMATED
      USEFUL LIVES OF AMORTIZABLE INTANGIBLE ASSETS**




We
      amortize our amortizable intangible assets over the shorter of the
      contractual/legal life or the estimated economic life.





Definite-lived
      intangible assets acquired from Genex represent costs of outside legal counsel
      related to obtaining new patents.  Patent costs are amortized over the
      legal life of the patents, generally fifteen years, starting on the patent
      issue
      date.  The costs of unsuccessful and abandoned patent applications are
      expensed when abandoned.  The cost to maintain existing patents are
      expensed as incurred.  The nature of the technology underlying these
      patents relates to 3D imaging, intelligent surveillance and 3D facial
      recognition technologies.




Technest
      also acquired commercialized technology relating to 3D facial recognition
      cameras and contracts and customer relationships from the application of 3D
      imaging technologies to breast cancer research for the National Institute of
      Health and disposable sensors and 3D face mapping for the Department of Defense.
      The amounts assigned to definite-lived intangible assets were determined by
      management based on a number of factors including an independent purchase price
      allocation analysis. These assets have an estimated useful life of five
      years.





Contracts
      and Customer relationships acquired as a result of business combinations (see
      Note 3) have been valued by management considering various factors including
      independent appraisals done by valuation and financial advisory firms in
      accordance with SFAS No. 141, “Business Combinations”, SFAS No. 142, “Goodwill
      and Other Intangible Assets”, FASB Concepts Statement Number 7 and EITF Issue
      No. 02-17, “Recognition of Customer Relationship Assets Acquired in a Business
      Combination”. These assets are being amortized over the contractual terms of the
      existing contracts plus anticipated contract renewals in accordance with EITF
      Issue No. 02-17.




**IMPAIRMENT
      OF LONG-LIVED ASSETS**




Pursuant
      to SFAS No. 144, we continually monitor events and changes in circumstances
      that
      could indicate carrying amounts of long-lived assets may not be recoverable.
      We
      recognize an impairment loss when the carrying value of an asset exceeds
      expected cash flows. Accordingly, when indicators or impairment of assets are
      present, we evaluate the carrying value of such assets in relation to the
      operating performance and future undiscounted cash flows of the underlying
      business. Our policy is to record an impairment loss when we determine that
      the
      carrying amount of the asset may not be recoverable. No impairment charges
      were
      recorded in the three months ended September 30, 2006 and 2005.




**REVENUE
      RECOGNITION**




We
      recognize revenue when the following criteria are met: (1) we have persuasive
      evidence of an arrangement, such as agreements, purchase orders or written
      requests, (2) we have completed delivery and no significant obligations remain,
      (3) our price to our customer is fixed or determinable, and (4) collection
      is
      probable.





Revenues
      from time and materials contracts are recognized as costs are incurred. Revenues
      from firm fixed price contracts are recognized on the percentage-of-completion
      method, either measured based on the proportion of costs recorded to date on
      the
      contract to total estimated contract costs or measured based on the proportion
      of labor hours expended to date on the contract to total estimated contract
      labor hours, as specified in the contract. However, during the three months
      ended September 30, 2006 less than 1% of Technest’s revenue has come from firm
      fixed price contracts.





Provisions
      for estimated losses on all contracts are made in the period in which such
      losses become known. Changes in job performance, job conditions, and estimated
      profitability, including those arising from contract penalty provisions, and
      final contract settlements may result in revision to cost and income and are
      recognized in the period in which the revisions are determined. Technest
      participates in teaming agreements where they are the primary contractor and
      they participate with other organizations to provide complex integrated remote
      sensor product and technology development services to the Federal government.
      Technest has managerial and oversight responsibility for all team members as
      well as the responsibility for the ultimate acceptability of all integrated
      technical performance criteria under the contracts for deliverable services
      and
      products. Technest as the prime contractor whom accepts risks for these customer
      funded tasks includes as revenues the amounts that they bill under the teaming
      arrangements and include as direct costs amounts that are reimbursable or paid
      to team members. Revenues under teaming arrangements amounted to $934,027 for
      the three months ended September 30, 2006.





31


**IMPACT
      OF RECENTLY ISSUED ACCOUNTING STANDARDS**




In
      September 2006, the FASB issued SFAS No. 157, “Fair Value
      Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework
      for measuring fair value in generally accepted accounting principles, and
      expands disclosures about fair value measurements. This statement is effective
      for financial statements issued for fiscal years beginning after Nov. 15, 2007.
      The Company is currently evaluating the impact of SFAS 157 on the consolidated
      financial statements.




In
      September 2006, the SEC issued Staff Accounting Bulletin No. 108 (“SAB
      108”). SAB 108 considers the effects of prior year misstatements when
      quantifying misstatements in current year financial statements. It is effective
      for fiscal years ending after Nov. 15, 2006. The Company does not believe the
      adoption of SAB 108 will have a material impact on the consolidated financial
      statements.




In
      June 2006, the FASB issued FIN No. 48, “Accounting for Uncertainty in
      Income Taxes — an Interpretation of FASB Statement No. 109” (“FIN 48”),
      which clarifies the accounting for uncertainty in tax positions. FIN 48 requires
      financial statement recognition of the impact of a tax position, if that
      position is more likely than not to be sustained on examination, based on the
      technical merits of the position. The provisions of FIN 48 will be effective
      for
      financial statements issued for fiscal years beginning after Dec. 15, 2006,
      with
      the cumulative effect of the change in accounting principle recorded as an
      adjustment to opening retained earnings. The Company does not expect the
      adoption of FIN 48 to have a material effect on the consolidated financial
      statements.







32




**RISK
      FACTORS**




*Any
      investment in our common stock involves a high degree of risk. You should
      consider carefully the risks described below and elsewhere in this report and
      the information under “Forward-Looking Statements,” before you decide to buy our
      common stock. If any of the following risks, or other risks not presently known
      to us or that we currently believe are not material, develop into an actual
      event, then our business, financial condition and results of operations could
      be
      adversely affected. In that case, the trading price of our common stock could
      decline due to any of these risks and uncertainties, and you may lose part
      or
      all of your investment.*





**Risks
      Related To Our Business, Results Of Operations And Financial
      Condition**




**We
      have a limited operating history. As a result, it may be difficult to evaluate
      our prospects for profitable operations and our ability to produce a positive
      return on Genex or EOIR.**




Technest
      has a limited operating history on which a potential investor may base an
      evaluation of us, our prospects and our ability to operate Genex or EOIR
      profitably.  If Technest is unable to sustain profitable operations,
      investors may lose their entire investment in Technest.





**We
      have a history of operating losses and cannot give assurance of future revenues
      or operating profits; investors may lose their entire
      investment.**




Technest
      has had net operating losses each year since its inception. As of September
      30,
      2006, our accumulated deficit was $17,110,230. If Technest continues to suffer
      losses as it has in the past, investors may not receive any return on their
      investment and may lose their entire investment.




**If
      we cannot obtain additional capital required to fund our operations and finance
      the growth our business, operating results and financial condition may suffer
      and the price of our stock may decline.**




The
      development of our technologies will require additional capital, and our
      business plan is to acquire additional revenue-producing assets. Although we
      believe that we have sufficient sources of liquidity to satisfy our obligations
      for at least the next 12 months, we may be unable to obtain additional funds,
      if
      needed, in a timely manner or on acceptable terms, which may render us unable
      to
      fund our operations or expand our business. If we are unable to obtain capital
      when needed, we may have to restructure our business or delay or abandon our
      development and expansion plans. If this occurs, the price of our common stock
      may decline and you may lose part or all of your investment.




We
      will
      have ongoing capital needs as we expand our business.  If we raise
      additional funds through the sale of equity or convertible securities, your
      ownership percentage of our common stock will be reduced. In addition, these
      transactions may dilute the value of our common stock.  We may have to
      issue securities that have rights, preferences and privileges senior to our
      common stock.  The terms of any additional indebtedness may include
      restrictive financial and operating covenants that would limit our ability
      to
      compete and expand. Although we have been successful in the past in obtaining
      financing for working capital and acquisitions, there can be no assurance that
      we will be able to obtain the additional financing we may need to fund our
      business, or that such financing will be available on acceptable
      terms.




**We
      have grown quickly; if we cannot effectively manage our growth, our business
      may
      suffer.**




We
      have
      rapidly and significantly expanded our operations through the acquisitions
      of
      EOIR in August 2005 and Genex in February 2005.  This growth has placed,
      and is expected to continue to place, a strain on our personnel, management,
      financial and other resources.  Some of our officers have no prior senior
      management experience at public companies.  To manage our growth
      effectively, we must, among other things:




·
            upgrade
                and expand our contract support, manufacturing facilities and capacity
                in
                a timely manner;




·
            successfully
                attract, train, motivate and manage a larger number of employees
                for
                contract support, manufacturing, sales and customer support
                activities;




33


·
            control
                higher inventory and working capital requirements;
                and




·
            improve
                the efficiencies within our operating, administrative, financial
                and
                accounting systems, procedures and
                controls.





To
      meet
      our growth objectives we must attract and retain highly skilled technical,
      operational, managerial and sales and marketing personnel.  If we fail to
      attract and retain the necessary personnel, we may be unable to achieve our
      business objectives and may lose our competitive position, which could lead
      to a
      significant decline in net sales.  We face significant competition for
      these skilled professionals from other companies, research and academic
      institutions, government entities and other organizations.




If
      we
      fail to manage our growth properly, we may incur unnecessary expenses and the
      efficiency of our operations may decline, adversely affecting our business
      and
      the price of our stock.





**Future
      acquisitions of other companies, if any, may disrupt our business and result
      in
      additional expenses, which could harm our business.**




We
      have
      made significant acquisitions in the past, and we plan to continue to review
      potential acquisition candidates, and our business plan includes building our
      business through strategic acquisitions. However, acceptable acquisition
      candidates may not be available in the future or may not be available on terms
      and conditions acceptable to us.




Acquisitions
      involve numerous risks including among others, difficulties and expenses
      incurred in the consummation of acquisitions and the assimilation of the
      operations, personnel, and services and products of the acquired companies.
      Additional risks associated with acquisitions include the difficulties of
      operating new businesses, the diversion of management's attention from other
      business concerns and the potential loss of key employees of the acquired
      company. If we do not successfully integrate the businesses we may acquire
      in
      the future, our business will suffer.




**If
      we fail to realize some or all of the anticipated benefits from our acquisition
      of EOIR, our business will suffer.**




Our
      combined company may fail to realize some or all of the anticipated benefits
      and
      synergies of the transaction as a result of, among other things, lower than
      expected order rates from customers of EOIR, unanticipated costs, deterioration
      in the U.S. economy and other factors. There can be no assurance that we will
      receive new orders under EOIR’s existing contract with the United States Army
      Night Vision and Electronic Sensors Directorate.




**Some
      of our competitors are much larger than we are, have better name recognition
      than we do and have far greater financial and other resources than we do. If
      we
      cannot effectively compete, our business may suffer and the price of our stock
      would decrease.**




With
      the
      U.S. government's large appropriation of money for homeland security programs,
      many companies are competing for the same homeland security contracts and there
      can be no assurance that Technest will effectively compete with large companies
      who have more resources and funds than we do. Several companies have been
      working on issues relevant to the safety of the American people for the past
      several years. Because of the services and additional human and financial
      resources that these larger companies can provide, they may be more attractive
      to the U.S. Government. Lockheed Martin and Northrop Grumman are providers
      of
      hardware engineering and systems engineering solutions. Computer Sciences
      Corporation and EDS provide computer and computer software solutions. Defense
      companies, such as General Dynamics, Boeing and Raytheon, are solutions
      providers that could easily expand their businesses into the homeland security
      business and are currently allocating resources to develop programs in this
      area.





**Our
      business may suffer if we cannot protect our proprietary
      technology.**




Our
      ability to compete depends significantly upon our patents, our trade secrets,
      our source code and our other proprietary technology.  Any misappropriation
      of our technology or the development of competing technology could seriously
      harm our competitive position, which could lead to a substantial reduction
      in
      revenue.




34


The
      steps
      we have taken to protect our technology may be inadequate to prevent others
      from
      using what we regard as our technology to compete with us. Our patents could
      be
      challenged, invalidated or circumvented, in which case the rights we have under
      our patents could provide no competitive advantages. Existing trade secrets,
      copyright and trademark laws offer only limited protection. In addition, the
      laws of some foreign countries do not protect our proprietary technology to
      the
      same extent as the laws of the United States, which could increase the
      likelihood of misappropriation.  Furthermore, other companies could
      independently develop similar or superior technology without violating our
      intellectual property rights.




If
      we
      resort to legal proceedings to enforce our intellectual property rights, the
      proceedings could be burdensome, disruptive and expensive, distract the
      attention of management, and there can be no assurance that we would
      prevail.




**Claims
      by others that we infringe their intellectual property rights could increase
      our
      expenses and delay the development of our business. As a result, our business
      and financial condition could be harmed.**




Our
      industries are characterized by the existence of a large number of patents
      and
      frequent claims and related litigation regarding patent and other intellectual
      property rights. We cannot be certain that our products do not and will not
      infringe issued patents, patents that may be issued in the future, or other
      intellectual property rights of others.





We
      do not
      conduct exhaustive patent searches to determine whether the technology used
      in
      our products infringes patents held by third parties. In addition, product
      development is inherently uncertain in a rapidly evolving technological
      environment in which there may be numerous patent applications pending, many
      of
      which are confidential when filed, with regard to similar
      technologies.




We
      may
      face claims by third parties that our products or technology infringe their
      patents or other intellectual property rights. Any claim of infringement could
      cause us to incur substantial costs defending against the claim, even if the
      claim is invalid, and could distract the attention of our management. If any
      of
      our products are found to violate third-party proprietary rights, we may be
      required to pay substantial damages. In addition, we may be required to
      re-engineer our products or obtain licenses from third parties to continue
      to
      offer our products. Any efforts to re-engineer our products or obtain licenses
      on commercially reasonable terms may not be successful, which would prevent
      us
      from selling our products, and, in any case, could substantially increase our
      costs and have a material adverse effect on our business, financial condition
      and results of operations.




**Fluctuations
      in our quarterly revenue and results of operations could depress the market
      price of our common stock.**




Our
      future net sales and results of operations are likely to vary significantly
      from
      quarter to quarter due to a number of factors, many of which are outside our
      control. Accordingly, you should not rely on quarter-to-quarter comparisons
      of
      our results of operations as an indication of future performance. It is possible
      that our revenue or results of operations in a quarter will fall below the
      expectations of securities analysts or investors. If this occurs, the market
      price of our common stock could fall significantly. Our results of operations
      in
      any quarter can fluctuate for many reasons, including:




·
            timing
                of orders from our largest customers - the DOD, Homeland Security,
                various
                INTEL and the United States Night Vision and Electronic Sensors
                Directorate;




·
            our
                ability to perform under contracts and manufacture, test and deliver
                products in a timely and cost-effective
                manner;




·
            our
                success in winning competitions for
                orders;




·
            the
                timing of new product introductions by us or our
                competitors;




·
            the
                mix of products we sell;




·
            competitive
                pricing pressures; and




·
            general
                economic climate.





35


A
      large
      portion of our expenses, including expenses for facilities, equipment, and
      personnel, are relatively fixed. Accordingly, if our revenues decline or do
      not
      grow as much as we anticipate, we might be unable to maintain or improve our
      operating margins. Any failure to achieve anticipated revenues could therefore
      significantly harm our operating results for a particular fiscal
      period.





**Our
      ability to service our debt and meet our cash requirements depends on many
      factors,** **some
      of which are beyond our control.**




Although
      there can be no assurances, we believe that the level of borrowings available
      to
      us, combined with cash provided by our operations, will be sufficient to provide
      for our cash requirements for the foreseeable future. However, our ability
      to
      satisfy our obligations will depend on our future operating performance and
      financial results, which will be subject, in part, to factors beyond our
      control, including interest rates and general economic, financial and business
      conditions. If we are unable to generate sufficient cash flow to service our
      debt, we may be required to:




·
            refinance
                all or a portion of our debt;




·
            obtain
                additional financing;




·
            sell
                some of our assets or operations;




·
            reduce
                or delay capital expenditures and/or acquisitions;
                or




·
            revise
                or delay our strategic plans.




If
      we are
      required to take any of these actions, it could have a material adverse effect
      on our business, financial condition, results of operations and liquidity.
      In
      addition, we cannot assure you that we would be able to take any of these
      actions, that these actions would enable us to continue to satisfy our capital
      requirements or that these actions would be permitted under the terms of our
      credit facilities.




**The
      covenants in our term loan facility with Silicon Valley Bank impose restrictions
      that may limit our ability and the ability of our subsidiaries to take certain
      actions.**




The
      covenants in our term loan facility with Silicon Valley Bank restrict our
      ability and the ability of our subsidiaries to, among other things:




·
            sell,
                transfer or lease certain parts of our business and property or that
                of
                our subsidiaries;




·
            incur
                additional debt;




·
            pay
                dividends and make other restricted payments and restricts our
                subsidiaries from doing the same;




·
            make
                certain investments, loans and
                advances;




·
            create
                or permit certain liens;




·
            enter
                into transactions with affiliates;




·
            engage
                in certain business activities; and




·
            consolidate
                or merge or sell all or substantially all of our assets or those
                of our
                subsidiaries.




Our
      term
      loan facility contains other covenants customary for credit facilities of this
      nature, including requiring us to meet specified financial ratios and financial
      tests. Our ability to borrow under our term loan facility will depend upon
      satisfaction of these covenants. Events beyond our control can affect our
      ability to meet those covenants.




If
      we are
      unable to meet the terms of our financial covenants, or if we violate any of
      these covenants, a default could occur under this agreement. A default, if
      not
      waived by our lender, could result in the acceleration of our outstanding
      indebtedness and cause our debt to become immediately due and payable. If
      acceleration occurs, we would not be able to repay our debt, and it is unlikely
      that we would be able to borrow sufficient funds to refinance our debt. Even
      if
      new financing is made available to us, it may not be on terms acceptable to
      us.





**Our
      credit facilities with Silicon Valley Bank are based on variable rates of
      interest, which could result in higher interest expenses in the event of an
      increase in interest rates.**




The
      interest rate that we pay on our credit facilities with Silicon Valley Bank
      depend on the Bank’s prime rate. This increases our exposure to fluctuations in
      market interest rates. If the Bank’s prime rate rises, the interest rate on our
      credit facilities also may increase. Therefore, an increase in the Bank’s prime
      rate may increase our interest payment obligations and have a negative effect
      on
      our cash flow and financial position.




36


**Risks
      Related to Contracting with the United States Government**





**Our
      contract with the United States Army Night Vision and Electronic Sensors
      Directorate expires in July 2007. We are in the “re-compete” process. If we are
      not awarded a new contract, our revenues would decrease significantly and our
      financial condition would be adversely affected.**





We
      have a
      contract with the United States Army Night Vision and Electronic Sensors
      Directorate that may provide for revenues of up to approximately $406 million
      (including revenue already recognized) depending upon the U.S. Army's needs
      of
      which our subsidiary, EOIR, recognized in excess of approximately $70.31 million
      in revenues for the year ended June 30, 2006 or 86.6% of our total consolidated
      revenues during that period. This contract expires in July 2007 and we
      anticipate that the U.S. Army will competitively award a replacement contract.
      We will expend substantial cost and managerial time and effort to prepare for
      the bid and proposal for this new contract. Although we believe that it is
      likely that we will be awarded a new contract, if we are not awarded a new
      contract, our revenues would significantly decrease and our financial condition
      could be adversely affected.





Although
      the U.S. Army has not announced the evaluation criteria for the replacement
      contract, there are several factors that are likely to be considered during
      the
      re-compete process, such as our ability to do the work or find subcontractors
      that can do the work; our competitive pricing; our reputation, the Government’s
      prior experience with our work; our competition; changes in Government programs
      or requirements; budgetary priorities; changes in fiscal policies; curtailment
      of the Government’s use of technology solutions firms; new contract
      requirements; and the government’s need for a diverse contracting base. If we
      are not able to satisfy the Government’s requirements, we may not be awarded a
      new contract.




**Our
      current and future expected revenues are derived from a small number of
      customers within the U.S. government such that the loss of any one ultimate
      customer could materially reduce our revenues. As a result, our financial
      condition and our stock price would be adversely affected.**




We
      currently derive substantially all of our revenue from contracts with the U.S.
      Government, including the DOD, Homeland Security and various INTEL within the
      U.S. Government. We have a contract with the United States Army Night Vision
      and
      Electronic Sensors Directorate that may provide for revenues of up to
      approximately $406 million (including revenue already recognized) depending
      upon
      the U.S. Army's needs of which our subsidiary, EOIR, recognized in excess of
      approximately $70.31 million in revenues for the year ended June 30, 2006 or
      86.6% of our total consolidated revenues during that period. Although we expect
      this contract to account for a substantial portion of our revenues going
      forward, this contract expires in July 2007 and we are in the process of
      competing for a new contract. If we are not awarded a new contract, our revenues
      would significantly decrease and our financial condition could be adversely
      affected.




In
      addition, the loss of this customer due to cutbacks, competition, or other
      reasons would materially reduce our revenue base. Annual or quarterly losses
      may
      occur or be increased if there are material gaps or delays in orders from one
      of
      our largest customers that are not replaced by other orders or other sources
      of
      income.





**Our
      largest customers are the DOD, Homeland Security, and various other INTEL whose
      operations are subject to unique political and budgetary constraints, involve
      competitive bidding, and our contacts with these customers may be subject to
      cancellation with or without penalty, which may produce volatility in our
      earnings and revenue.**




Our
      largest customers are the DOD, Homeland Security, and various other INTEL.
      Due
      to political and budgetary processes and other scheduling delays that may
      frequently occur relating to the contract or bidding process, some government
      agency orders may be canceled or delayed, and the receipt of revenues or
      payments may be substantially delayed. This irregular and unpredictable revenue
      stream makes it difficult for our business to operate smoothly. Obtaining
      contracts from government agencies is challenging, and government contracts
      often include provisions that are not standard in private commercial
      transactions. For example, government contracts may:




·
            include
                provisions that allow the government agency to terminate the contract
                without penalty under some
                circumstances;




·
            be
                subject to purchasing decisions of agencies that are subject to political
                influence;




37


·
            contain
                onerous procurement procedures; and




·
            be
                subject to cancellation if government funding becomes
                unavailable.





In
      addition, federal government agencies routinely audit government contracts.
      These agencies review a contractor's performance on its contract, pricing
      practices, cost structure and compliance with applicable laws, regulations
      and
      standards. These audits may occur several years after completion of the audited
      work. An audit could result in a substantial adjustment to our revenues because
      we would not be reimbursed for any costs improperly allocated to a specific
      contract, and we would be forced to refund any improper costs already
      reimbursed. If a government audit uncovers improper or illegal activities,
      we
      may be subject to civil and criminal penalties and administrative sanctions,
      including termination of contracts forfeiture of profits, suspension of
      payments, fines and suspension or debarment from doing business with federal
      government agencies. In addition, our reputation could be harmed if allegations
      of impropriety were made against us.





**Our
      business could be adversely affected by changes in budgetary priorities of
      the
      Government.**




Because
      we derive a substantial majority of our revenue from contracts with the
      Government, we believe that the success and development of our business will
      continue to depend on our successful participation in Government contract
      programs. Changes in Government budgetary priorities could directly affect our
      financial performance. A significant decline in government expenditures, or
      a
      shift of expenditures away from programs that we support, or a change in
      Government contracting policies, could cause Government agencies to reduce
      their
      purchases under contracts, to exercise their right to terminate contracts at
      any
      time without penalty or not to exercise options to renew contracts. Any such
      actions could cause our actual results to differ materially from those
      anticipated. Among the factors that could seriously affect our Government
      contracting business are:




•
            changes
                in Government programs or requirements;




•
            budgetary
                priorities limiting or delaying Government spending generally, or
                specific
                departments or agencies in particular, and changes in fiscal policies
                or
                available funding, including potential Governmental shutdowns (as
                occurred
                during the Government’s 1996 fiscal year);




•
            curtailment
                of the Government’s use of technology solutions firms.




**Our
      Government contracts may be terminated by the government at any time and may
      contain other provisions permitting the government not to continue with contract
      performance. If lost contracts are not replaced, our operating results may
      differ materially from those anticipated.**




We
      derive
      substantially all of our revenue from Government contracts that typically span
      one or more base years and one or more option years. The option periods
      typically cover more than half of the contract’s potential duration. Government
      agencies generally have the right not to exercise these option periods. In
      addition, our contracts typically also contain provisions permitting a
      government client to terminate the contract for its convenience. A decision
      not
      to exercise option periods or to terminate contracts could result in significant
      revenue shortfalls from those anticipated.





**Our
      Government contracts contain numerous provisions that are unfavorable to us.**




Government
      contracts, including ours, contain provisions and are subject to laws and
      regulations that give the government rights and remedies, some of which are
      not
      typically found in commercial contracts, including allowing the Government
      to:




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




•
            
            claim
                rights in systems and software developed by us;




•
            
            suspend
                or debar us from doing business with the Government or with a Government
                agency, impose fines and penalties and subject us to criminal prosecution;
                and




38


•
            
            control
                or prohibit the export of our data and technology.




If
      the
      Government terminates any of our contracts for convenience, we may recover
      only
      our incurred or committed costs, settlement expenses and profit on work
      completed prior to the termination. If the Government terminates any of our
      contracts for default, we may be unable to recover even those amounts, and
      instead may be liable for excess costs incurred by the Government in procuring
      undelivered items and services from another source. Depending on the value
      of
      the particular contract, that type of termination could cause our actual results
      to differ materially from those anticipated. Our Government contracts also
      contain organizational conflict of interest clauses that limit our ability
      to
      compete for certain related follow-on contracts. For example, when we work
      on
      the design of a particular system, we may be precluded from competing for the
      contract to install that system. As we grow our business, we expect to
      experience organizational conflicts of interest more frequently. Depending
      upon
      the value of the matters affected by an organizational conflict of interest
      issue that precludes our participation in a program or contract could cause
      our
      actual results to differ materially from those anticipated.





**We
      derive significant revenue from contracts and task orders awarded through a
      competitive bidding process. If we are unable to consistently win new awards
      over any extended period, our business and prospects will be adversely affected.**




Substantially
      all of our contracts and task orders with the Government are awarded through
      a
      competitive bidding process. We expect that much of the business that we will
      seek in the foreseeable future will continue to be awarded through competitive
      bidding. Budgetary pressures and changes in the procurement process have caused
      many Government clients to increasingly purchase goods and services through
      indefinite delivery/indefinite quantity, or ID/IQ, contracts, GSA schedule
      contracts and other government-wide acquisition contracts. These contracts,
      some
      of which are awarded to multiple contractors, have increased competition and
      pricing pressure, requiring that we make sustained post-award efforts to realize
      revenue under each such contract. In addition, in consideration of recent
      publicity regarding the practice of agencies awarding work under such contracts
      that is arguably outside their intended scope, both the GSA and the DOD have
      initiated programs aimed to ensure that all work fits properly within the scope
      of the contract under which it is awarded. The net effect of such programs
      may
      reduce the number of bidding opportunities available to us. Moreover, even
      if we
      are highly qualified to work on a particular new contract, we might not be
      awarded business because of the Government’s policy and practice of maintaining
      a diverse contracting base.




The
      competitive bidding process presents a number of risks, including the following:




•
            we
                bid on programs before the completion of their design, which may
                result in
                unforeseen technological difficulties and cost overruns;




•
            we
                expend substantial cost and managerial time and effort to prepare
                bids and
                proposals for contracts that we may not win;




•
            we
                may be unable to estimate accurately the resources and cost structure
                that
                will be required to service any contract we win; and




•
            we
                may encounter expense and delay if our competitors protest or challenge
                awards of contracts to us in competitive bidding, and any such protest
                or
                challenge could result in the resubmission of bids on modified
                specifications, or in the termination, reduction or modification
                of the
                awarded contract.




If
      we are
      unable to win particular contracts, we may be unable to provide clients services
      that are purchased under those contracts for a number of years. If we are unable
      to consistently win new contract awards over any extended period, our business
      and prospects will be adversely affected and that could cause our actual results
      to differ materially from those anticipated. In addition, upon the expiration
      of
      a contract, if the client requires further services of the type provided by
      the
      contract, there is frequently a competitive re-bidding process. There can be
      no
      assurance that we will win any particular bid, or that we will be able to
      replace business lost upon expiration or completion of a contract, and the
      termination or non-renewal of any of our significant contracts could cause
      our
      actual results to differ materially from those anticipated.




39


**Our
      business may suffer if we or our employees are unable to obtain the security
      clearances or other qualifications we and they need to perform services for
      our
      clients.**




Many
      of
      our Government contracts require us to have security clearances and employ
      personnel with specified levels of education, work experience and security
      clearances. High-level security clearances can be difficult and time-consuming
      to obtain. If we or our employees lose or are unable to obtain necessary
      security clearances, we may not be able to win new business and our existing
      clients could terminate their contracts with us or decide not to renew them.
      To
      the extent we cannot obtain or maintain the required security clearances for
      our
      employees working on a particular contract, we may not derive the revenue
      anticipated from the contract, which could cause our results to differ
      materially from those anticipated.




**The
      Government may change its procurement or other practices in a manner adverse
      to
      us.**




The
      Government may change its procurement practices or adopt new contracting rules
      and regulations, such as cost accounting standards. It could also adopt new
      contracting methods relating to GSA contracts or other government-wide
      acquisition contracts, or adopt new socio-economic requirements. These changes
      could impair our ability to obtain new contracts or win re-competed contracts.
      New contracting requirements could be costly or administratively difficult
      for
      us to satisfy, and, as a result could cause actual results to differ materially
      from those anticipated.




**Restrictions
      on or other changes to the Government’s use of service contracts may harm our
      operating results.**




We
      derive
      a significant amount of revenue from service contracts with the Government.
      The
      Government may face restrictions from new legislation, regulations or union
      pressures, on the nature and amount of services the Government may obtain from
      private contractors. Any reduction in the Government’s use of private
      contractors to provide services could cause our actual results to differ
      materially from those anticipated.





**Our
      contracts and administrative processes and systems are subject to audits and
      cost adjustments by the Government, which could reduce our revenue, disrupt
      our
      business or otherwise adversely affect our results of operations.**




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





**Unfavorable
      government audit results could force us to adjust previously reported operating
      results and could subject us to a variety of penalties and sanctions.**




The
      federal government audits and reviews our performance on awards, pricing
      practices, cost structure, and compliance with applicable laws, regulations,
      and
      standards. Like most large government vendors, our awards are audited and
      reviewed on a continual basis by federal agencies, including the Defense
      Contract Management Agency and the Defense Contract Audit Agency. An audit
      of
      our work, including an audit of work performed by companies we have acquired
      or
      may acquire or subcontractors we have hired or may hire, could result in a
      substantial adjustment in our operating results for the applicable period.
      For
      example, any costs which were originally reimbursed could subsequently be
      disallowed. In this case, cash we have already collected may need to be refunded
      and our operating margins may be reduced. To date, we have not experienced
      any
      significant adverse consequences as a result of government audits.




40


If
      a
      government audit uncovers improper or illegal activities, we may be subject
      to
      civil and criminal penalties and administrative sanctions, including termination
      of contracts, forfeiture of profits, suspension of payments, fines and
      suspension or debarment from doing business with U.S. Government agencies.





**Employee
      misconduct, including security breaches, could result in the loss of clients
      and
      our suspension or disbarment from contracting with the Government.**




We
      may be
      unable to prevent our employees from engaging in misconduct, fraud or other
      improper activities that could adversely affect our business and reputation.
      Misconduct could include the failure to comply with procurement regulations,
      regulations regarding the protection of classified information and legislation
      regarding the pricing of labor and other costs in government contracts. Many
      of
      the systems we develop involve managing and protecting information involved
      in
      national security and other sensitive functions. A security breach in one of
      these systems could prevent us from having access to such critically sensitive
      systems. Other examples of employee misconduct could include time card fraud
      and
      violations of the Anti-Kickback Act. The precautions we take to prevent and
      detect this activity may not be effective, and we could face unknown risks
      or
      losses. As a result of employee misconduct, we could face fines and penalties,
      loss of security clearance and suspension or debarment from contracting with
      the
      Government, which could cause our actual results to differ materially from
      those
      anticipated.





**If
      our subcontractors or vendors fail to perform their contractual obligations,
      our
      performance as a prime contractor and our ability to obtain future business
      could be materially and adversely impacted and our actual results could differ
      materially from those anticipated.**




Our
      performance of Government contracts may involve the issuance of subcontracts
      or
      purchase orders to other companies upon which we rely to perform all or a
      portion of the work we are obligated to deliver to our clients. A failure by
      one
      or more of our subcontractors or vendors to satisfactorily deliver on a timely
      basis the agreed-upon supplies and/or perform the agreed-upon services may
      materially and adversely impact our ability to perform our obligations as a
      prime contractor.





A
      performance deficiency by a subcontractor or a vendor could result in the
      Government terminating our contract for default. A default termination could
      expose us to liability for excess costs of re-procurement by the Government
      and
      have a material adverse effect on our ability to compete for future contracts
      and task orders.




Depending
      upon the level of problem experienced, such problems with subcontractors could
      cause our actual results to differ materially from those anticipated.





**Risks
      Related To “Controlled Companies”**





**We
      are a majority owned subsidiary of Markland. As a result, the ability of
      minority shareholders to influence our affairs is extremely
      limited.**




As
      of
      November 7, 2006, Markland controlled approximately 82% of outstanding Technest
      common stock on a primary basis.  As a result, Markland has the ability to
      control all matters submitted to the stockholders of Technest for approval
      (including the election and removal of directors) and to control Technest’s
      management and affairs.  Pursuant to the Stockholder Agreement between
      Markland and Technest dated March 13, 2006, Markland agreed to elect Joseph
      Mackin, Gino Pereira, and our three independent directors, Robert Doto, Gen.
      David Gust (US Army Rtd.) and Darlene Deptula-Hicks.




This
      concentration of ownership may have the effect of delaying, deferring or
      preventing a change in control, impeding a merger, consolidation, takeover
      or
      other business combination involving us, or discouraging a potential acquirer
      from making a tender offer or otherwise attempting to obtain control, which
      in
      turn could materially and adversely affect the market price of the common
      stock.




Minority
      shareholders of Technest will be unable to affect the outcome of stockholder
      voting as long as Markland or any other party retains a controlling interest.
      Further, pursuant to the Stockholder Agreement entered into between Markland
      and
      Technest on March 13, 2006, Markland agreed for a period of twelve months from
      the date of the agreement, not to vote the shares held by it to increase the
      size of our board of directors or to remove any of the directors currently
      in
      office.





41


**If
      our majority stockholder, Markland Technologies, Inc., sells or transfers all
      or
      a significant portion of the shares of our common stock that it currently holds,
      a change of control could result, which could significant disrupt our
      operations.**





Currently,
      Markland owns approximately 82% of our outstanding common stock. Markland has
      declared a distribution to its stockholders of 2,500,000 shares that it owns
      of
      Technest and has placed in escrow an aggregate of 4,640,192 shares of our common
      stock held by Markland to secure the conversion of the Markland Series E
      preferred stock. Upon the distribution to its stockholders of 2,500,000 shares
      of Technest, Markland’s ownership of Technest will be 66.7%. If all of the
      shares held in escrow were transferred by Markland, Markland’s ownership of
      Technest would drop to 38.5%. These holdings represent a significant portion
      of
      Markland’s assets. If Markland disposes of a large number of shares of our
      common stock for any reason, a change of control may result.  In
      particular, Markland is subject to various legal actions, proceedings and claims
      and may become subject to additional actions, proceedings and claims in the
      future. Were any of these claims to result in an outcome adverse to Markland,
      the resulting damages or amounts paid in settlement could be satisfied partially
      or wholly with shares of our common stock. A change of control at the
      shareholder level could result in a change to the composition of our board
      and,
      ultimately, a change in our management and business plan.  Any such
      transition could lead to, among other things, a decline in service levels,
      disruption in our operations and departures of key personnel, which could in
      turn harm our business.





**Gino
      Pereira serves as a director and Chief Financial Officer of Technest and
      Markland. Conflicts of interest could arise as a result of these overlapping
      positions.**





While
      Mr.
      Pereira’s employment agreement provides that he shall spend no less than 60% of
      his time working for Technest, there can be no assurance competing demands
      on
      Mr. Pereira at a given time will not result in an allocation of time and
      resources unfavorable to us. Neither our organizational documents nor our
      policies specify a minimum standard of time and attention that our officers
      and
      directors are required to devote to us, and there can be no assurance that
      conflicts of interest will not arise.





In
      light
      of Markland’s significant holdings of our common stock and the potential for
      conflict given Mr. Pereira’s current positions with Markland and Technest, in an
      effort to avoid even the mere appearance of a conflict, the board of directors
      of Technest on September 22, 2006 formed a special committee comprised of the
      three independent directors, Robert Doto, Gen. David Gust (US Army Rtd.) and
      Darlene Deptula-Hicks, to address issues arising from or related to, directly
      or
      indirectly, the ownership of our common stock by Markland and its assignees
      and to take any action the special committee deems appropriate.





**Risks
      Related To Capital Structure**




**Shares
      eligible for future sale, if sold into the public market, may adversely affect
      the market price of our common stock.**




Pursuant
      to the terms of the Merger Agreement and the Registration Rights Agreements
      executed on February 14, 2005 in connection with our acquisition of Genex,
      Technest was obligated to file one or more registration statements with the
      Securities and Exchange Commission covering shares that are being registered
      pursuant to a registration statement that was filed with the SEC. In addition,
      we are obligated to registered shares held by Markland or any of its
      transferees. Our common stock is thinly traded. The registration of these shares
      for public resale may result in a greater number of shares being available
      for
      trading than the market can absorb. This may cause the market price of our
      common stock to decrease.




**The
      sale of material amounts of common stock could encourage short sales by third
      parties and further depress the price of our common stock.  As a result,
      you may lose all or part of your investment.**




The
      significant downward pressure on our stock price caused by the sale of a
      significant number of registered shares could cause our stock price to decline,
      thus allowing short sellers of our stock an opportunity to take advantage of
      any
      decrease in the value of our stock. The presence of short sellers in our common
      stock may further depress the price of our common stock.




**Technest
      does not foresee paying cash dividends in the foreseeable
      future.**




Technest
      has not paid cash dividends on our stock and does not plan to pay cash dividends
      on our stock in the foreseeable future.




42


**Risks
      Related To Investing In Low- Priced Stock**




**It
      may be difficult for you to resell shares of our common stock if an active
      market for our common stock does not develop.**




Our
      common stock is not actively traded on a securities exchange and we do not
      meet
      the initial listing criteria for any registered securities exchange or the
      Nasdaq National Market System. It is quoted on the less recognized OTC Bulletin
      Board. This factor may further impair your ability to sell your shares when
      you
      want and/or could depress our stock price. As a result, you may find it
      difficult to dispose of, or to obtain accurate quotations of the price of,
      our
      securities because smaller quantities of shares could be bought and sold,
      transactions could be delayed and security analyst and news coverage of our
      company may be limited. These factors could result in lower prices and larger
      spreads in the bid and ask prices for our shares.




**Technest’s common
      stock is “penny stock,” with the result that trading of our common stock in any
      secondary market may be impeded.**




Due
      to
      the current price of our common stock, many brokerage firms may not be willing
      to effect transactions in our securities, particularly because low-priced
      securities are subject to SEC rules imposing additional sales requirements
      on
      broker-dealers who sell low-priced securities (generally defined as those having
      a per share price below $5.00). These disclosure requirements may have the
      effect of reducing the trading activity in the secondary market for our stock
      as
      it is subject to these penny stock rules. Therefore, stockholders may have
      difficulty selling those securities.  These factors severely limit the
      liquidity, if any, of our common stock, and will likely continue to have a
      material adverse effect on its market price and on our ability to raise
      additional capital.




The
      penny
      stock rules require a broker-dealer, prior to a transaction in a penny stock,
      to
      deliver a standardized risk disclosure document prepared by the SEC, that:





(a)
            contains
                a description of the nature and level of risk in the market for penny
                stocks in both public offerings and secondary trading;




(b)
            contains
                a description of the broker’s or dealer’s duties to the customer and of
                the rights and remedies available to the customer with respect to
                a
                violation to such duties or other requirements of securities laws;




(c)
            contains
                a brief, clear, narrative description of a dealer market, including
                bid
                and ask prices for penny stocks and the significance of the spread
                between
                the bid and ask price;




(d)
            
            contains
                a toll-free telephone number for inquiries on disciplinary actions;




(e)
            defines
                significant terms in the disclosure document or in the conduct of
                trading
                in penny stocks; and




(f)
            contains
                such other information and is in such form, including language, type,
                size
                and format, as the SEC may require by rule or regulation.





In
      addition, the broker-dealer also must provide, prior to effecting any
      transaction in a penny stock, the customer with:




(a)
            bid
                and ask quotations for the penny stock;





(b)
            the
                compensation of the broker-dealer and its salesperson in the transaction;





(c)
            the
                number of shares to which such bid and ask prices apply, or other
                comparable information relating to the depth and liquidity of the
                market
                for such stock; and





(d)
            monthly
                account statements showing the market value of each penny stock held
                in
                the customer’s account.





Also,
      the
      penny stock rules require that prior to a transaction in a penny stock not
      otherwise exempt from those rules, the broker-dealer must make a special written
      determination that the penny stock is a suitable investment for the purchaser
      and receive the purchaser’s written acknowledgment of the receipt of a risk
      disclosure statement, a written agreement to transactions involving penny
      stocks, and a signed and dated copy of a written suitability statement.




43


We
      cannot
      predict the extent to which investor interest in our stock or a business
      combination, if any, will lead to an increase in our market price or the
      development of an active trading market or how liquid that market, if any,
      might
      become.




**The
      market price of our common stock may be volatile. As a result, you may not
      be
      able to sell our common stock in short time periods, or possibly at
      all.**




Our
      stock
      price has been volatile. From January 2003 to November 7, 2006, the trading
      price of our common stock ranged from a low price of $0.02 per share to a high
      price of $63.29 per share. Many factors may cause the market price of our common
      stock to fluctuate, including:




·
            variations
                in our quarterly results of
                operations;




·
            the
                introduction of new products by us or our
                competitors;




·
            acquisitions
                or strategic alliances involving us or our
                competitors;




·
            future
                sales of shares of common stock in the public market;
                and




·
            market
                conditions in our industries and the economy as a
                whole.




In
      addition, the stock market has recently experienced extreme price and volume
      fluctuations. These fluctuations are often unrelated to the operating
      performance of particular companies. These broad market fluctuations may
      adversely affect the market price of our common stock. When the market price
      of
      a company's stock drops significantly, stockholders often institute securities
      class action litigation against that company. Any litigation against us could
      cause us to incur substantial costs, divert the time and attention of our
      management and other resources or otherwise harm our business.




**Risks
      Related to the Homeland Security and Defense Industries**




**The
      homeland security and defense industries are characterized by rapid
      technological change and evolving industry standards, and unless we keep pace
      with the changing technologies, we could lose customers and fail to win new
      customers.**




Our
      future success will depend, in part, upon our ability to develop and introduce
      a
      variety of new products and services and enhancements to these new product
      and
      services in order to address the changing and sophisticated needs of the
      homeland security marketplace. Delays in introducing new products, services
      and
      enhancements, the failure to choose correctly among technical alternatives
      or
      the failure to offer innovative products and services at competitive prices
      may
      cause customers to forego purchases of our products and services and purchase
      those of our competitors. Frequently, technical development programs in the
      homeland security industry require assessments to be made of the future
      directions of technology and technology markets generally, which are inherently
      risky and difficult to predict.




**We
      face intense competition, which could result in lower revenues and higher
      research and development expenditures and could adversely affect our results
      of
      operations.**




Current
      political tensions throughout the world have heightened interest in the homeland
      security industry, and we expect competition in this field, which is already
      substantial, to intensify. If we do not develop new and enhanced products,
      or if
      we are not able to invest adequately in our research and development activities,
      our business, financial condition and results of operations could be negatively
      impacted. Many of our competitors have significantly more cash and resources
      than we have. Our competitors may introduce products that are competitively
      priced, have increased performance or functionality, or incorporate
      technological advances that we have not yet developed or implemented. To remain
      competitive, we must continue to develop, market and sell new and enhanced
      systems and products at competitive prices, which will require significant
      research and development expenditures.




44


We
      cannot
      assure you that we will be able to compete successfully against current and
      future competitors.




**Risks
      Relating to New Corporate Governance Standards**




**We
      expect our administrative costs and expenses resulting from new regulations
      to
      increase, adversely affecting our financial condition and results of
      operations.**




We
      face
      new corporate governance requirements under the Sarbanes-Oxley Act of 2002,
      the
      NASDAQ Capital Market requirements and SEC rules adopted thereunder. These
      regulations when we become subject to them will increase our legal and financial
      compliance and make some activities more difficult, time-consuming and
      costly.





**New
      corporate governance requirements have made it more difficult to attract
      qualified directors. As a result, our business may be harmed and the price
      of
      our stock may be adversely affected.**




New
      corporate governance requirements have increased the role and responsibilities
      of directors and executive officers of public companies. These new requirements
      have made it more expensive for us to maintain director and officer liability
      insurance. We may be required to accept reduced coverage or incur significantly
      higher costs to maintain coverage. As a result, although we recently elected
      three directors that satisfy the “independence” standards of NASDAQ, it may be
      more difficult for us to attract and retain other qualified individuals to
      serve
      as members of our board of directors.




**If
      we fail to maintain effective internal controls over financial reporting, the
      price of our common stock may be adversely affected.**




We
      are
      required to establish and maintain appropriate internal controls over financial
      reporting. Our internal controls over financial reporting may have weaknesses
      and conditions that need to be addressed, the disclosure of which may have
      an
      adverse impact on the price of our common stock.




Failure
      to establish those controls, or any failure of those controls once established,
      could adversely impact our public disclosures regarding our business, financial
      condition or results of operations. In addition, management's assessment of
      internal controls over financial reporting may identify weaknesses and
      conditions that need to be addressed in our internal controls over financial
      reporting or other matters that may raise concerns for investors. Any actual
      or
      perceived weaknesses and conditions that need to be addressed, disclosure of
      management's assessment of our internal controls over financial reporting or
      disclosure of our independent registered public accounting firm's attestation
      to
      or report on management's assessment of our internal controls over financial
      reporting may have an adverse impact on the price of our common
      stock.




**Standards
      for compliance with Section 404 of the Sarbanes-Oxley Act of 2002 are uncertain,
      and if we fail to comply in a timely manner, our business could be harmed and
      our stock price could decline.**




Rules
      adopted by the SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002
      require annual assessment of our internal control over financial reporting,
      and
      attestation of this assessment by our independent registered public accountant.
      We expect that these requirements will first apply to our annual report for
      the
      fiscal year ending June 30, 2008 and June 30, 2009, respectively. The standards
      that must be met for management to assess the effectiveness of the internal
      control over financial reporting are new and complex, and require significant
      documentation, testing and possible remediation to meet the detailed standards.
      We may encounter problems or delays in completing activities necessary to make
      an assessment of its internal control over financial reporting. In addition,
      we
      may encounter problems or delays in completing the implementation of any
      requested improvements and receiving an attestation of its assessment by our
      independent registered public accountants. If management cannot assess our
      internal control over financial reporting as effective, or our independent
      registered public accounting firm is unable to issue an unqualified attestation
      report on such assessment, investor confidence and share value may be negatively
      impacted.





45




**Item
      3. Controls and Procedures**




**Evaluation
      of Disclosure Controls and Procedures.**




Based
      on
      our management's evaluation (with the participation of our principal executive
      officer and principal financial officer), as of the end of the period covered
      by
      this report, our principal executive officer and principal financial officer
      have concluded that our disclosure controls and procedures (as defined in Rules
      13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended,
      (the "Exchange Act")) are effective to ensure that information required to
      be
      disclosed by us in reports that we file or submit under the Exchange Act is
      recorded, processed, summarized and reported within the time periods specified
      in Securities and Exchange Commission rules and forms.




**Changes
      in Internal Control Over Financial Reporting.**




There
      was
      no change in our internal control over financial reporting during the quarter
      ended September 30, 2006 that has materially affected, or is reasonably likely
      to materially affect, our internal control over financial reporting. It should
      be noted that any system of controls, however well designed and operated, can
      provide only reasonable, and not absolute, assurance that the objectives of
      the
      system are met. In addition, the design of any control system is based in part
      upon 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 goals under all potential
      future conditions, regardless of how remote.




46


**PART
      II.**  **OTHER
      INFORMATION**




**ITEM
      1. Legal Proceedings.**




*Technest
      Holdings, Inc* *.*





On
      or
      about July 23, 1998, H & H Acquisition Corporation, individually and
      purportedly on behalf of Technest Holdings, commenced an action in United States
      District Court, Southern District of New York entitled H & H Acquisition
      Corp., individually and on behalf of Technest Holdings, Inc. v. Financial
      Intranet Holdings, Inc. Technest Holdings, Inc., F/K /A Financial Intranet,
      Inc., Ben Stein, Interwest Transfer Co., Steven A. Sanders, Michael Sheppard,
      Maura Marx, Henry A. Schwartz, Leonard Gotshalk, Gotshalk Enterprises, Law
      Office of Steven A. Sanders, P.C. and Beckman, Millman & Sanders, LLP, 98
      Civ. 5269. The plaintiffs are purporting to act on behalf of Technest in the
      context of a shareholder’s derivative suit. The action’s principal basis appears
      to be a claim that Ben Stein, a former director and Secretary of Technest,
      wrongfully claims ownership of shares of common stock that Stein agreed to
      purchase from H&H. According to H&H, these shares belong to them.
      H&H asserts sixteen causes of action. Only some make allegations against
      Technest Holdings, Inc., Michael Sheppard and Maura Marx, former officers of
      Technest.




Technest,
      Mr. Sheppard and Ms. Marx believe that the claims against Technest, Mr. Sheppard
      and Ms. Marx are without merit and are vigorously defending the action.
      Technest, Mr. Sheppard and Ms. Marx have filed responses to the claims against
      them. The responses deny all material allegations of the complaint and the
      claim
      asserted by the transfer agent, and asserts a variety of defenses. We cannot
      make any assurances about the litigation’s outcome.





In
      June
      2006, the court directed the parties to address the court’s continuing subject
      matter jurisdiction over Technest in the H&H matter. Technest has responded
      to the court’s direction and believes that as a result of intervening corporate
      actions, the injunctive relief sought by the plaintiff which gives rise the
      court’s subject matter jurisdiction in this case has been rendered moot, thereby
      depriving the court of continuing subject matter jurisdiction. Technest believes
      that the case as currently styled is fundamentally a dispute between H&H
      Acquisition Corp. and Ben Stein.





As
      of
      November 7, 2006, Technest has not been notified of a trial date for this
      matter.





On
      or
      about May 30, 2006, Deer Creek Fund LLC filed a claim for Interference with
      Contract and Breach of the Implied Covenant of Good Faith and Fair Dealing
      against Technest, seeking unspecified monetary damages.  Deer Creek alleges
      misconduct on the part of Technest related to a proposed sale by Deer Creek
      of
      157,163 shares of Technest common stock at $7.00 per share and the applicability
      of certain selling restrictions under a registration rights agreement entered
      into between the parties. Technest believes that the allegations in this
      lawsuit are entirely without merit. Technest has been aggressively defending
      this action, and has filed an answer denying Deer Creek’s allegations and
      vigorously opposes all relief sought.





*EOIR
      Technologies, Inc.*




*Joseph
      R. Moulton, Sr.*





On
      or
      about September 16, 2004, Joseph R. Moulton, Sr. initiated a lawsuit in the
      Circuit Court of Spotsylvania County, Virginia, against Markland, EOIR, and
      our
      former Chief Executive Officer and former Director, Robert Tarini, in his
      capacity as Markland’s Chief Executive Officer. Mr. Moulton was the largest
      single shareholder of EOIR prior to its acquisition by Markland, owning
      approximately 67% of the EOIR capital stock. Mr. Moulton received approximately
      $5,863,000 in cash and a promissory note of EOIR in the approximate principal
      amount of $6,967,000 for his shares of EOIR at the closing of the acquisition
      of
      EOIR by Markland.




In
      his
      complaint Mr. Moulton asserts, among other things, that Markland and EOIR
      breached their obligations under the Stock Purchase Agreement, dated June 30,
      2004, pursuant to which Markland acquired EOIR, by terminating Mr. Moulton's
      employment with EOIR and removing him from the EOIR board of
      directors.




On
      August
      3, 2006, Mr. Moulton, Technest, Markland, EOIR and Robert Tarini reached a
      settlement agreement pursuant to which upon payment of $120,000 and the
      pre-payment of certain EOIR outstanding promissory notes, the parties each
      dismissed their claims against one another.




47


*Greg
      and Mary Williams*




Markland
      and EOIR were notified on July 11, 2005 by counsel for Greg and Mary Williams,
      former shareholders and employees of EOIR and, in the case of Mr. Williams,
      a
      former director of Markland, that the Williams’ filed a lawsuit in the
      Commonwealth of Virginia, naming EOIR and Markland as defendants, seeking
      damages in the amount of $3,000,000 regarding a number of contractual disputes
      involving the registration of shares of Markland common stock underlying certain
      options issued to the Williams’ in connection with the acquisition of EOIR by
      Markland and severance payments pursuant to severance agreements by and among
      the Williams’, EOIR and Markland. On August 3, 2005, EOIR and Markland filed an
      answer and a demurrer denying all liability. On November 4, 2005, the Court
      heard the demurrer filed by EOIR Technologies, Inc. and Markland Technologies,
      Inc. and denied it. On April 6, 2006, a hearing was held in the Circuit Court
      for the City of Fredericksburg, Virginia on the Williams’ motion for summary
      judgment. On May 4, 2006, the court granted the Williams’ motion for summary
      judgment with regard to liability on Count I of the Williams’ claim regarding
      severance payment and Count III of their claim regarding Markland’s failure to
      register shares of Markland’s common stock underlying their options. We have,
      and continue to assert that Count III of the Williams’ complaint does not allege
      wrongdoing by EOIR and thus, we believe that we have no liability on that claim.
      Count II of the claim, which seeks a declaration that the promissory notes
      issued to Mr. and Mrs. Williams in connection with the acquisition of EOIR
      by
      Markland on June 29, 2004 are in default and an acceleration of the payments
      due
      under those notes, was not addressed by the court’s order.





On
      July
      27, 2006, we entered into an agreement with the Williams pursuant to which
      we
      paid them $246,525 in satisfaction of their claims for severance under Count
      I
      and agreed to pay the outstanding balance of their promissory notes, along
      with
      all accrued but unpaid interest, in satisfaction of Count II which was paid
      on
      August 10, 2006. The Williams continue to assert claims against us for
      attorney’s fees and costs on all three counts of their complaint. Count III was
      not addressed by this agreement.





On
      September 1, 2006, we entered into an agreement with Markland pursuant to which
      we agreed to indemnify Markland against any judgment for damages or attorney’s
      fees ordered by the Court pursuant to Counts I or II and Markland agreed to
      indemnify us against any judgment for damages or attorney’s fees ordered by the
      Court pursuant to Count III.





On
      October 24, 2006, the trial of this case was continued to March 21, 22 and
      23,
      2007, at which time the damages, if any, for Count III will be determined as
      well as costs and attorney’s fees, if applicable, for Counts I, II and
      III.





In
      the
      event that Mr. and Mrs. Williams prevail in any of their claims against
      Markland, Technest shares owned by Markland would be among the assets available
      to satisfy a resulting judgment.





**ITEM
      2. Unregistered Sales of Equity Securities and Use of
      Proceeds.**





As
      consideration for an agreement with Crystal Research Associates, LLC for their
      assistance in the creation of marketing information entered into on July 17,
      2006, we issued Crystal a Warrant to purchase 200,000 shares of Technest common
      stock at an exercise price of $1.89 per share, 110% premium to the closing
      price
      of Technest common stock on July 17, 2006. The Warrant expires on July 17,
      2011.
      We also entered into a Registration Rights Agreement with Crystal pursuant
      to
      which we granted “piggy-back” and S-3 registration rights for the shares of
      Technest common stock underlying the Warrant. This transaction was not
      registered under the Securities Act, but was made in reliance upon the
      exemptions from the registration requirements of the Securities Act set forth
      in
      Section 4(2) thereof. The Warrant and Registration Rights Agreement were filed
      as Exhibits 4.15 and 4.16 to our Annual Report on Form 10-KSB filed with the
      SEC
      on October 13, 2006.





On
      October 20, 2006, we issued 20,000 shares of our common stock to each of Darlene
      Deptula-Hicks, Robert Doto and David Gust, or non-employee directors, as
      compensation for their election and service on the Company’s board of directors
      beginning in March 2006. These shares are subject to forfeiture in the event
      that the grantee is not providing services to Technest as a director on April
      1,
      2007. This transaction was not registered under the Securities Act, but was
      made
      in reliance upon the exemptions from the registration requirements of the
      Securities Act set forth in Section 4(2) thereof.





48


**ITEM
      6.  EXHIBITS**





Exhibit
                No.
            Description
            Filed
                with this Quarterly Report
            Incorporated
                by referenceForm
            Filing
                Date
            Exhibit
                No.4.1
            Technest
                Common Stock Warrant issued to Silicon Valley Bank dated August 4,
                2006.
            
            8-K
            August
                14, 2006
            4.14.2
            Registration
                Rights Agreement between Technest Holdings, Inc. and Silicon Valley
                Bank
                dated August 4, 2006.
            
            8-K
            August
                14, 2006
            4.24.3
            Technest
                Common Stock Warrant issued to Crystal Research Associates LLC dated
                July
                17, 2006.
            
            10-KSB
            October
                13, 2006
            4.154.4
            Registration
                Rights Agreement between Technest Holdings, Inc. and Crystal Research
                Associates LLC dated July 17, 2006.
            
            10-KSB
            October
                13, 2006
            4.1610.1
            Loan
                and Security Agreement for Term Loan among Silicon Valley Bank, Technest
                Holdings, Inc., E-OIR Technologies, Inc. and Genex Technologies,
                Inc.
                dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.110.2
            Loan
                and Security Agreement for Working Capital Line of Credit among Silicon
                Valley Bank, Technest Holdings, Inc., E-OIR Technologies, Inc. and
                Genex
                Technologies, Inc. dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.210.3
            Intellectual
                Property Security Agreement among Silicon Valley Bank, Technest Holdings,
                Inc., E-OIR Technologies, Inc. and Genex Technologies, Inc. dated
                August
                4, 2006.
            
            8-K
            August
                14, 2006
            10.310.4
            Unconditional
                Guaranty by Markland Technologies, Inc. dated August 4,
                2006.
            
            8-K
            August
                14, 2006
            10.410.5
            Stock
                Pledge Agreement between Markland Technologies, Inc. and Silicon
                Valley
                Bank dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.510.6
            Agreement
                relating to Certain Promissory Notes between Technest Holdings, Inc.
                and
                Joseph P. Mackin dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.610.7
            First
                Allonge to Promissory Note of Joseph P. Mackin dated August 4,
                2006.
            
            8-K
            August
                14, 2006
            10.710.8
            Restricted
                Stock Grant Agreement between Technest Holdings, Inc. and Joseph
                P. Mackin
                dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.810.9
            Indemnification
                Agreement between Technest Holdings, Inc. and Markland Technologies,
                Inc.
                dated September 1, 2006.
            
            10-KSB
            October
                13, 2006
            10.3631.1
            Certification
                by CFO of Periodic Report Pursuant to Rule 13a-14(a) or Rule
                15d-14(a).
            X31.2
            Certification
                by CEO of Periodic Report Pursuant to Rule 13a-14(a) or Rule
                15d-14(a).
            X32.1
            Certification
                by CEO and CFO of Periodic Report Pursuant to 18 U.S.C. Section
                1350.
            X






49


**SIGNATURES**





In
      accordance with the requirements of the Exchange Act, the registrant caused
      this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.




**TECHNEST
                HOLDINGS, INC.**Date: November
                14, 2006
            By:
            /s/ Joseph
                P. Mackin
              Joseph
                P. Mackin
              Chief
                Executive Officer and PresidentDate: November
                14, 2006
            By:
            /s/ Gino
                M.
                PereiraGino
                M. Pereira
              Chief
                Financial Officer







50


**Exhibit
      Index**






Exhibit
                No.
            Description
            Filed
                with this Quarterly Report
            Incorporated
                by referenceForm
            Filing
                Date
            Exhibit
                No.4.1
            Technest
                Common Stock Warrant issued to Silicon Valley Bank dated August 4,
                2006.
            
            8-K
            August
                14, 2006
            4.14.2
            Registration
                Rights Agreement between Technest Holdings, Inc. and Silicon Valley
                Bank
                dated August 4, 2006.
            
            8-K
            August
                14, 2006
            4.24.3
            Technest
                Common Stock Warrant issued to Crystal Research Associates LLC dated
                July
                17, 2006.
            
            10-KSB
            October
                13, 2006
            4.154.4
            Registration
                Rights Agreement between Technest Holdings, Inc. and Crystal Research
                Associates LLC dated July 17, 2006.
            
            10-KSB
            October
                13, 2006
            4.1610.1
            Loan
                and Security Agreement for Term Loan among Silicon Valley Bank, Technest
                Holdings, Inc., E-OIR Technologies, Inc. and Genex Technologies,
                Inc.
                dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.110.2
            Loan
                and Security Agreement for Working Capital Line of Credit among Silicon
                Valley Bank, Technest Holdings, Inc., E-OIR Technologies, Inc. and
                Genex
                Technologies, Inc. dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.210.3
            Intellectual
                Property Security Agreement among Silicon Valley Bank, Technest Holdings,
                Inc., E-OIR Technologies, Inc. and Genex Technologies, Inc. dated
                August
                4, 2006.
            
            8-K
            August
                14, 2006
            10.310.4
            Unconditional
                Guaranty by Markland Technologies, Inc. dated August 4,
                2006.
            
            8-K
            August
                14, 2006
            10.410.5
            Stock
                Pledge Agreement between Markland Technologies, Inc. and Silicon
                Valley
                Bank dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.510.6
            Agreement
                relating to Certain Promissory Notes between Technest Holdings, Inc.
                and
                Joseph P. Mackin dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.610.7
            First
                Allonge to Promissory Note of Joseph P. Mackin dated August 4,
                2006.
            
            8-K
            August
                14, 2006
            10.710.8
            Restricted
                Stock Grant Agreement between Technest Holdings, Inc. and Joseph
                P. Mackin
                dated August 4, 2006.
            
            8-K
            August
                14, 2006
            10.810.9
            Indemnification
                Agreement between Technest Holdings, Inc. and Markland Technologies,
                Inc.
                dated September 1, 2006.
            
            10-KSB
            October
                13, 2006
            10.3631.1
            Certification
                by CFO of Periodic Report Pursuant to Rule 13a-14(a) or Rule
                15d-14(a).
            X31.2
            Certification
                by CEO of Periodic Report Pursuant to Rule 13a-14(a) or Rule
                15d-14(a).
            X32.1
            Certification
                by CEO and CFO of Periodic Report Pursuant to 18 U.S.C. Section
                1350.
            X







51